Against the tide: All this optimism is depressing


David Roche
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This year is not set to be one of economic recovery – the financial assets that are cheap are cheap for a very good reason, and it’s not a propitious one.

I am depressed by all the optimism. The story runs that 2009 will be a good year because assets are cheap, cash is piling up on the sidelines and 75% of the credit crisis is over. But it seems to me that the lessons of the credit crisis are the hardest for investors to learn. And they have not yet been learnt.

In my book, 2009 will be a bad year punctuated by sharp rallies in risk assets. For a start, let’s deal with the story of cheap assets. Equities can be construed as being cheap because markets have fallen. Debt, to all but the beneficiaries of bailouts and governments themselves, is horribly expensive for the same reason. Triple-B corporates in the US are paying nearly 10% for their borrowing, and high-yield corporate bonds still trade close to 20%. It is a tough call to consider equities to be cheap unless this changes; what corporation can make money for shareholders if it has to pay creditors rates equal to many times the return on capital?

Tired argument

The other tired cheap-equity argument is that dividend yields are higher than yields on government bonds. So they should be when profit and dividend growth are likely to be negative or terribly low. After all, corporations are riskier than governments and thus have to pay more. If profits don’t grow, the dividend yield must rise above government bond yields to achieve that.

Equities don’t look cheap if a prolonged downturn in profits is the future for corporates. For example, based on analysts’ consensus forecasts of earnings for 2009, which in my book are still too high, the S&P is trading on a P/E ratio of 22 compared with a long-run average of 15. This does not look like a realistic assessment of the profit growth that will be.

Nor is it likely that piles of cash are building on the sidelines ready to re-enter the market. It is more likely that the cash raised (around $500 billion by households in the US last year) is being applied to reduce leverage. Every major household deleveraging period is marked by reductions in financial assets and rising savings rates being used to pay down debt. This is hardly a world where tidal waves of money are building up to buy the market.

In my book, 2009 will be a bad year punctuated by sharp rallies in risk assets

A greater misunderstanding still is the view that the credit crisis is 75% over. That’s about right as a figure for the percentage of write-downs of credit losses that we see for the cycle as a whole. But that doesn’t mean credit will not continue to contract for at least another year. Banks still need more capital than they have succeeded in raising in order to resume lending at anything like the rates that would support positive GDP growth. Banks will have to operate at lower leverage ratios than before. This means they will shrink their balance sheets. And worse, demand for credit, rather than supply, is now what will drive credit contraction because corporate investment is shot and the consumer is changing his mores from leverage to thrift.

Nevertheless, the spectacle of money being thrown at the credit problem by central banks and governments is now so universal and indiscriminate that it will have long-term consequences. The immediate consequence is that there will be no economic recovery this year. Markets are factoring in a rebound in the second half. They won’t get it. When recovery does come, secular growth rates will be reduced because of resource misallocation. The US will emerge from this crisis with a potential growth rate of 2% or less, compared with 3.5% over the past decade. This will put the US growth rate about 0.25% to 0.5% behind Europe’s and close to that of Japan.


Equities might well rally on the stimulus announcement from president Barack Obama but then struggle, as corporate earnings and macro data disappoint. This year, I suspect that more money will be made in credit markets than in equities – particularly corporate debt markets, where we expect spreads to narrow. Emerging market sovereign risk spreads are likely to widen substantially and their currencies weaken. For emerging markets, weakening external accounts and big problems rolling over private sector foreign currency debt will drive this process.

OECD government bonds will do badly despite their current safe-haven status. And the dollar will pay the price of the US government’s excessive funding needs, which will more than offset any increase in household saving.

Commodity and energy prices might stabilize at low levels but the benefit to corporations and consumers will accrue to balance sheet restructuring and not be used for shopping sprees.

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