Against the Tide: It’s a suckers’ rally


David Roche
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Only suckers believe that the remedies applied to the credit crisis have cured the underlying sickness. There’s more painful adjustment to come, and it could last two to five years.

There has been a recovery in risk asset markets in the past month. But this is a suckers’s rally based on the expectation that the credit crunch might be over and that there will be no systemic financial failure.

For the April fools, the credit crisis is over. The US medicine will turn the economy by mid-year. The housing overhang is fast disappearing. Europe is fine. And who cares about Japan anyway – it has been in recession for a decade. As for Asia and other emerging markets, they continue to boom. So buy, buy, buy!

However, in my view markets are ignoring the impact of the ensuing economic recession that is hitting the US and will spread globally. That will feed back into an extension of the losses in credit markets and lower financial asset prices. So it won’t be over as quickly as the market expects.

The problem is compounded by the failure of the authorities to address the financial crisis in the right way. Cutting interest rates and providing huge dollops of liquidity does not solve the issues of solvency. Rather, it debases currencies, particularly the dollar (as the Federal Reserve is the main culprit). That fuels global inflation.

Let me tell you why I think that this is the suckers’ rally oft foretold, much awaited, and now upon us. First, the state of the world economy is deteriorating. The evidence of recession is stronger in US consumer and labour markets, as well as in Japan. Distress is spreading to credit markets other than sub-prime mortgages. Default rates across a broad range of credit categories are on the rise. Money market spreads, particularly for Libor, have hardly budged, so the financial sector is as stressed as ever. And bank losses continue to mount and bank capital to be destroyed.

Number of months between peak and trough in recessions

Source: CEPR

Second, a long, slow process of liquidity contraction must follow the long, accelerating process of credit expansion that produced egregious levels of debt in almost every compartment of the global economy. The credit crisis is not about sub-prime mortgages but about correcting this phenomenon. The means of doing so is the destruction of financial sector capital that forces credit contraction and asset price falls.

The key

We have seen only the first round of that in a very small number of economic sectors, meaning big damage in a few of them. There are also substantial lags in the process of liquidity contraction and its impact on the real economy. The recession in the US labour market is only beginning now. It is the key to the next round of credit contraction.

What recession does is to create a feedback loop whereby more debts go bad and more asset prices fall. It does so because profits tank and corporations are crucial in supporting the prices of their own equity and debt. It does so because consumer incomes will fall and the increasing burden of excessive debt will mean increased defaults and fire sales of assets.

It is this feedback loop that is missing in investors’ minds. Investors think that all the pain will be over by summer. I think the process will take between two and five years. If the pain were to be over by summer, none of the underlying imbalances would have been addressed.

Liquidity contraction will continue to be driven by reduced risk appetite and deleveraging. Given the massive amount of debt now needed to generate each unit of GDP, this means less GDP.

Moreover, downturns in labour markets are of much longer duration than economic recessions. This matters enormously, particularly in the US. In the US, growth in labour incomes, equity extraction from rising asset prices, and an ample supply of credit to all and sundry are essential to the wellbeing of the consumer. Asset prices, credit losses and consumption are all wagons linked to the same train. The fiscal stimulus package will only provide a momentary blip to household income to delay this sad process. 

David Roche is president of Independent Strategy Ltd, a London-based research firm.