A New Phase in the Cycle
October 20, 2008 - Recessionary conditions are becoming more pronounced in the developed world and simultaneously reducing growth prospects in emerging countries. And inflationary pressures that were still raising concerns a few months ago are dissipating, as disinflationary forces begin to predominate.
Commodity prices continue to trend lower as demand falls. Analysts are hurriedly revising their forecasts for oil prices in a downward direction and OPEC is talking of the possible need for production cutbacks. Normally, in these circumstances, prices tend to fall even lower than consensus forecasts.
The ability of Chinese authorities to prevent growth from dipping below their unofficial eight-percent target is important for commodity markets as well as the general tenor of global growth. To achieve this goal, policymakers have taken steps to ease monetary policy and boost domestic demand. However, currently, the economy depends quite substantially on exports to sustain a high growth rate.
It seems unlikely that domestic demand can be stimulated sufficiently to compensate for the shortfall in exports. The shift from reliance on foreign markets to the local one is a multiyear project and may not have the immediate impact that policymakers desire.
We have seen lots of action from governments all over the world to deal with the financial crisis. Deteriorating conditions and the possibility of systemic failure made them bring out the heavy artillery. After a fumbling and bumbling start, the Europeans implemented the sort of drastic measures that markets were looking for. The Americans followed suit, and there were lots of copycats everywhere. As a result, the global financial system has achieved a modicum of stability, though repair work in the regions where most of the damage has occurred will take some time to carry out.
The sequence of events in the credit cycle that we have witnessed is very similar to past cycles. When credit is readily available and borrowing is cheap, all assets become inflated and leveraging is multiplied several-fold. When the bubble bursts, everything goes into reverse. Risk aversion increases substantially, asset prices are marked down and there is a scramble for liquidity. However, investors may be attracted to government bonds for safe-haven reasons and bid their price up.
Recently, Nassim Taleb observed that what has occurred cannot be classified as a black-swan event. His reasoning is that the buildup and the unravelling were fairly predictable, provided you had an independent mind - - distanced from the crowd - - and refused to listen to comforting explanations from officials.
For those unfamiliar with the relatively new entrant to the Wall-Street menagerie, a black-swan event is one that is unexpected and can have a major impact. A typical example is the 9/11 terrorist attack. Just ask the noted speculator, Victor Niederhoffer, how much it hurt his portfolio of short put-options. Taleb’s thesis is that such unexpected events aren’t that rare and, moreover, cannot be predicted by the methodology employed by banks and most hedge funds.
Ben Bernanke says that “broader economic recovery will not happen right away”. Well, that must count as quite an understatement. It is not clear who is the intended audience for such fudgy words. The reality is that we have experienced one of the biggest housing busts in US history, combined with a major financial crisis.
Households are suffering negative income and wealth effects, amid rising unemployment. We are witnessing a breakdown in consumer and business confidence. A whole system of leveraged consumption and asset overvaluation is undergoing a correction. Evidently, the economy closest to the US model is the UK. But there are, also, many other economies with housing or banking problems.
Generally speaking, what has distinguished the present cycle is its global dimension. The interconnected nature of the global economy has meant that the asset bubble occurred in many countries and regions across the world. Now that it has gone into reverse, the deleveraging and deflation is also global.
Many people sense that the consequences of the present crisis will be significant for the global economy and geopolitics for years to come. There are so many issues that we will need to analyse in more depth. Among them are: (1) the role of the government in the economy, (2) the nature and extent of regulation, (3) the future state of banking, (4) the shifts in global economic and political power. (5) government fiscal problems and its consequences. Obviously, all of the above have investment consequences, in terms of both risks and opportunities.