SERIOUS MONEY:FINANCIAL MARKETS have demonstrated an uneasy calm in recent weeks but the bounce in US stock prices has proved unconvincing given the lack of breadth alongside sluggish volume. The recent uplift in prices seems to be nothing more than a "bear trap" and certainly not the birth of a new cyclical bull market.
The secular bull market that began in the US more than 25 years ago under the auspices of Paul Volcker at the helm of the Federal Reserve and Ronald Reagan as president came to an end eight years ago with the collapse of the technology bubble.
Excessive money creation under the Greenspan era at the Federal Reserve, however, brought the economy back to life and growth centred on leveraged consumption and unproductive residential investment, hardly a model of long-term sustainability.
The illusion of wealth creation via rising home prices brought with it an explosion in leverage, with credit market debt reaching an unprecedented 350 per cent of GDP.
The “Great Moderation” or “Goldilocks” fairytale gave way to dislocation in subprime mortgages last summer and has since spread to the entire financial system. The “Great Unwind” or deleveraging process has begun.
The earliest evidence of this deleveraging or recapitalisation process actually dates back to 2002 and 2003 as the corporate sector put its balance sheet in order following the collapse of Enron and WorldCom. Easy money combined with financial innovation, however, enabled both the financial and household sectors to leverage their balance sheets in a reckless manner.
The financial sector’s share of corporate earnings reached 40 per cent in 2006 as against just 10 per cent two decades earlier and returns on equity exceeded 20 per cent, aided by the use of questionable off-balance-sheet vehicles.
The music has since stopped, and the financial system remains undercapitalised despite the injection of almost $400 billion in new capital over the past year.
The list of casualties continues to grow with the failure of 275 mortgage lenders and more than 70 hedge funds so far. The government-sponsored entities, Fannie Mae and Freddie Mac, are close to insolvent and unlikely to be able to withstand further declines in house prices. Systemic risk remains high.
The rehabilitation of the financial system will take years and not months as some commentators believe. Estimates of the cumulative losses arising from the debacle now range from $900 billion to $2 trillion and, regardless of which estimate proves correct, substantial equity issuance will be required to repair ailing balance sheets.
Regulation will be stepped up in response to the crisis and investment banks are likely to be required to adopt the lower leverage business model of commercial banks. Credit will remain restricted to all but the healthiest borrowers, which means that monetary policy alone will not be sufficient to propel the economy forward. This means that fiscal policy will be required to boost aggregate demand.
The surge in household debt in recent years has been well-documented, with more than 60 per cent of the increase in indebtedness since the early-1980s occurring in recent years. Seemingly healthy balance sheets are becoming less so by the day and cumulative losses could come to $6 trillion by the time house prices hit bottom.
Fiscal measures will be required to keep the consumer afloat as the simultaneous deleveraging of households and the financial sector can not be allowed to happen. Thus, the rehabilitation of the household sector is likely to be protracted.
America’s asset-based economy is in demise as debt capacity has been exhausted and there are few assets left to inflate.
Asset-price gains have outstripped nominal GDP growth for far too long, leading to an excessive build-up of debt.
Wealth, however, cannot grow faster than GDP in the long run. Indeed, economic growth theory illustrates that a market economy always requires three to four units of capital to produce one unit of output. America’s wealth-to-GDP ratio ranged from 3.2 to 3.8 until the 1990s, when it soared to almost five. Mean reversion is now in full swing and wealth gains are likely to fall below nominal GDP growth for an extended period. The secular bear market rolls on.
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