The credit crisis is not over. The move by the Federal Reserve to flood the US credit market with liquidity through its new-fangled term auction facility and term securities lending facility is innovative in its attempt to get credit markets moving again. However, it will fail. The depth of the defaults and the breadth of the crunch are too big for the Fed to absorb.
Indeed, in terms of the hit to the capital of the financial institutions that have invested in the great global asset-backed securities boom, we are not even halfway through the crunch.
The US housing slump and the continuing falls in house prices in Europe have already led to heavy losses in the sub-prime mortgage market. But there are more shoes to fall in the consumer and corporate debt markets as well as in credit insurance instruments. And as the global economy slows, defaults and losses will mount.
Global liquidity is already contracting because securitized debt markets (both asset-backed debt and synthetic debt using derivatives) are shrinking rapidly. Eventually, bank credit will also contract and, with it, so will the global economy.
During the period of economic contraction, financial asset prices previously boosted by cheap leverage will fall. Risk appetite drives leverage, and leverage is the source of the vast majority of liquidity in the New Monetarism framework.
My estimate of the hit to the financial sector from dud assets has changed very little since we started weighing up the figures many moons ago. When all is done I expect total losses of about $1.4 trillion globally, or 2.5% of world GDP. Of that, more than $600 billion (or one-third) of US and EU banks’ tier-1 capital will have been destroyed and as much again of the capital of non-bank financial intermediaries.
NBFIs’ vicious circle
The new factor in this period of liquidity contraction compared with its predecessors is the role of the non-bank financial intermediaries (NBFIs). Their balance sheets have ballooned to nearly half that of the commercial banks.
The balance sheets of NBFIs are far more volatile than those of banks. They seek to maintain leverage at a fixed percentage of assets. Therefore, when asset prices fall, NBFIs tend to rein in credit to a larger extent than the banks. By doing so, they drive asset prices down. That in turn forces them to curtail credit further. This reinforces asset price declines by destroying asset money in the periods of liquidity contraction, just as it does the opposite when liquidity is expanding.
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Losses from the credit crisis |
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To date |
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Source: Datastream |
This process of credit contraction has not yet begun in earnest. I reckon bank credit globally will have to contract by up to 15% to 20% from peak levels, and liquidity (as we have defined it) will have to fall by up to 7% to 8% to re-establish tier 1 ratios at pre-crisis levels.
When it does, the real economy will start to feel the real pain. And most risk asset prices will fall further. We don’t reckon there will be a 1929-style Great Depression. Rather, the cycle will take the form of a long U-shaped period of low growth and poor price performance for most financial assets set by deleveraging.
And every recession creates a bear market in equities. Financials and consumer-related sectors are already suffering. Resource stocks will also eventually suffer as global growth slows. We’re likely to see a further 15% to 20% decline in equity markets.
Global equities might be cheap relative to bonds. But that’s partly because bond yields have been historically low in the era of disinflation and partly because corporate profits have been at record highs.
Corporate profits are now declining and, led by the financials, corporate balance sheets are beginning to deteriorate. I expect a 40% peak-to-trough drop in earnings per share. European profits might hold up longer but equity prices won’t. Don’t expect much in the way of decoupling.
The defensive areas are healthcare, telecoms, food and beverages. Sectors related to climate change are the strategic plays.
David Roche is president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com