Anatomy of a Global Downturn
Business Times Singapore 13 February 2009
FAR from being at, or even near, the trough of the economic and financial system crisis, are we still staring into the abyss? And if things have to get worse before they get better, how much worse, and for how long? Is a 'relief rally' likely in equity markets before long? The Business Times invited a group of experts (who correctly predicted that the crisis would be far worse than most people expected) to tell us where things are likely to go from here - and what kind of investment portfolio to build against an uncertain future.
Ernest Kepper: Former official of the International Finance Corporation
and Wall Street investment banker who now heads an Asian financial consultancy
Jesper Koll: President and chief executive officer at Tantallon Research, Japan
William Thomson: Chairman of Private Capital Ltd in Hong Kong; Director Finavestment Ltd., and Advisor to Axiom Alternative Funds London.
Christopher Wood: Managing director and equity strategist at CLSA Asia-Pacific Markets in Hong Kong
Moderator: Anthony Rowley, Tokyo Correspondent, The Business Times
Anthony Rowley: We are very pleased to welcome you back, gentlemen, at this critical junction in global financial and economic affairs. I would like to start by asking each of you how far you think activity is likely to recover this year in the world's major economies, and how effective the various stimulus packages announced so far are likely to be?
William Thomson: The next few years are going to be very difficult with high unemployment, possible stagflation and social unrest - as we are seeing in Iceland and some of the Baltic nations. Already we are hearing protectionist voices and the future continuation of globalisation could be severely tested. This year will almost certainly see negative growth overall in the G-7 countries and, at best, we will see some stabilisation in the second half of the year.
But I look for a more L-shaped recovery, rather than a typical V-shaped recovery. There is a very real danger that we could be going to follow a modified Japanese scenario of the 1990s.
The outlook is extremely opaque as we are in the accelerating point of the downturn. While both monetary and fiscal policies have become very relaxed in the US, the UK and elsewhere, funds have mostly been going to recapitalise the banking systems, where they are hoarded rather than re-lent, awaiting the next set of losses and the next recapitalisation. US President Barack Obama's major fiscal stimulus has still to be passed and whilst any tax cuts will have an immediate effect, the spending on infrastructure, etc, will take a considerable time to filter into the economy.
Jesper Koll: The real problem facing global business managers and investors is not so much what will happen in the next couple of months, but what will happen in the next couple of years. Sure, tax cuts and increased public spending are poised to boost demand so that by April/May the global economy will stop contracting. But the problem of excess capacity will not be fixed. Whether in steel, cement, cars or computers, the world has built capacity to supply for 4 or 5 per cent global growth. Unfortunately that may be at least one or 2 per cent too much. So a fair bit of the global productive capital stock is poised to stay idle for quite a while. Governments' focus on supporting demand is very important, of course. But reducing supply is even more important at this stage. Creative destruction is a necessary condition for the next real recovery.
Christopher Wood: I think economic activity in the major Western economies will not recover this year.
Ernest Kepper: I'm doubtful about prospects for the next two to three years as the authorities have failed to get to grips with the financial crisis, resorting to a series of hasty measures to try and support the banking system. The money has been given ineffectually and hasn't worked. So far, the crisis is worsening and little has been realised in terms of getting the banking system working normally again. The current economic model, driven by deregulation and the financial markets, will require radical changes. The future model will have to look dramatically different.
Perhaps what we are seeing is the downside of globalisation, where a crisis that began in the United States can infect all of the world's major economies. It is this dynamic that is having a global impact because the US consumer alone has been accounting for 20 per cent of global GDP - twice that of the entire Japanese economy. Over the past 15 years, businesses in the US, Europe and Japan relocated their manufacturing capacity to places where operating costs were the lowest, for the most part being in the Asian region, especially China, making Asia the manufacturing heartland of the world. The cheap money and easy credit of the last 10 to 15 years led to a bubble in fixed investment in Asia, especially in China.
Meanwhile, what I call the abstract global financial system goes on for the sole reason that players agree on the rules - but the paper or cyber money value for these real goods has become an abstract or intellectual value, and there is no longer a direct link to real goods. These financial instruments/vehicles are so abstract that their valuation is no longer understood, and is corrupted.
Rather than increased bank regulation we need a regulatory agency to control the creation and issuance of financial instruments. This would prevent the introduction of instruments such as financial derivatives and sub-prime mortgages that do not make any positive economic or financial contribution.
Anthony: How much more trouble do you see on the financial horizon?
William: I would hope that most of the damage has been done. After all, the big institutions in the US and the UK are now mostly on state life support. The only real question is how many will eventually have to be nationalised and the form that takes. The financial sector has to shrink as a proportion of GDP in the developed world and the adjustment is going to be painful, especially in the UK, which became over-dependent on the City and financial services. There are huge uncertainties for the future. Questions such as whether investment banking and commercial banking should co-exist in the same institution need to be revisited and how the regulatory system will and should adapt. It failed miserably in the last cycle and needs to be modified to account for globalisation. One thing we can be sure of: we will not be going back to status quo ante.
Jesper: The global banking crisis is now over in the sense that all governments are committed to save depositors, prop-up money markets and, if necessary, nationalise weak banks. What remains, however, is the almost complete lack of new profit opportunities for banks. So banks will have to break up and sell those businesses that are not part of their core competence. At the same time we'll see much more aggressive consolidation of global banking and finance. How long before a Chinese bank buys a European or American one?
Ernest: No industry or institution will be spared in the downturn and the biggest impact will be felt by companies in banking, construction, entertainment and the automotive business. Government and central bank action will not be enough to save either the financial system or the global economy. If the crisis was brought on by too much borrowing and spending you can't solve it by increased government borrowing or by paying off all the bad loans with taxpayer dollars.
The economy will continue to slow down; more jobs will be lost, businesses will go bankrupt and real estate fall into foreclosure. It is doubtful that the attempts to stop this momentum will show any signs of success over the next 12 months. This is a global depression that will touch everyone.
Around the world many banks will amalgamate with each other in order to survive. The US dollar will continue to lose its value. The Obama administration's measures would provide artificial life support for the banks at considerable expense to the taxpayer, but would not provide them the margins and yield curves that enable them to resume lending at competitive rates Another ceiling on banks' growth is the danger of excessive regulation due to the large losses suffered by the general public. All this means that financial institutions and banks will be less profitable, and lose their level of importance in the economy.
Anthony: How big a 'debt mountain' are governments creating by their fiscal stimulus plans, and how will it be paid down - by the sweat of the taxpayer's brow or through inflation?
Jesper: Let's be clear about one thing: the size of public debt build-up that we are now experiencing is simply unprecedented. Basically, most major economies will see debt-to-GDP ratios double this year and most G-7 countries will be left with debt ratios well in excess of 140 per cent of GDP. At those levels, a little inflation does basically nothing to fix the problem. Only inflation rates well in excess of, say, 10 per cent or 15 per cent could start to make a dent. In other words, we are not looking at a little inflation but at hyper-inflation as a real risk. Another solution would be debt default. Either way, I expect a sharp divergence between sovereign debt interest rates in the coming years.
Christopher: We are facing a debt mountain reflecting years of above-trend credit growth. This debt mountain is deflationary, although the policy response does create a risk of hyper-inflation.
William: We are definitely in a bond bubble and the interest rates that investors are prepared to accept on long- term sovereign debt are quite irrational. The UK and the US, unlike Japan, are not high-saving economies and it seems likely that the eventual result of the debt mountains and quantitative easing, alongside the run down in commodity inventories, will lead to considerable inflation in the medium term - say, by 2011/12.
Ernest: The basic question here is, how high is the debt mountain and what is it made of? Some estimates indicate that total global debt is in the range of US$750 trillion, and the total financial derivatives outstanding are in the range of US$450 trillion. This brings up two significant underlying issues - the lack of transparency in the markets (the fact that we don't know what's going on or even who the players are), and the lack of the basis to determine the true value of financial instruments. Because of these two issues alone, we can expect a very significant transformation of the financial system as we know it.
The size of the US-dollar derivative market may never be fully revealed. However, it can be expected that the current billion-dollar bailouts of banks will lead to extensive restructuring of the global financial system without ever determining the value of many of these derivative financial instruments.
Anthony: So, are government bond markets safe any longer, given the huge fiscal deficits that are being built in the US and elsewhere?
William: The bond markets are becoming the latest financial casino. Who rationally believes that a 2 per cent yield on 30-year US Treasury debt makes sense when the country faces massive unfunded pension and other liabilities for the baby-boomers now entering retirement? US government indebtedness, including such social security liabilities, amounts to over four times US GDP as opposed to the frequently quoted sovereign debt figure of 60-70 per cent of GDP.
The US, with its miserable savings rate, is dependent on the willingness of foreign central bankers to fund these deficits. The Chinese are already nearing the end of their patience as they face losses on their holdings and enormous domestic needs. If US Treasury Secretary Timothy Geithner makes good his threat to name China a currency manipulator, then the US bond markets will face real trouble sooner rather than later. Of course, that may have been just a ploy (for Mr Geithner) to get confirmed, in which case the Ponzi finance game will continue for a little longer.
Ernest: With the financial system bailouts, US public debt has spiralled. It is expected that at some point in time foreign holders of some US$15 trillion to US$20 trillion of US paper could start asking questions regarding whether the yield is sufficient to allow for the perceived risks.
Moreover, China, the Middle East and other sovereign wealth funds may have greater priorities in funding and bailing out their own economies than investing in US paper. If these holders do lose their appetite for Treasury paper, US authorities could be forced to raise yields to a substantially high level - in the range of 10 per cent or so. China, for instance, may suffer from a severe drop in trade and foreign capital inflows. Because of its structural over-reliance on exports and manufacturing, China may be required to utilise its extensive stock of international assets to boost domestic demand and this could cause reduction in its purchases of US Treasuries. As a result, foreign demand for US government bonds could shrink drastically as the US requires increased funding for its bailout and stimulus programmes. This could lead to extreme downward pressure on the US dollar.
Jesper: Government bonds will continue to be the benchmark against which all other assets are measured. The big opportunity is to play one issuer against the other. Simply put, all governments have responded to the crisis at more or less the same time and in the same manner. This uniformity is poised to end. Cycles and policy will now start to differ from country to country, so I expect interest rate differentials to start to widen - and fluctuate - quite substantially.
Anthony: Do you foresee any signs of a 'relief rally' in equity markets or has investor psychology been so badly bruised as to rule out any forays into equities in the short term?
William: A relief rally seems quite likely before too long. The markets were severely oversold in late 2008 and we have had a tentative bounce since then. A greater bounce may require confidence that the financial crisis has been sustainably contained. However, some sort of bounce seems likely in 2009 given a historical context. After all, the 2008 declines were similar in magnitude to those in 1929 - 47 versus 48 per cent. 1930 saw a better than 50 per cent rally before the markets collapsed again to their ultimate lows in 1932 - not that I am predicting that 2010 will be as bad as 1931/2.
There are great values around at present but at the same time some securities are still overpriced based on likely earnings outcomes. The returns on carefully selected equities should far exceed that in government bonds. The main caveat to all this is the structure of US President Obama's tax changes. An increase in marginal tax rates, especially on capital gains and dividends, would almost certainly be interpreted negatively by the market and at best moderate any rally.
Christopher: Wall Street-correlated world stock markets are still overdue more for a short-term, policy-driven relief rally than that which occurred between November and early January.
Ernest: I would not put much weight on any rally because the recession will be much worse than expected. Even the IMF expects the global economy to come to a virtual halt. Any such rally would likely be the result of short-term trading or speculation. There are too many speculators in the market who buy merely on the chance that they can sell higher, and not enough long-term investors who would like to see a company's profits go up and be paid out of dividends.
If stocks can be considered cheap, that is only relative to their values over the recent past when they were grossly over-valued. Current price earnings ratios can be expected to fall well below their long-term average of 16 before a turnaround kicks in. As corporate earnings start to drop, stocks would have to fall in order to maintain a price earnings average. I would expect stocks to fall another 15 to 20 per cent before bottoming out, and don't expect any sort of serious rebound until the credit markets recover from the greatest creation of liquidity over the last 10 years that the financial system has ever seen. That will take years. Therefore, the next 12 to 24 months or so will likely be a period of a lot of confusion in the equity markets.
A model portfolio
Given the sober outlook that they envisage for the global economy and the international financial system, how would our experts recommend constructing an investment portfolio for the short to medium term?
William: First of all, the insurance position in gold remains a vital cornerstone of any medium-term portfolio. After that, diversification is the key. If fixed income is a necessity for the portfolio, then high-grade corporate and emerging market bonds would be favoured over G-7 sovereigns.
Within a US equity portfolio I believe one should get exposure to sectors that will benefit from any economic restructuring and investment in the coming years - areas such as health, infrastructure and clean energy. But I would emphasis high-quality dividend-paying companies in the US and elsewhere. I do not think the world has gone ex-growth in the medium term and so commodities still warrant exposure, especially after their extreme sell-offs since last summer. Beyond that, I also favour selected emerging market equities.
Emerging markets have been almost indiscriminately hammered as foreign cash has been repatriated and the de-leveraging story has unwound. As a result values exist there, especially in Asia. For instance, the Korean market sells for about the same as it sold for at the time of the Seoul Olympics whilst the economy in won terms is six times as large. The stock markets there, in Taiwan and Thailand sell for low single-digit multiples and around 6 per cent yields. Assuming no great reversal of globalisation, greater growth in Asia will continue and these are compelling values. The only developed market with similar values is Germany. Emerging markets are much better long-term equity investment based on relative valuations and growth potential.
Jesper: This is a great time for a stock picker, a hard time for an asset allocator. I do not think it wise to focus on so-called asset classes, bonds, stocks, or cash. Rather, all focus has to be very company-specific. For example, car companies are offering very interesting opportunities right now. It really is darkest before the dawn. A Japanese car company stock may very well do two or three times as well as a German one. But then even among the Japanese ones, one may go bust and another one move to total world domination. More so than ever, focus on stocks, on companies, on their managers and their real competitive edge.
Another thought is on the US dollar. It is tempting to be a dollar bear, given all the problems in the US. I am the opposite, more a dollar bull. The reason is simple. America's policy and corporate management response to the crisis is poised to be more focused and more decisive than anywhere else in the world. Wall Street will remain the dominant global financial centre and America will offer the most compelling investment opportunities in the world. America has become cheap, with lots of super- cheap assets now for sale. The world will start buying more aggressively into America. That's where the real value is. So the dollar should rise
Ernest: I recommend acquiring gold in whatever form. Gold was, and is, a form of cash, and it probably always will be. Paper currency, on the other hand, is a promise to redeem in terms of something else - and as national debts mount higher, the chances of default mount with it. Further, though the US prints increasing numbers of dollars, the amount of gold backing those dollars up is small - and will probably get smaller. With the dollar's value falling, people will begin to buy gold; its potential upward rise will then be unlimited. I also recommend a strong currency, such as the Japanese yen or Swiss francs, as a good place to hold liquid reserves.
Christopher: My recommended long-term US dollar-denominated global portfolio is to have 5 per cent in German physical property, 5 per cent in Japan physical property, 10 per cent in Asia ex-Japan physical property; 35 per cent in domestic demand-oriented Asia ex-Japan equities, 15 per cent in Japanese equities; 15 per cent in unhedged gold mining stocks and 15 per cent in gold bullion.