[Mb-civic] Buttonwood The ghost of crashes past Economist

Wed Dec 15 10:49:49 PST 2004

Buttonwood 

The ghost of crashes past

Dec 14th 2004 
>From The Economist Global Agenda

Your columnist signs off, wishing one and all a merry Christmas, but
forecasting a not-so-happy 2005 for the financial markets

IT HAS been an emotional time for the family Buttonwood these two weeks
past. Your columnist¹s two daughters were in a car accident, though luckily
escaped unscathed. To such trauma has been added the sort of pride that
brings a tear to the eye of any parent with an ounce of feeling: daughter
number two played Mary in the school nativity play.

As Christmas is fast approaching and this is the final Buttonwood of the
year (and the last by this columnist), readers will perhaps forgive the
sentimental segue into the rather less Christmassy topic of financial
markets, where the questions on Buttonwood¹s mind are: how can risky assets
the world over be as expensive as they are? And are they likely to stay that
way?

For reasons that will probably remain mysterious, financial markets turned
on a sixpence a little over two years ago, on October 9th 2002. Having had
their confidence shattered by a bear market‹caused in large part by the
popping of the technology bubble, a rash of corporate scandals, worries that
many firms¹ debts were much greater than they had admitted to, and the
threat of terrorist attacks‹confidence (and its handmaiden, greed) started
to replace fear as the motivating force in financial markets. The world, it
became clear, would not fall apart after all.

Moreover, many assets were historically cheap. Yields on emerging-market
bonds, junk bonds and even some investment-grade corporate bonds climbed,
and their prices correspondingly fell. Though still pricey by historical
measures, shares, especially those connected in some way with technology,
were certainly cheaper than they had been in March 2000.

They aren¹t any more. In a successful attempt to stimulate risk, central
banks around the world slashed interest rates. At the forefront of these
efforts was the Federal Reserve, which cut rates 13 times between January
2001 and June 2003, to a niggardly 1%. At 3.8 percentage points, the spread
of both emerging-market and American high-yield bonds over Treasuries is now
less than the extra yield offered by American investment-grade bonds in the
autumn of 2002. To the question of how much compensation investors should
receive for investing in risky assets, Buttonwood has no pat answer. In
2002, it is clear, they were generously compensated. In December 2004,
equally clearly, the rewards are too meagre.

But just how meagre? To be sure, the world has proved remarkably resilient
in the face of war in the Middle East, the threat of terror, a high oil
price, recently rising interest rates in America and a shaky dollar. Growth
has been robust; indeed, according to the International Monetary Fund, this
latest recovery in the world economy has been the strongest in 40 years.
Corporate profits have been growing at record levels in most rich countries.
So, it should perhaps come as little surprise that corporate default rates
have dropped precipitously and equities have been putting in a decent
performance (though they have struggled a bit this year compared with last).

And yet it does come as a bit of a surprise to this columnist. Financial
markets, after all, are meant to be forward-looking, and, barring a
miracle‹admittedly a possibility not to be dismissed lightly at this time of
year‹the prospects for the world economy look decidedly gloomy.

 The biggest problem is debt, specifically the debts run up by Americans and
their government. Though China has accounted for much of world growth in
recent years, America and its spendthrift consumers are still the bedrock of
the world economy. But they spend borrowed money. At 0.2%, their savings as
a percentage of household income have been falling remorsely for years and
are now lower than at any time since the Great Depression. The government
deficit is headed for the stars. The dearth of domestic savings means that
America has to rely on foreigners: some four-fifths of the world¹s float of
available savings is consumed by America.

One consequence of this is an American current-account deficit that is now
about 6% of GDP‹and is starting to give investors the jitters. America has
been lucky so far because it is able to borrow in its domestic currency. But
the foreign-exchange markets are becoming decidedly nervous about the
dollar. What would happen to domestic interest rates were there to be a run
on the currency?

 Presumably, inflationary fears would mount. Presumably, too, short-term
interest rates would have to rise more sharply than the Fed would like‹or
markets now expect‹to reward investors better for parking their money in
dollars. Neither would make long-term Treasury bonds an especially alluring
investment, at least not in the short term. Rapidly rising interest rates
would not exactly be a boon for consumption either. How could they be when
consumers are so indebted? The amount that Americans spend on servicing
their debts is almost at record levels, despite low interest rates. It used
to be that American consumers borrowed long term and at a fixed rate. In
recent years, they have increased the proportion of short-term debt, thereby
making themselves more vulnerable. Nowhere does this apply more than in the
housing market, which, like housing markets in many other parts of the
world, looks suspiciously frothy.

Expect, in that case, a sharp increase in bad loans, which would knock some
of the wind out of America¹s banks. Expect, too, an increase in corporate
defaults and a fall in corporate profitability‹not least because perhaps
half of all corporate profits in America come from the financial sector,
which has spewed out money in recent years thanks to benign economic
conditions and the huge difference between short-term and long-term rates.

None of this is likely to cause many smiles on Wall Street. American
investors have had to buy apparently turbo-charged assets because they save
so little. Shares are admittedly not as expensive as they were‹the average
S&P 500 stock currently sells for about 18 times its per-share earnings, not
that far above its historic average. But this is a time when you would
expect that number to be lower and falling, because only a fool would expect
the record profits of recent times to continue. With a rash of defaults
looming, corporate bonds look even worse value.

What all of this means for markets other than America¹s will depend in part
on the speed with which it happens. If Wall Street falls with a thud, other
markets are likely to follow suit. If, on the other hand, it deflates
slowly, they may not suffer too badly. Emerging-market debt looks
ridiculously expensive either way, though equities, especially in Asia, look
better value. Indeed, many Asian markets are sufficiently cheap that they
will be cushioned from the worst. They might‹whisper it‹even prosper.

 That is about all the seasonal good cheer that Buttonwood has to offer,
except to say thank you to those many readers who have written, even to
those who have disagreed with every word. The column will return in January
under new authorship. In the meantime, have a happy Christmas.

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