Against the tide: Sustaining the unsustainable
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Against the tide: Sustaining the unsustainable

The buoyant stock market is built on credit stimuli that cannot continue until there is a recovery in the real economy – and that is still way over the horizon.

Can the present stock market rally last into the autumn and beyond? I reckon that the US economy will need to have a V-shaped recovery for the prevailing valuations of equities, oil and commodities to hold. That will not happen.

First, consumer income will be increasingly determined by wages, not fiscal hand-outs. Disposable income will fall as the hand-outs fade out of the picture. Despite the manifest profligacy of the US authorities, they cannot repeat their generosity without completely blowing out the fiscal arithmetic and then suffering a foreign buyers’ strike for US treasuries.

The latest June figures for US personal income and consumption showed the biggest fall in income in four years as government hand-outs fell out of the equation. The savings rate also declined.

Second, there is no need yet for corporations to invest because (despite the market euphoria on earnings in the second quarter of 2009), profits in the US and Europe are still lousy and spare capacity is through the roof. So the rundown in inventories, to be followed by a restocking (which is supposed to spark an explosion in manufacturing output), will be much less powerful than expected.

The leverage party
cannot be repeated.
The savings-deficit countries must see a return to thrift

Third, the credit machine is impaired and so is demand for credit. This is not only because there are piles of bad debts still to surface from consumers, commercial real estate and highly leveraged corporate players. The other key reason is that the recent improvement in bank financing is attributable to injections of central bank money. Wholesale debt markets are only dribbling finance into the banks. Is it really conceivable that the central banks will be able to double or triple their balance sheets to finance a credit-driven consumer recovery? I doubt it. Fourth, none of the core problems that caused the credit crisis have been addressed. Consumer leverage is worse now than it was then. So is bank leverage. The leverage party cannot be repeated. The savings-deficit countries (the US and the UK) must see a return to thrift, which will cap consumer spending.

Of course, this view can be wrong in any number of ways. Near 90% of the people keep their jobs and work income, so the mass of consumer purchasing power only falls by the amount of unemployment and wage decline. If the price of things (either goods in the shops or investments) falls by more than the combined contraction of household wealth and income, they become cheaper in terms of the ability of most households to buy them.

Those who don’t have cash are still busy paying down their debts. But the haves can have enough purchasing power to move the economy off the bottom. This sort of recovery is self-sustaining. Note that government has little to do with it!

Not a bang but a whimper

US corporate profits growth and industrial capacity utilization

Source: Datastream, Independent Strategy

But I do not think this natural recovery will happen (at least not yet). The reasons are that government interference has prevented prices from adjusting as they should. This holds for everything from real estate to equities and consumer products. As government solvency worsens, households will also be less willing to spend because they know they will have to bail out the government through higher taxes later. Therefore the twin springs of the natural recovery are broken. Why are asset markets going up if it is so obvious they shouldn’t be? It’s liquidity-driven. Central banks have ploughed money into financial institutions, buying up their toxic assets. The financial institutions that owned these assets now have cash. They don’t want to hold all this cash because it earns little. So they have been reallocating something of the order of $400 billion to $600 billion to equities (and additional amounts to other risk assets).

That is what is driving the rally in these assets. And it tallies more or less with the amount of money needed to move the market the way it has. This insider game between financial institutions and the central banks can go further. But it is unsustainable. When it stops, so will the rally. Any future recovery in financial asset prices will then depend on the shape of economic recovery.

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

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