The Price Report, November 2007
There is little doubt, in my mind, that we are presently at one of the rare defining moments in financial history, a time that will be referred to forevermore by economic and market historians, much as is the Wall Street crash of 1929 or the credit and banking crisis of 1973-4. Until the last few weeks it has been difficult to detect that from the attitudes of investors, however. During the spring and summer, equity market bulls seemed to make a surprisingly smooth transition from being bullish because global economic growth and profits were going to be so strong to being bullish because the Fed would be cutting rates because the economy is so weak. Until recently, to the extent that the credit crisis was considered to be an important factor, there seemed to be a fairly universal assessment that it must be positive for stocks, much as the 1998 LTCM crisis turned out to be once the Fed began to cut interest rates.
An important reason why equity investors have been fairly relaxed about the credit market troubles is that they have been identified with one relatively small sector – subprime mortgages. It is easy to do a calculation based on subprime mortgages outstanding and likely default and recovery rates and conclude that the damage to the US economy should be containable. Then the problem is reduced to one of transparency and separating the losses from the good credits. That thinking is why the stock market reacted so enthusiastically to the initial write-offs by the investment banks.
Unfortunately, over the coming months investors will find out that this crisis is not really solely about subprime mortgages. It is much more serious than that. It is the beginning of the inevitable realignment of credit and wealth with incomes and accumulated savings. Classically, economic growth occurs over time because some real resources (land, labour) are freed from providing for present consumption in order to create the means for greater output in the future. This is the process of savings and investment. In a perfectly stable situation (which never happens in practice, of course) wealth will increase in line with incomes and output as the result of saving.
This is far cry from what has been happening in the US for the past several years, or for that matter in the UK and much of Europe. For the US, prior to the beginning of the ‘Greenspan bubble’ in 1995 the ratio of personal sector net worth (at market values) to GDP tended to fluctuate around an average of 3.4. Now the ratio stands at 4.1.This is despite that the US has been saving very little. Over the past four years total US personal sector assets have grown at an annualized rate of 9.3% and total non-financial credit market debt has grown at a similar rate of 8.6%. But Nominal GDP has grown significantly more slowly, at only about 6%.
The rapid growth of credit market debt – the credit bubble – has allowed for the financing of the huge imbalances between income and spending across the world. Part of this is the famous ‘vendor financing’ arrangement in which the Chinese effectively have been lending to the US to finance US residents’ purchases of Chinese goods. But another big part of it is the yen carry trade (and the Swiss franc carry trade). The financial world, and corporates and governments also, have drawn upon Japanese savings by borrowing yen to create leverage, extending the global credit pyramid further. The yen has therefore become increasingly undervalued, contributing to the result that Japanese GDP in dollar terms is no higher today than it was 14 years ago despite that the net foreign assets of Japan’s monetary system alone (i.e. the banks, the central bank and the government’s foreign reserves) have ballooned to over US$1.4 trillion.
This has been an extremely unstable macroeconomic situation, in which subprime mortgages are merely the tip of the iceberg. I have likened it to ‘financial Jenga’, after the game in which players build a tower of wooden blocks higher, until it collapses. The basic building blocks of this long game of financial Jenga have been the moral hazard created by central bank monetary policies and Asian central bank intervention, in particular the role of Japanese intervention in encouraging the carry trade, augmented by the huge mis-pricing of risk embodied in new credit derivatives. As the credit bubble built up, superficially the global economy appeared surprisingly robust. Growing imbalances were easily financed via easy availability of credit. Asset price appreciation allowed personal savings rates to be run down without impairing personal balance sheets. Consequent strong consumer spending, relative to personal incomes, allowed corporate profit share to rise, further underpinning equity prices.
This state of affairs could never have lasted forever. The global currency carry trade has resulted in high interest rate currencies becoming more and more overvalued. This has led to huge current account deficits in countries such as Turkey and economies in Eastern Europe, that have left these economies at least as vulnerable as the Asian economies were prior to the late 1990s Asian crisis. Credit growing well in excess of income requires permanently rapid asset price inflation and/or accelerating generalized inflation. This was running up against central bank tightening. Savings rates cannot decline forever either; at some stage real interest rates would be forced up. I think it was the latter that was happening in the spring. Before the big crack in the markets, real interest rates (reflected in bond yields) had been rising sharply.
In this broader perspective, subprime is merely the first part of the credit edifice to give way, not the whole story. But even for the market bears, who accept this, the investment conclusions are by no means obvious. The bears split into two camps – the ‘inflationists’ and the ‘deflationists’. For the inflationists the outlook is clear. The huge debt overhang will not be allowed to wreak havoc over the financial sector and therefore it will be inflated away. Central banks will print enough money to inflate incomes and asset prices to the point where the debt is no longer a big burden and can easily be serviced. As far as the inflationists are concerned, soaring gold and oil prices and the collapsing dollar already prove that they have won this debate.
However, in truth it is too soon to tell. The fact that stock markets are still not far from their highs and the yen has appreciated only minimally against high interest rate currencies, tell us that the ‘real’ credit bust has yet to happen – we have merely seen the opening act. When the credit pyramid begins to unwind properly, deflation will appear far more of a threat. Dramatic rate cuts in the US and Europe, which will then become necessary, will only risk unwinding the carry trade more quickly. After all, 17 consecutive rate rises in the US did little to halt the momentum of the credit bubble as it built up and it is far from clear that rate cuts will do much to stop it unravelling. Already there are clear indicators of an incipient deflation. House prices in the US are falling. In the past, whenever house price inflation has been significantly below consumer price inflation the economy has always been in recession and inflation has been set to fall. This does not square with the message from the gold price. It does square with the message from the bond markets though, and equity investors should be concerned that, as is often the case, it is the bond markets that are right.