Markets get back to business, as summer ends and reality strikes

Markets get back to business, as summer ends and reality strikes

September 1st, 2009

Well, as the punchline to a famous joke goes: “The tea break is over; on your heads.” Sell in May and go away, they say. Well, it wasn’t like that this time. Instead, it was a case of buy in May, and June, and July, and August. But the underlying story is the same. The summer is not a good time to judge things. Stock markets have this strange habit of performing oddly during those barmy summer days. But this morning it is back to work. The serious business begins. And it hasn’t been the most auspicious of build ups; markets across the world did a wobbly yesterday. While Brits were enjoying the last bank holiday of the summer, no doubt laying on the beach enjoying the rain, markets everywhere else fell precipitously. The truth is, the next few months will see a kind of stretched out moment of truth. Euphoria returned during the summer, the recession came to an end across much of the world in the second quarter, and may well have ended in the UK and US in the third quarter. But now the battle is on. China led yesterday’s plunge. Investors are fretting over a kind of “China syndrome”. The catalyst was a rumour that the Chinese state is to give some of its companies, especially steelmakers and airlines, permission to default on their derivative contracts. So it works like this. Some Chinese firms are exposed to foreign companies via derivative contracts. What do they do? Do they suffer the kind of fate seen in the West, as mortgage securitisation brought its banks to their knees? Warren Buffett once famously called derivatives weapons of mass financial destruction. We now know that he was right. But if Chinese firms are allowed to default, the mass destruction will be to foreign companies, especially banks. It is only a rumour, and one mustn’t attach too much credence to a rumour. But, what with the Chinese attitude to Rio Tinto after it refused China’s offer to buy the company out, it is worrying. This has got markets spooked. The truth is, however, there are other reasons to be worried about China. China’s recovery has almost entirely derived from a massive fiscal boost. This can not continue. In any case, if you believe the underlying cause of the recession was global imbalances, the Chinese stimulus did very little to correct this. In China, the problem before the crisis of too much investment and not enough consumption, has become even worse. Meanwhile, in the West, analysts are scratching their heads. Is this recovery the real deal? It probably depends on what you believe caused the problem. If you believe the recession is down to a perfect storm of banking errors, then yes, the crisis is near its end The economist Paul Krugman is fond of telling the story of a baby-sitting circuit in New York. Members of this circuit got a credit every time they baby-sat, which they could spend on finding another member of the circuit to baby-sit for them. But by chance, the majority of the members felt they wanted to build up more credits. So, rather than going out, they tried to do more baby-sitting. But because other members of the circuit had a similar idea, there was a shortage of people who wanted baby-sitters. So people who wanted to build up credit panicked, so they went out even less. As a result the circuit experienced a kind of recession. There was no good reason for this recession; just bad luck, and human nature compounding the bad luck. The solution was to issue every member with an additional baby-sitting credit. This created new confidence, and people started to go out again, demand for baby-sitters rose, the recession ended. A similar idea applies to fiscal stimuli and quantitative easing, of course. If the recession is down to bad luck, or perhaps banking errors, then these measures will do the trick. But if the recession is caused because debt levels rose too high in the first place, and because of global imbalances, then neither of these measures help. In fact, by papering over the cracks, they can make things worse. It is tempting to conclude that the recession is ending because the world’s economies have engaged in more hair of the dog. China is seeing more investment. House prices are rising again in the UK, and maybe are close to recovery in the US. This will no doubt stimulate consumption. In Germany, exports are helping to lift growth. In other words, all the very factors that seemed to lie behind global imbalances before the crisis have come back. And yet, according to EEF, 47 per cent of firms which took part in its latest survey reported an increase in the cost of finance from banks and other finance providers in the past two months. This compares with 44 per cent in the second quarter and 37 per cent in the first quarter. This is the highest figure since this survey was first conducted at the end of 2007. Manufacturers also reported higher costs for new lines of borrowing. And that seems to be the problem. The recovery in the UK seems to be coming from consumers, but credit for business is just as awful as before. So the UK’s own imbalances, too much consumption and not enough investment, become even deeper. This column is not against quantitative easing, per se. Globally, the deep-rooted problem really is lack of demand. Across the world consumers are not spending enough, growth in potential capacity has outstripped growth in demand. But in the UK and the US, it just happens to be the other way round. Quantitative easing is a good thing, but it is being adopted by the wrong countries. If in the UK this new money was used to lend to business, such that the UK’s potential capacity rose, then provided this was matched by a rise in consumption in China, Germany and Japan, this would be good. It is just that this recovery has too much déjà vu about it. Instead of business benefiting from quantitative easing, house prices are benefiting. Alas, it does rather appear that the global economy has not really adjusted at all. And why is that? Maybe it’s because not enough failure was allowed. Too many banks and other firms were saved from their erroneous ways by the government. If you are bailed out every time you get things wrong, you don’t learn. The fear is that the world’s economy has not learned its lesson, and if that is right, then the likelihood is that while recession ends, the prospects grow for a second recession down the line. Article author: Michael Baxter from Defaqto,to see more articles by the author go to: For financial advice call Mark or Clare at GMP Independent Financial Advisers LLP on 0207 2886400    

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