MLC Market Watch

By MLC Market Watch Team

28 Apr 2009

Bad times, drastic measures

This article appeared in the Australian Financial Review’s Asset magazine, April 2009 edition, page 36-37.

Brian Parker, Investment Strategist at MLC, explains why this global financial crisis is the worst since the Great Depression.

No-one currently invested in superannuation funds or managing funds on behalf of super fund members, or advising superfund members has ever experienced anything like the kind of financial conditions we have seen over the past twelve months. Apart from cash and nominal government bonds, every other major asset class has performed poorly. Anyone who tells you they have lived through anything like this kind of a financial crisis is either deluded, or in their mid 90s. This is the worst global financial crisis since the Great Depression.

Since they reached a peak in the latter stages of 2007, global sharemarkets have fallen by between 40% and 60%, and that’s despite a partial recovery in these markets over the last few months. Market conditions remain extremely volatile. Money and credit markets have shown some improvement, after utterly seizing up in the wake of the Lehman Brothers failure, but conditions are still far from normal.

It is my view that the US economy is going to contract sharply in 2009 – by more than the 1.7% decline the consensus is currently expecting. The consensus view would make this downturn less severe than 1982 – it looks to me like being worse than 1982. No country is immune right now. The global economy is likely to contract, and in Australia, it is difficult to see how we can escape all this without a mild recession.

There are two extra comments that I need to make about what sounds like, and is a gloomy economic prognosis.

The first is that this is likely to occur despite the best efforts of many Governments, including our own, to cushion the blow of the financial crisis by adopting a range of fiscal measures. In the US, the Obama administration has now signed into law a stimulus package, including a range of tax and spending measures, totalling nearly 800 billion US Dollars. Treasury Secretary Geithner announced an outline of a plan to rescue the US banking system, but markets were disappointed, rightly in my view, with a lack of any real detail as to how it would work.

Locally, last year’s package of fiscal measures, which put a good deal of cash into consumers’ pockets in the lead up to Christmas, has been followed by a $42 billion package of measures, now passed into law, which includes further cash hand-outs to a range of households, as well as a massive program of infrastructure spending. The Reserve Bank hasn’t been idle either. Official cash rates have now been cut to 3.25% – the lowest since the mid-1960s, and further rate cuts are likely over the coming months. My best guess at this point is that cash rates decline by a further three quarters of a percent to 2.5% over the remainder of 2009. While all of these measures will help cushion the economy, they won’t be enough to prevent consumers from slowing their spending significantly, and won’t stop a further rise in unemployment.

The second comment about the economic outlook is this: a good deal of that bad news, and maybe more, is already reflected in market pricing. Financial markets tend to be more forward looking than any economist, any analyst, or any piece of economic data. They have weakened significantly in advance of this recession and are factoring in a global recession, and a very sharp fall in corporate profits that will inevitably result. Whether equity markets are factoring in enough of a fall in earnings remains an open question. At the very least, opportunities are emerging, and many of the world’s best investors are not selling right now – they’re buying. Moreover, just as equities weakened before the economy did, it is also the case that equity markets tend to recover well before the economy does, and I suspect that this time will be no different.

In credit markets, after the dramatic sell-off last year, the yields available on corporate bonds are extremely attractive. It’s virtually certain that the percentage of companies that are going to default on their debt will inevitably rise as the world recession deepens. However the yields on offer in these markets look to be pricing in a level of corporate defaults that is at least as bad, or worse, than the kind of defaults that occurred in the Great Depression!

There isn’t any point in me or anyone else for that matter, sugar-coating this: this is the biggest financial and economic crisis we have seen since the 1930s. However, every crisis, every recession, every bear market, comes to an end, and this one will be no different. Before it does end, a crisis throws up opportunities, and this one is also doing just that.

There have been some positive developments in recent months, both on the policy front and in markets, but we’re not out of the woods yet. The economic news is likely to get worse before it eventually, and inevitably, gets better. In the meantime, we need to see a genuine and detailed plan to fix the US and global banking systems, and we have yet to see one. We can’t have sustainable economic recovery without fixing troubled banking systems. Such a plan probably needs to involve measures that were previously viewed as unthinkable, including the temporary nationalisation of a number of banks in the US and elsewhere. This is not to say the entire system needs a Government takeover – there are a number of banks that have been well-managed, and can see this through with little or no Government aid.

Nationalisation is anathema to both the US public and politicians – it’s the kind of thing that happens in the old Soviet Union (or worse still, France!) However, if taxpayers are going to be asked to fund any plan to fix the banks, then taxpayers, and not current bank shareholders, boards, and senior management, should get the lion’s share of any eventual upside. To ask Joe Public to hand over a lazy trillion dollars, and then allow banks to go on their merry way is frankly immoral. Even a number of Republican members of Congress have acknowledged that nationalisation has to be on the table – even if only as the least unpalatable of the unpalatable options available.

When sharemarkets and the economy do begin to recover, there will still be issues to deal with.

Over the next year and beyond, the US (and other) Governments’ call on world bond markets is going to be huge. If the private sector’s demand for credit remains weak (which it quite likely will for a while yet) then perhaps public borrowing requirements can be met with little upward pressure on what remain historically low long bond yields. However, as the economy recovers, private demand for credit is going to increasingly collide with enormous public borrowing. It is difficult to see how government bond yields can remain as low as they are in that environment.

In their efforts to kick-start money markets and ensure that banks have sufficient liquidity, the world’s central banks have injected staggering amounts of liquidity into money markets. Once recovery takes hold, that liquidity could find its way into the real economy, and fuel inflation, unless central banks drain it from the system in a timely manner. Then again, higher inflation might be just the right medicine in a world that fears deflation and needs to bring down the real value of debt.