Year of fears leaves trail of deflation despondency

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Few capital markets participants will be sorry to see the back of 2002. Fear dominated the year: fear of more terrorist attacks, fear of the consequences of a war against Iraq, fear of more corporate scandals, fear of losing yet more money, fear of losing one's job, fear of going to jail.
And by the end of the year, another fear had taken hold of financial policymakers, a fear that will dominate the markets for months to come. It is the fear of deflation.
That's a familiar, sickening feeling in Japan but one that has only recently seized politicians and central bankers in Europe and the US in its icy clutch. Even now they can barely bring themselves to name this prospect, like patients who instinctively recoil from even breathing the word "cancer" lest they should, by doing so, bring the dread condition on themselves.
The consequences of deflation for highly indebted companies in the US and Europe would indeed be fearful. It would wreak havoc in financial markets that would make last year's wrenching volatility seem a tame prelude. That's why the world's financial leaders are now fully focused on the threat - even while portraying it as a distant one.

It may well be distant. But it is undoubtedly to ward off this horror that the Federal Reserve and the European Central Bank cut interest rates at the end of last year. For that reason too George W Bush decided he could dispense with the services of any financial and economic adviser still resisting fiscal expansion in the name of namby-pamby deficit discipline.
And there is another gnawing fear. Though policymakers look strong when acting in unison to cut interest rates to boost growth and prop up markets, any similar synchronized attempt to devalue their own currencies - and strong arguments are being advanced that the dollar, the euro and the yen must all weaken - might have potentially dire outcomes.
Although faith in the Federal Reserve is diminished, it is not yet extinguished: not judging by the rise in the major stock market indices during November and early December that followed the Fed's 50 basis point rate cut to a 41-year low - a cumulative cut of 525bp in the past two years.
Yet the investment banks' market strategists clearly have no idea what's going to happen next. For every Pangloss calling for 18% equity returns this year, there's a doom-sayer calling for a decline of similar dimensions. There's no indication yet that corporate America is in robust health. Third-quarter 2002 earnings were stale; they were above sell-side analysts' estimates but these had already been downgraded several times. Few, if any, executives felt able to present rosy outlooks for the fourth quarter or the first quarter of 2003.
The big question facing many companies is how to deal with the pension and healthcare deficits that have built up as returns from the markets have fallen. A recent Merrill Lynch survey (Decomposing pensions) estimated that the 348 companies in the S&P500 that run defined-benefit pension plans would have had a combined net liability of between $458 billion and $638 billion at the end of 2002. That's going to need some creative solutions, and ones that won't be regarded as suspect or simply dodging tax or accounting rules.
How can banks plan for such an uncertain year? Investors clearly favour retail banks with no exposure to investment banking. They'll be OK, unless of course unemployment spikes, the value of real-estate collateral collapses and consumers start to default. For investment banks most of the upside this year will probably once again come from proprietary trading within the ranges. Some customers will risk the wrath of shareholders by seeking to issue new equity to repair their balance sheets. But most will avoid new debt-financed investment and conserve earnings to reduce liabilities. That's not a blueprint for joy in the debt markets.
For M&A specialists banks could be their own best customers. Last year ended with two large deals - HSBC's bid for Household and Crédit Agricole's for Crédit Lyonnais. It's not clear that either will succeed, but they highlight the likely increase in corporate restructuring in the financial world.

The US treasury market reaches breaking point

Abigail Hofman:

Year of fears leaves trail of deflation despondency

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