By Andy Xie, guest economist to Caijing and board member of Rosetta Stone Advisors
False hope built on government stimulus measures may feel good today, but it will only delay necessary reforms.
Stock markets have roared back since their early March lows: by April 17, the S&P 500 was up 23.7 percent, FTSE 100 16.5 percent, HSI 37.5 percent, Shanghai A 20.8 percent and Nikkei 26.3 percent. Even American banks, the epicenter of the financial crisis, are reporting good earnings. The U.S. president is talking about silver linings. Fed Chairman Bernanke is seeing “green shoots.” Japan just announced another fiscal stimulus package. The market is expecting a second Chinese stimulus. Suddenly, it feels like you must get in now or it will be too late.
But this is a bear market bounce that will end in tears. What will bring it down will be the likely torrent of new issues. Banks that report good earnings and speak about recovery will probably try to raise massive amounts of capital, taking advantage of the market rally, to weather the long winter ahead. IPOs will swamp emerging markets. Money flowing from bullish investors will become the winter clothing for distressed banks and companies.
Indeed, the placement torrent may have already begun, and this bear rally may end within a month or two. There could be another bear rally in the fall due to the encouraging economic news. That rally will end when (1) the economic recovery proves unsustainable and economic indicators dip a second time, and (2) inflationary pressures tick up, forcing central banks to tighten despite weak economic conditions. Asset prices will hit their final bottom, probably in the second half of 2010, when fiscal stimulus funds are exhausted and central banks are unable to print more money.
In the beginning of 2009, I predicted a bear market rally in the second and third quarters. Revising that prediction, I now see two bear rallies in 2009. We are in the middle of the first. Private placements and IPOs will bring it down. Improved indicative economic news in the third quarter may spark another rally. In my previous article, I expanded my economic outlook to predict the second dip in 2010.
Fear has dominated financial markets since the sub-prime crisis began in the summer of 2007. Rallies were brief, mere backdrops to deeper market plunges. The latest rally, in the past five weeks, has been the longest. As it went on, it pulled in more and more skeptics. But I sense desperation among the bulls. The other day a CNBC host in the U.S. nearly kicked out a bearish guest who expected “waves of financial crises to come.” When I told an acquaintance that Hong Kong property prices will drop substantially, he furrowed his eyebrows and said emphatically that Hong Kong people had holding power. Faith rather than evidence is what’s keeping the bulls going.
But the big test for the market will come when companies begin to issue stocks for cash. It began with Goldman Sach’s US$5 billion offer of common stocks right after its ‘good’ earnings announcement. The odds are that other global financial institutions would do the same, all in the good name of repaying the government. (But if they are in good shape, why would they need to raise money to repay the government?) In emerging markets too, IPOs will begin soon, ending nearly two years of drought. IPOs are what emerging markets are all about, as their underlying economies are hungry for capital.
When the IPOs hit the markets, investors should think about why businesses want to raise money. The global economy is unlikely to be strong in the foreseeable future. Businesses shouldn’t need capital to expand. The likely answer is that they are preparing for lean times ahead. I suspect businesses making optimistic noises in public are, in fact, still bearish about the future. As long as the market remains buoyant, they will take advantage of the opportunity to raise money. The supply of stocks will eventually overwhelm the market.
The bull case is built on three assumptions: (1) the market decline is already deep enough; (2) the global economy is either recovering or about to; and (3) more government stimulus money is coming, should there be more trouble. The bear case rests on: (1) this is a debt crisis, the debt levels are still too high, and the global economy can’t resume growth until debt levels recede to normal; (2) the world economy is still shrinking, though at a slower pace; and (3) government stimulus can’t start another growth cycle as the global economy must restructure itself first.
I am in the bear camp. The bull case is really based on comparing the current recession with other recessions in the past half-century. However, this is a once-a-century recession. The only comparable one was the 1930s Great Depression. For a new growth cycle to begin, two conditions must be met: (1) debt levels, relative to income, in consuming economies (U.S., U.K., Australia, Ireland, Spain, etc.) must return to levels prevailing two decades ago, and (2) the manufacturing export economies (China, Germany, and Japan, etc.) must become significantly less production-oriented.
The debt crisis is far from over. Just look at the U.S. financial sector debt – the source of all problems in this crisis. It has not come down, despite all the talk about deleveraging. It stood at $17.2 trillion at the end of 2008, higher than $15.8 trillion in September 2007, when the crisis began. Even though it can’t borrow from the market like before, it is borrowing from the Fed and the government. How could we say that the crisis is over when the U.S. financial sector’s leverage hasn’t declined?
The economic fallout of the debt bubble bursting is just beginning. By the end of 2008, households’ net wealth in the U.S. had declined by $13 trillion or 20 percent from its peak in 2007. U.S. property prices are still declining. The odds are that the value of all residential properties in the U.S. would decline by another $5 trillion or more before stabilizing. On the other hand, U.S. household debt has not fallen. It stood at $13.8 trillion at the end of 2008. For the first time since the 1930s, aggregate household debt would exceed the value of the property that households own in the U.S. Obviously, borrowing against property to fund consumption is no longer possible.
Income prospects look very poor. Unemployment is rising rapidly in the U.S., Europe and Japan. As the credit-funded portion of global demand vanishes, the labor force behind it loses their jobs. As the unemployed curtail their consumption, the multiplier effect pushes unemployment even higher. This vicious cycle is yet to reach its natural peak. The impact of rising unemployment on demand may last through 2010.
Many who argue for a bull case are actually hoping for another bubble. The thinking is that if enough people believe in the bull case, their money keeps it going, rising asset prices support demand growth, corporate earnings improve, and the bull case is validated. The hope for another bubble is widespread in the world today. Even policymakers are secretly hoping for another bubble. They all remember how good life was during the bubble. The crisis has weighed down on everyone’s spirits. It seems that “doing the right thing” is just too hard.
Bear rallies emanate from psychological leftovers of bubbles. When a bubble stays around too long, most begin to view it as the norm. When the bubble bursts and the pain becomes unbearable, most pine for the “good old days.” Their collective action causes a rally that creates the illusion that the bubble has returned. But a bubble, after bursting, can never be brought back. If you blow air into a balloon with a hole, it can puff up if you blow hard enough but as soon as you stop blowing, it deflates again, to nothing.
Governments and central banks are trying hard to stop asset prices from falling. The hope now rests on government bailouts. Interest rates are near zero and budget deficits are at scary levels. When inflation rises, it will close the door on more government bailouts. When the last hope is gone, asset prices will truly bottom. I think this will happen in 2010.
Some argue, why can’t we revive the old bubble or start a new one? The problem is that after a bubble has lasted several years, its bust leaves so much rubbish around that a new bubble cannot take root. For example, high levels of existing debt make further debt growth difficult. Without debt, a new bubble would have no legs. The economy needs time to recover before it can support another bubble. If you are waiting for another bubble to bail you out, I am afraid it’s going to be a long wait.
Human psychology is surprisingly susceptible to a collective change in mood. Herd mentality is a well recognized but unproven psychological phenomenon. A person is more likely to believe in something if people he or she knows already do. The safety-in-numbers behavior is often observed in the animal kingdom. While crossing the African savanna, migrating wilder beasts cross crocodile infested rivers together. The idea is that the crocodiles can eat only one wilder beast at a time. When many cross at the same time, only one will be eaten, and the rest can cross safely. It seems that many succumb to the herd mentality to handle risk in the financial world. Bubbles appear repeatedly in human history, despite the setbacks they cause, because the herd instinct remains deeply rooted in our brains and takes control when the environment permits.
When wilder beasts cross a river together, the advantage is real. If they cross separately, they give more time to crocodiles to eat them. For this advantage to be realized, a herd of wilder beasts needs a leader, someone who begins the rush. The first one to go has a higher probability to be eaten. Hence, in this case, irrational behavior, though not advantageous for individuals, is good for the group. The evolutionary advantage of such irrational behavior for the collective well being is the reason it is so prevalent in the animal, as well as human, world.
Similarly, some bubbles are actually advantageous for economic development. For example, the IT bubble created and perfected technology that is still benefiting the world today, even though those who invested in it lost their money. Those who thought IT would make them rich are like the head of the wilder beast herd, unknowingly sacrificing themselves for the common good. Most technology-driven bubbles are like that: good for the world but bad for investors. Joseph Schumpeter’s theory of creative destruction is about such bubbles. Because so many bubbles are not harmful, governments and central banks have taken a cavalier attitude towards it.
From time to time, a huge bubble of productive assets builds up. In most cases its consequences are devastating. The global property bubble falls into this category. Derivative products – another class of unproductive assets – hid leverage behind the property boom and made it bigger than any other in history. The debt accumulated for building unproductive assets caused widespread bankruptcies (e.g. the U.S. in the 1930s), hyperinflation (e.g. Germany in the 1920s), or massive government debt (e.g. Japan in the 1990s). It takes a long time, and a productive debt bubble, to heal the wound.
The pain so far is acute but not depression-like. The reason is government stimulus measures are helping businesses and households stay afloat despite their insolvency. As governments exhaust their fiscal and monetary firepower, they are trying to verbally improve investor confidence, hoping that asset markets will improve and economies will follow. Such verbal stimulus is indeed having an impact.
For example, the U.S. government is conducting a stress test on the banks. The test is a scenario analysis, i.e. whether banks can survive the downturn under different possible scenarios. I am sure most banks would ‘pass’ the test with flying colors, but this is self-deception. The U.S. financial system is technically bankrupt. The strength of a banking system reflects the strength of the economy it serves. Just look at the balance sheet of the U.S. household sector. How could U.S. banks survive when so many of their customers have negative equity?
Such confidence tricks are significantly impacting sentiment and financial markets, but they can’t reverse the trend. Property prices are falling and unemployment rates are rising across the world. Temporary euphoria in financial markets cannot reverse that. Reality will eventually extinguish the irrational euphoria. Once inflation rises, it will close the final door of hope – the government bailout. Interest rates can and will rise despite badly performing economies. Only then will asset prices truly bottom out.
The false hope today may feel good but it only delays necessary reforms. It actually makes things worse. As governments spend money to revive the past, they won’t be left with money required to ease the pain caused by structural reforms in the future. The world is behaving like a bankrupt drug addict, spending welfare checks to feed an addiction. Once the checks are all spent, the addict has to go cold turkey to kick the habit.