Of all the images associated with the still-unfolding credit crunch and economic slowdown one of the most poignant was right at the start of the crisis in September 2007. It was the scene in Kingston-upon-Thames as customers of Northern Rock took part in the first bank run in the UK since the Victorian era. This was a very British sort of panic. There was no pushing or shoving. The police were not in attendance. An orderly queue formed in one of London’s more affluent suburbs and the credit crunch changed from being an abstraction into something very real.
The effects are still being felt. In December I was in Kingston doing some late Christmas shopping. Out of curiosity I went into Woolworths. It looked as though it had been laid waste by the Golden Horde. This single British high street is a microcosm of what is unfolding in the global economy. The credit crunch started in the arcane world of Libor spreads and the seizure in wholesale markets hit a handful of relatively insignificant institutions. The canker has spread throughout the financial system and is now destroying businesses, jobs and economic growth. Last year was never going to be pleasant. This year will likely be no better.
The economic outlook is grim. Most of the developed world is already in a recession. Some economists now expect that global growth will contract for the first time in the post-war era. The IMF recently did an analysis of what happens when an economy falls prey to the unholy trinity of a recession combined with a credit crunch and a house price bust. Not surprisingly, in 122 developed market recessions since 1960, those associated with sharp credit contractions or housing price corrections are deeper and longer.
The key question for investors is how much of this misery is already in the price? The good news is that barring a debt deflation spiral that makes Japan’s lost decade look like a stroll through the cherry blossom on Mount Yoshino, the worst may be over for asset prices. Since the start of the recession in December 2007 the Dow Jones Industrial Average has fallen more sharply than in every US downturn since 1920 with the exception of 1929.
Corporate bond yields point to a post-war high in default rates. Across asset classes, prices suggest that investors believe a slump in the style of 1929–33 is about to unfold. This has become a widely held view. A consensus is always dangerous. This particular unanimity of view also looks wrongheaded. There will be no replay of the 1930s, during which US GDP contracted by 41%, or a rerun of 1990s’ Japan. A far more realistic forecast is that global growth will stay below 2% for two years before recovering in 2011.
| We may not yet have hit the bottom but we are close to it. |
Deflation will soon be shown to be a chimera. Modern, open economies, such as the UK and the US, are far less susceptible to deflation than has historically been the case. For example, UK housing prices are down 40% in dollars. For Wall Street bankers that remain gainfully employed, a stint in the UK and a house in Mayfair has rarely been so attractive and affordable. Bankers did not globetrot in the 1930s. Nor does it make sense to compare the situation now with Japan. Any visitor to the famous food hall at the Mitsukoshi department store in Tokyo will soon discover that Japan does not have an open economy. But the biggest reason of all why the world economy will not endure a debt deflation spiral is the remarkable reaction of policymakers.
The US Federal Reserve moved real interest rates into negative territory rapidly early last year. At the time it was criticized and the dollar suffered. A year is a long time in central banking at the moment. Now, most of the G7 is cutting rates and the dollar has rallied. The Fed is pursuing quantitative easing to further loosen monetary policy and push long-term yields lower. It took Japan 11 years to come up with this policy mix. By then the battle had been lost and deflation was entrenched.
This is not true in the US. Macroeconomics is all about leads and lags. The policy effect will not be felt for a few months yet. When it does, doomsayers will once more be dusting down the history of the Weimar Republic and writing about hyperinflation. However, the great thing about printing presses is that they do come with an off switch.
It has become tradition for this column to offer one investment idea for the year ahead. In 2006, emerging market equities was the asset class judged most likely to outperform. In 2007, volatility got the nod. It was always going to be difficult to better that trade and so it has proved. Last year’s selection, the iBoxx Global Inflation-Linked Bond Index in euros, has fallen 1.75%. Given how other asset classes have fared you could have done a lot worse. This year the choice is developed market equities. We may not yet have hit the bottom but we are close to it. The most sensible course of action is to buy early to avoid disappointment.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own