Bracing for a year of brutal trench warfare

There was palpable relief as at the end of 2008 the ‘financial’ crisis moved into the ‘real’ economy. Commentators could move to the relatively familiar language of ‘recessions’ and ‘depressions’.

The arcane minutiae of securitised debt, derivatives and toxic three letter acronyms (ABS; CDO; MBS; SIV; CDS etc) could be left behind Familiarity, no matter how terrible, is comforting.

Markets are hoping for stability and the shoots of recovery in 2009. There are reasons for caution.

Banks continue to be in the intensive care unit and on life support. Further losses, more bank failures, a bleak earnings outlook and difficulties in raising equity and funding will mean the need for continued state largesse. Some financial institutions are clinging to state led “no bank left behind” equity programmes for survival. The creeping nationalisation of many banking systems is probable.

Financial system balance sheets will continue to contract reducing the availability of funding and increasing the costs of funds. “Loan” and “debt” are now four-letter words.
Substantial losses in investment portfolios of insurance companies, pension funds, asset managers and endowments will emerge.

A combination of investor redemptions and unavailability of leverage will result in gradual liquidation of a significant portion of the hedge fund industry.

The sharp decrease in debt levels is driving reduction in growth pushing most major economies into recessions or near recessions. The financial headlines scream “de-leveraging” at every turn. Companies are cutting production, reducing staff and costs, suspending investment plans, raising equity and trying to sell assets to reduce debt.
Consumer spending is falling sharply as individuals increase savings and reduce debt.
Falling investment earnings and lower interest rates also adversely affect the income of savers reducing consumption. Increasing unemployment (as companies retrench) and lower investment (as global demand collapses) mean the chance for a quick recovery is receding. Emerging markets have not “decoupled”. China and India have slowed sharply. Russia, Brazil and the Gulf are also facing a slowdown as commodity prices fall sharply in the face of slower global growth. Global trade is also slowing. The de-leveraging may claim further casualties. Over 71% of debt outstanding as at 2008 was rated non-investment grade. This compares with less than 30% as at 1980 and less than 50% as at 1990.

Companies that have taken on debt to finance acquisitions will face challenges in refinancing debt. Many private equity transactions, undertaken on aggressive terms, may be unable to service its debt commitments and will need to be restructured or will default.

The central banks have flooded money markets with liquidity. The money unsurprisingly is not flowing through into the economy. Banks are stockpiling the cash or using it to purchase government bonds.

The money is needed by banks to finance around $5-10 trillion of assets that are returning to bank balance sheets from the off-balance “shadow banking” system. Banks also need to refinance substantial amounts of maturing debt and meet contractual payments to corporations who are drawing down credit facilities. Banks are reluctant to lend as the real economy slows with rising unemployment and lower corporate earnings. Banks also lack the risk capital to make loans.

Central banks, in some countries, have moved to re-capitalise the banks and have guaranteed bank borrowings. This provides the banks with expensive capital and funding. It is difficult to see that these steps will be sufficient to arrest a sharp decline in the balance sheets and credit creation capacities of banks.

In 2008, aware of the massive de-leveraging of the financial system, credit markets bought government bonds anticipating slower growth and lower interest rates.

Equity market, at least initially, viewed lower rates as supporting growth and to corporate earnings. By late 2008, equity markets saw low rates as symptomatic of low growth prospects and declining corporate earnings.

Equity market did not react positively to the announcement from the US Federal Reserve that it will adopt a zero interest rate policy. Equities remained weak even as interest rates continued to decline.

The experience of Japan is salutary. Zero interest rates and doses of fiscal medicine have not restored the health of the Japanese economy that remains mired in a form of suspended animation. The rest of world is struggling to avoid turning ‘Japanese’.

The health of the financial system and the extent of the slowdown in the real economy remain key concerns.

The financial sector bailouts (carmakers are apparently now banks!) and government spending have converted a private sector problem into a public sector financing problem. High levels of public debt in and poor fiscal positions of some countries mean that the spending may be difficult to finance.

The continued heavy reliance on savers in Asia, Europe and the Middle East is increasingly problematic given emerging problems in these countries that may limit the funds available. At a minimum the increased issuance of public debt risks crowding out other borrowers. The problem is most acute for the US. In late 2008, Akio Mikuni, president of Japanese credit ratings agency Mikuni & Co, suggested that Japan should write-off its holdings of Treasuries because he believed that the US government would struggle to finance increasing debt levels let alone repay the borrowings. He suggested that debt forgiveness was the only way out of the problem.

These pressures have manifested themselves in the currency markets. The last weeks of 2008 saw astonishing volatility in the euro/$ rate which moved between $1.3356 to $1.4719 (10.2%) in less than one week.

The risk of deflation (falling prices) is creating another massive asset price bubble in government bonds. Investors concerned about recession and deflation have purchased long maturity bonds driving long-term interest rates to unprecedented levels. A rate less than 3% pa for 30 year US government debt appears inadequate compensation for the risk entailed.

The coming year may see new phases in the financial crisis as the world continues to aggressively reduce debt. This will result in a sharp reduction to sustainable growth rates. $4 to $5 of debt is required to create $1 of growth. Approximately half the recorded growth in US over recent years was driven by debt primarily from mortgage equity withdrawals. As the level of debt in the global economy decreases, attainable growth levels also decline.

In effect, the world used debt to accelerate its consumption. Spending that would have taken place normally over many years was squeezed into a relatively short period.
Business over invested misreading the demand and assuming that the exaggerated growth would continue indefinitely creating significant over-capacity in many sectors.

A lower growth future has political and social implications. China and India are deeply concerned about failing to provide jobs for the millions coming into the workforce each year.

As in Genesis, the “years of plenty” have ended. The improvident wasted the bounty of the years of prosperity and now find themselves in want in the “years of dearth”.
2008 was the year of “shock and awe”. 2009 may well prove to be a year of grim and brutal trench warfare as the world adjusts to a new economic order and reduced expectations.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall)