Assessing the damage...

Cees Bruggemans, chief economist of FNB, gave his assessment of the costs of the financial crisis in one of his weekly commentaries published on the 24th November 2009. Here follows excerpts from the article:

The original focus was very much on financial asset losses, with estimates in the trillions of dollars, and equity markets tanking with losses in the tens of trillions.

But though the financial asset losses were painful and real (ultimately some $2.5 trillion worth, of which three-quarters by now written off, yet questions remaining whether global toxic assets really have been fully dealt with), the equity paper losses have already been mostly erased as markets bounced sharply in 2009.

The global output forever lost in 2008-2009 probably amounted to $3 trillion, with at least twice that opportunity loss still to be counted through 2015-2020.

The agonising pain deluged on bank shareholders and managements, hedge funds and insurers, especially in large parts of the West, has been on vivid display throughout. But this was ultimately only a small sliver of humanity facing the piper.

Much larger numbers of people ultimately paid a major price because of the financial failure of preceding years and the manner in which the financial crisis hit the global economy broadside.

The number of US housing foreclosures runs in the many millions. A much larger multiple lost their work and livelihood. So far, some 8 million private sector jobs have been lost in the US alone, a number that will still climb by another 1 million through Easter 2010. To this must be added another 1 to 2 million discouraged workers ceasing to look for work and falling from view. And we must then still incorporate the substantial shortening in US working time, going by temporary workers and reduced working hours. And then we must still allow for the 1-2 million youngsters newly added to the labour pool during 2008-2009 for whom there was little scope overall.

This amounts to a lot of pain in a 150 million workforce, where nominal wage increases are currently minimal and bonuses mostly reduced, heavily constraining household income. Together with tightened bank credit and terms, and consumer unwillingness to take up new debt, it paints a picture of a weakened colossus.

In the years ahead, policy action in the US and elsewhere is geared to get financial markets functioning normally again, extending credit to creditworthy customers, but also to support effective demand, thereby gradually restoring business confidence in the future and a willingness to take risk and resume investing (and hiring) more boldly again.

Yet it will be slow going. Not only are employers fiercely intend on improving productivity (and repairing their bottom lines), thereby allowing GDP and national income to expand, but they prefer doing so without rehiring of new labour, at least in the short term.

Then, in the case of the US, once employers finally start hiring again, the first 100 000 of new jobs created monthly will merely absorb newcomers to the labour force (population growth and migratory changes). Only thereafter will the economy start to rehire from the unemployment pool and possibly create new opportunities for currently discouraged individuals.

Absorbing the new additions to the labour pool, and reducing unemployment to acceptable levels could well take up to a decade, considering the relative slow cyclical take-off currently underway, the high emphasis on improving productivity, the lingering uncertainty in so many walks of life, and the consequent inhibition to start hiring normally again quite soon.

Instead, the hardship for many will be spread out over many years.

The senior leadership in the various major central banks (Fed, ECB, BOE) and in national governments (US, UK, Germany, France and others) seem highly aware of these realities and their possible political implications. Under these circumstances we don't encounter any early eagerness to withdraw support for their respective economies, rather the contrary as evidence multiplies of staying the course for longer, though trying to placate bond market vigilantes every step of the way.

Yet state finances are deteriorating, calling for early remedial action. Even so, governments seem intend on discovering how far they can go with their support actions to ensure that economic recovery truly vests. And though central banks are now actively signaling a gradual reduction in quantitative easing (bond buying) next year, they will do so warily, throughout cautiously examining whether the perceived normalization of financial markets proves genuine and can continue.

Meanwhile, with resource slack as large as it is, core inflation at 1% and likely still moving closer to zero next year, and inflation expectations subdued, the major central banks have every reason to keep their interest rates near zero for longer, probably throughout 2010, as ever so gently signaled by Fed, ECB and BOE.

The next crisis looming: Asset bubbles?

Robert Zoellick, president of the World Bank, recently aired his views on certain dangers arising from the massive monetary and fiscal stimuli governments have embarked upon to avoid the dire consequences of the financial crisis of 2008. Here are some excerpts from the article that was published on FT.com:

As the world begins to recover from the worst downturn since the Great Depression, the conventional wisdom is that we have employed lessons of the past effectively: a flood of money; a dose of fiscal stimulus; and an avoidance of the worst trade protectionism.

Of course, governments knew these dramatic actions would have consequences. Central banks have been watching carefully for early signs of the traditional danger – inflation. Yet in a new era of global competition, companies are unlikely to have the pricing power that led to “demand pull” inflation in decades past; nor are unions likely to be able to make wage demands that contributed to “cost-push” stagflation. Walmart and the developing world’s labour force have changed the paradigm.

Yet the revival of John Maynard Keynes should not lead us to ignore Milton Friedman: where will all that money go? For a hint of the future, look to Asia, where a new risk is emerging: asset bubbles.

Asia is now leading the world economy with increases in industrial production and trade, partly reflecting the growth in China and India. This welcome economic upswing is accompanied by rising equity and property prices.

The combination of loose money, volatile commodity markets and poor harvests – such as occurred recently in India – could make 2010 another dangerous year for food prices in poor countries. Asset bubbles could be the next fragility as the world recovers, threatening again to destroy livelihoods and trap millions more in poverty.

Unfortunately, the chapters in the history books about how to deal with asset bubbles usually precede tales of woe. Asset bubbles can be more insidious than traditional product inflation, because they seem to be a sign of health: higher values lift the real economy, which in turn can send the bubbles higher.

Waiting for bubbles to burst and then cleaning up the aftermath is now a new lesson of what not to do. But tightening interest rates too abruptly – especially where recoveries are weak, such as in the US and Europe – could trigger another downturn.

Australia, with its ties to the Asian economies, has already raised interest rates. Asian countries, which traditionally follow the US Fed’s monetary policy, will be under pressure to follow. But raising rates while the Fed keeps its rates close to zero would cause Asian currencies to appreciate. This would make their exports more expensive and decrease overseas sales, hurting recoveries based on exports. More­over, there is competition from China. The renminbi is tied to a declining US dollar that makes Chinese goods cheaper to buy than those of Asian rivals.

It would also help if North America and Europe took a closer look at the agenda that Australia and many Asian countries are starting to pursue. To build confidence and opportunity for the private sector, the Asia-Pacific countries are advancing structural reforms – including in service sectors – to boost productivity and potential growth. These reforms will help them to compete even if their currencies appreciate.

Perhaps the primary lesson from history is for countries to co-operate in making assessments that distinguish their situations, avoiding one-size-fits-all “exit strategies”, and cautioning against currency or trade protectionism.

These will be the challenges for the Group of 20 nations in 2010. The G20 had better put asset price bubbles and new growth strategies on its agenda. Otherwise, the solutions of 2008-09 could plant the seeds of trouble in 2010 and beyond.

China's credit growth worries...

China stood out this year as the one economy apparently not stalled by the global economic crisis, but their continued growth was brought about by rapid credit extension - always a worrisome aspect. FT.com reported the following story how Chinese banks will have to seek additional capital to prop up their capital adequacy ratios:

China’s banks are preparing to raise tens of billions of dollars in additional capital to meet regulatory requirements following an unprecedented expansion of new loans this year, according to people familiar with the matter.

China’s 11 largest listed banks will have to raise at least Rmb300bn ($43bn) to meet more stringent capital adequacy requirements and maintain loan growth and business expansion, according to estimates from BNP Paribas.

China’s banking regulator has warned it would refuse approvals for expansion and limit banking operations if lenders did not meet new capital adequacy requirements, a move that has prompted the country’s largest state-owned banks to prepare capital-raising plans for next year and beyond.

China’s banking regulator is definitely aware of potential asset quality issues and is pushing for higher capital adequacy requirements to offset deterioration in asset quality.

Following government orders to prop up the domestic economy in the face of the global crisis, Chinese banks extended a record Rmb8,920bn in loans in the first 10 months of the year, up by Rmb5,260bn from the same period a year earlier.

This unprecedented loan expansion resulted in a record fall in their core capital adequacy rates from just over 10 per cent at the end of last year to 8.89 per cent by the end of September, a drop that worries regulators.

A spokesman from the banking regulator said the vast majority of Chinese commercial banks met current capital adequacy requirements but lenders were expected to conduct reviews of their asset quality and ensure they continue to meet regulatory requirements.

The advent of the Efficient Market Hypothesis

Richard Thaler, professor of economics and behavioral science at the University of Chicago commented in a FT.com article about how the theory of Efficient Markets (otherwise known as EMH) led many to believe that the market should always be right. Hence, we have witnessed in recent years some gross policy errors and mistaken beliefs.

The previous generation of economists, such as John Maynard Keynes, were less formal in their writing and less tied to rationality as their underlying tool. This is no accident. As economics began to stress mathematical models, economists found that the simplest models to solve were those that assumed everyone in the economy was rational. This is similar to doing physics without bothering with the messy bits caused by friction. Modern finance followed this trend.

The EMH has two components that I call "The Price is Right" and "No Free Lunch". The price is right principle says asset prices will "fully reflect" available information, and thus "provide accurate signals for resource allocation". The no free lunch principle is that market prices are impossible to predict and so it is hard for any investor to beat the market after taking risk into account.

For many years the EMH was "taken as a fact of life" by economists. However, as early as 1984 Robert Shiller, the economist, correctly and boldly called this "one of the most remarkable errors in the history of economic thought". The reason this is an error is that prices can be unpredictable and still wrong; the difference between the random walk fluctuations of correct asset prices and the unpredictable wanderings of a drunk are not discernable.

Simply put, it is hard to reject the claim that prices are right unless you have a theory of how prices are supposed to behave. For example, stock market observers - as early as Benjamin Graham in the 1930s - noted the odd fact that the prices of closed-end mutual funds (whose funds are traded on stock exchanges rather than redeemed for cash) are often different from the value of the shares they own. This violates the basic building block of finance - the law of one price - and does not depend on any pricing model.

Compared to the price is right component, the no free lunch aspect of the EMH has fared better. Mr Michael Jensen's doctoral thesis published in 1968 set the right tone when he found that, as a group, mutual fund managers could not outperform the market. There have been dozens of studies since then, but the basic conclusion is the same. Although there are some anomalies, the market seems hard to beat. That does not prevent people from trying. For years people predictedfees paid to money managers would fall as investors switched to index funds or cheaper passive strategies, but instead assets were directed to hedge funds that charge very high fees.

Now, a year into the crisis, where has it left the advocates of the EMH? On the free lunch component there are two lessons. The first is that many investments have risks that are more correlated than they appear. The second is that high returns that are based on high leverage may be a mirage. One would think rational investors would have learnt this from the fall of Long Term Capital Management, when both problems were evident, but the lure of seemingly high returns is hard to resist.

So where does this leave us? Counting the earlier bubble in Japanese real estate, we have now had three enormous price distortions in recent memory. They led to misallocations of resources measured in the trillions and in the latest bubble, a global credit meltdown. If asset prices could be relied upon to always be "right", then these bubbles would not occur.

While imperfect, financial markets are still the best way to allocate capital.

Not-so-efficient markets...

John Kay, author and columnist for Financial Times, wrote an article about the existing views on efficient markets. Here follows some excerpts:

Warren Buffett said most of what you need to know about efficient markets. “Observing correctly that the market was frequently efficient, they [academics, investment professionals and corporate managers] went on to conclude incorrectly that it was always efficient. The difference between the propositions is night and day.”

Mr Buffett has made his money not from the part that is frequently efficient, but from the part that is infrequently inefficient.

The efficient market hypothesis has been the bedrock of financial economics for almost 50 years. Market efficiency is a hypothesis about the way markets react to information and does not necessarily imply that markets promote economic efficiency in a wider sense. But there is a relationship between the two concepts of efficiency.

There are three versions of the efficient market hypothesis. The strong version claims that everything you might know about the value of securities is “in the price”. It is closely bound up with the idea of rational expectations, whose implications have dominated macroeconomics for 30 years. Policy interventions are mostly futile, monetary policy should follow simple rigid rules, market prices are a considered reflection of fundamental values and there can be no such things as asset-price bubbles.

These claims are not just empirically false but contain inherent contradictions. If prices reflect all available information, why would anyone trouble to obtain the information they reflect? If markets are informationally efficient, why is there so much trade between people who take different views of the same future? If the theory were true, the activities it purports to explain would barely exist.

Economic models are illustrations and metaphors, and cannot be comprehensive descriptions even of the part of the world they describe. There is plenty to be learnt from the theory if you do not take it too seriously – and, like Mr Buffett, focus on the infrequent inefficiency rather than the frequent efficiency.

The weak efficient market theory tells us that past prices are no guide to what will happen to security prices in future. There is a good deal of evidence for this claim: you would be as well employed studying the patterns on your palm as patterns on charts. But there is also evidence of a tendency for short-term price movements to continue in the same direction – momentum is real. If you know precisely when the short term becomes the long term, this would make you very rich. It is possible to make money – or policy – through reading boom-and-bust cycles. But most participants do not.

The semi-strong version of the theory claims that markets reflect all publicly available information about securities. What is general knowledge will be in the price. But inside information, or original analysis, might add value.

The strong version of the efficient market hypothesis is popular because the world it describes is free of extraneous social, political and cultural influences. Economics is not so much the queen of the social sciences but the servant, and needs to base itself on anthropology, psychology – and the sociology of ideologies.

False ideas don't survive...

Martin Wolf, chief economics reporter for the Financial Times, recently reviewed a new book by Andrew Smithers: Wall Street Revalued: Imperfect Markets and Inept Central Bankers.

The big points of the book are four: first, asset markets are only "imperfectly efficient"; second, it is possible to value markets; third, huge positive deviations from fair value - bubbles - are economically devastating, particularly if associated with credit surges and underpricing of liquidity; and, finally, central banks should try to prick such bubbles. "We must be prepared to consider the possibility that periodic mild recessions are a necessary price for avoiding major ones." I have been unwilling to accept this view. That is no longer true.

The efficient market hypothesis, which has had a dominant role in financial economics, proposes that all relevant information is in the price. Prices will then move only in response to news. The movement of the market will be a "random walk". Mr Smithers shows that this conclusion is empirically false: stock markets exhibit "negative serial correlation". More simply, real returns from stock markets are likely to be lower, if they have recently been high, and vice versa. The right time to buy is not when markets have done well, but when they have done badly. "Markets rotate around fair value." There is, Mr Smithers also shows, reason to believe this is true of other markets in real assets - including housing.

A standard objection is that if markets deviate from fair value, they must present chances for arbitrage. Mr Smithers demonstrates that the length of time over which markets deviate is so long (decades) and their movement so unpredictable that this opportunity cannot be exploited. A short seller will go broke long before the value ship comes in. Similarly, someone who borrows to buy shares when they are cheap has an excellent chance of losing everything before the gamble pays off. The difficulty of exploiting such opportunities is large for professional managers, who will lose clients. The graveyard of finance contains those who were right too soon.

Mr Smithers proposes two fundamental measures of value - "Q" or the valuation ratio, which relates the market value of stocks to the net worth of companies and the cyclically adjusted price-earnings ratio, which relates current market value to a 10-year moving average of past real earnings. Professional managers use many other valuation methods, all of them false. As Mr Smithers remarks sardonically: "Invalid approaches to value typically belong to the world of stockbrokers and investment bankers whose aim is the pursuit of commission rather than the pursuit of truth."

Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But, in the end, powerful forces will bring them back. Trees do not grow to the sky and markets do not attain infinite value. When stocks reach absurd valuations, investors will stop buying and start to sell. In the end, the value of stocks will move back into line with (or below) the value - and underlying earnings - of companies. House prices will, in the long term, also relate to incomes.

The era when central banks could target inflation and assume that what was happening in asset and credit markets was no concern of theirs is over. Not only can asset prices be valued; they have to be. "Leaning against the wind" requires judgment and will always prove controversial. Monetary and credit policies will also lose their simplicity. But it is better to be roughly right than precisely wrong. Pure inflation targeting and a belief in efficient markets proved wrong. These beliefs must be abandoned.

Not all bubbles are the same...

Frederic Mishkin, author and professor of finance at Columbia University and a former member of the Fed Board, believes not all asset-price bubbles are dangerous and one has to understand the underlying drivers before panicking about the effects of very accommodating monetary policies. Excerpts from an article that was published on FT.com follows:

There is increasing concern that we may be experiencing another round of asset-price bubbles that could pose great danger to the economy. Does this danger provide a case for the US Federal Reserve to exit from its zero-interest-rate policy sooner rather than later, as many commentators have suggested? The answer is no.

Asset-price bubbles can be separated into two categories. The first and dangerous category is one I call “a credit boom bubble”, in which exuberant expectations about economic prospects or structural changes in financial markets lead to a credit boom. The resulting increased demand for some assets raises their price and, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more, creating a positive feedback loop. This feedback loop involves increasing leverage, further easing of credit standards, then even higher leverage, and the cycle continues.

Eventually, the bubble bursts and asset prices collapse, leading to a reversal of the feedback loop. Loans go sour, the deleveraging begins, demand for the assets declines further and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets. The resulting deleveraging depresses business and household spending, which weakens economic activity and increases macroeconomic risk in credit markets. Indeed, this is what the recent crisis has been all about.

The second category of bubble, what I call the “pure irrational exuberance bubble”, is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fuelled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. This is one of the key reasons that the bursting of the bubble was followed by a relatively mild recession. Similarly, the bubble that burst in the stock market in 1987 did not put the financial system under great stress and the economy fared well in its aftermath.

Because the second category of bubble does not present the same dangers to the economy as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker.

Asset-price bubbles of this type are hard to identify: after the fact is easy, but beforehand is not. Nonetheless, if a bubble poses a sufficient danger to the economy as credit boom bubbles do, there might be a case for monetary policy to step in. However, there are also strong arguments against doing so, which is why there are active debates in academia and central banks about whether monetary policy should be used to restrain asset-price bubbles.

But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy.

Tightening monetary policy in the US or Europe to restrain a possible bubble makes no sense at the current juncture.

The world is flat...

Ricco Friedrich, a portfolio manager at Sanlam Investment Management, listed recently his seven myths of investing in a weekly newsletter published by Glacier Research:

Myths are widely held beliefs that are mistaken as truths. For example, for long periods of time people believed (and acted) as if the world was flat. Below are similarly misguided assumptions that exist in the financial markets that I have come across during my investment career. I have found the reality that lies behind these to be invaluable in guiding my investment decisions.

Myth 1 - There is no free lunch

While I subscribe to the aphorism, “If something is too good to be true, it probably is”, I believe there is one free lunch in the financial markets, the impact of which is often understated. This has often been referred to as the eighth wonder of the world and, you’ve guessed it, it’s compounding.

Everyone can benefit from compounding. It is not a zero sum game and it does not require any special insight. The benefit of compounding can best be illustrated by the following example. If you can achieve a return of say 12% a year from your equity portfolio, it will effectively double in value every six years. For every R100 you put away at age 25, you will have R5 279 when you retire at 60. If you delay your savings until you turn 30, your R100 will only be worth a comparable R2 674. So you see it’s the last double that has a material impact on your pension savings, which means you should start saving as early as possible to benefit from the impressive power of compounding.

Myth 2 - Earnings drive share prices

While this may be true in the short term, valuation ultimately trumps short-term earnings expectations. On their own, earnings do not create value for shareholders, dividends do. I have seen several companies that have consistently grown earnings, but at the expense of shareholder value creation, which comes from generating cash and reinvesting the cash back into the business at returns that are above the cost of capital.

Sometimes it takes years for the market to recognize that the emperor is in fact wearing no clothes (i.e. earnings are growing, but not shareholder value). Some examples that come to mind in the past 10 years are CS Holdings and Imperial (prior to its recent unbundling).

Myth 3 - Active managers outperform the market

This is a highly contentious issue and, while some managers do outperform their benchmark, they are certainly in the minority. If you look at the data over the last year, active managers have done quite well. Just over 50% of all unit trust managers in the combined general equity, value and growth category outperformed the JSE All Share Index. But unfortunately as one increases the time horizon, so the statistics get worse. Over 10 years, just one third of all managers beat the JSE All Share Index (and this is ignoring the affects of survivorship bias). Investing in the market is a zero sum game, half will outperform the Index and the other half will not. After taking fees into account, roughly only half of the remaining group (i.e. roughly one quarter) actually beat the JSE All Share Index. While there is no magic formula for beating these odds, a detailed, disciplined and value-oriented approach to investing should swing these odds in your favor.

Myth 4 - You can make money in the long run by investing in Initial Public offerings (IPO’s)

This is one of the biggest myths of all time. If you look back to the 1998 IPO listings boom, there are very few companies that are still listed today. We conducted a study of all the new listings that took place in 2007. Of all the companies that listed in 2007 and 2008, the average return they have delivered is negative 45% on an equal weighted basis. In fact, only two companies are trading above their IPO price. With this track record, you would be much better off just investing in the JSE All Share Index rather than speculating on IPO’s.

The main reason IPO’s perform so poorly is that often the reason for listing is that the current owners of the unlisted business believe they can get more for the company by listing it than it is actually worth. Of course there are some management teams that list for the right reasons and with good intention but these tend to be in the minority.

Myth 5 - Volatility = risk

As investment managers, we believe our goal is to ensure that we achieve our client’s financial objectives by taking on the least amount of risk. In our view, risk does not reside in share price changes and cannot be summarised into a single number, such as the traditional measures used in portfolio management theory. The only risk that really matters is the prospect of a permanent loss of capital because portfolio management theory tells you nothing about the fundamentals of the companies you are investing in, their business risk or their balance sheet risk.

Myth 6 - Markets are efficient

As an active manager, you would, of course, expect us to believe the equity market is inefficient. Most of the time, however, the market is probably efficient. If you view the market as a complex adaptive system, consisting of many participants all pulling in different directions, then on average prices will generally trade at close to fair value. It’s only when the market mechanism breaks down and the scale tips to either side that mispricing opportunities arise. The two most recent examples of this over the past 10 years have been the IT bubble in 2001 and the commodities bubble in 2008.

Myth 7 - We can accurately forecast the future

This may seem obviously false, but many economists, analysts and fund managers spend a large portion of their time trying to forecast the future. Many of these professionals earn large salaries and bonuses irrespective of the accuracy of the outcome of their predictions. I have seen numerous examples of analysts who calculated valuations on companies based on short-term earnings forecasts that never materialized. When the future turned out to be different, so did their forecasts and valuations. What they thought was a bargain, turned out to be a lemon.

Understanding financial market behaviour...

George Soros, one of the most successful investors ever, published recently his well-thought opinions about how financial markets work and some clues what needs to be done to prevent similar financial crises in the future. Here are some excerpts from the article that appeared on FT.com:

The efficient market hypothesis holds that financial markets tend towards equilibrium and accurately reflect all available information about the future. Deviations from equilibrium are caused by exogenous shocks and occur in a random manner. The crash of 2008 falsified this hypothesis.

I contend that financial markets always present a distorted picture of reality. Moreover, the mispricing of financial assets can affect the so-called fundamentals that the price of those assets is supposed to reflect. That is the principle of reflexivity.

Instead of a tendency towards equilibrium, financial markets have a tendency to develop bubbles. Bubbles are not irrational: it pays to join the crowd, at least for a while. So regulators cannot count on the market to correct its excesses.

The crash of 2008 was caused by the collapse of a super-bubble that has been growing since 1980. This was composed of smaller bubbles. Each time a financial crisis occurred the authorities intervened, took care of the failing institutions, and applied monetary and fiscal stimulus, inflating the super-bubble even further.

I believe that my analysis of the super-bubble offers clues to the reform that is needed. First, since markets are bubble-prone, financial authorities must accept responsibility for preventing bubbles from growing too big.

Second, to control asset bubbles it is not enough to control the money supply; you must also control credit. The best known means to do so are margin requirements and minimum capital requirements. Currently they are fixed irrespective of the market’s mood because markets are not supposed to have moods. They do, and authorities need to counteract them to prevent asset bubbles growing too large. So they must vary margin and capital requirements. They must also vary the loan-to-value ratio on commercial and residential mortgages to forestall real estate bubbles.

Third, since markets are unstable, there are systemic risks in addition to the risks affecting individual market participants. Participants may ignore these systemic risks, believing they can always sell their positions, but regulators cannot ignore them because if too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or a collapse. That means the positions of all major participants, including hedge funds and sovereign wealth funds, must be monitored to detect imbalances. Certain derivatives, like credit default swaps, are prone to creating hidden imbalances so they must be regulated, restricted or forbidden.

Fourth, financial markets evolve in a one-directional, non-reversible manner. Financial authorities have extended an implicit guarantee to all institutions that are too big to fail. Withdrawing that guarantee is not credible, therefore they must impose regulations to ensure this guarantee will not be invoked. Such institutions must use less leverage and accept restrictions on how they invest depositors’ money.

It is not the right time to enact permanent reforms. The financial system is far from equilibrium. The short-term needs are the opposite of what is needed in the long term. First you must replace the credit that has evaporated by using the only source that remains credible – the state. That means increasing national debt and extending the monetary base. As the economy stabilises you must shrink this base as fast as credit revives – otherwise, deflation will be replaced by inflation.

We are still in the first phase of this delicate manoeuvre. Banks are earning their way out of a hole. To cut their profitability now would be counterproductive. Reform has to await the second phase, when the money supply needs to be brought under control and carefully phased in so as not to disrupt recovery. But we cannot afford to forget about it.

China, forever China?

Not everybody is bullish about the longer term prospects for China. Peter Tasker, a market analyst for a Tokyo-based asset management firm wrote the following article that appeared on FT.com.

Emerging markets, it seems, have had a good crisis. In contrast to the debt-ridden G7 economies, they have quickly resumed their growth trajectory.

To anyone who has lived through the rise and fall of the Japanese bubble economy, it should set off alarm bells.

Remember that it was in the years following the 1987 "Black Monday" crash that Japanese assets went from being expensive to absurdly overvalued and the Nikkei's dizzy rise to 39,000 forced the bears to throw in the towel.

Then, as now, the logic seemed unassailable. While the western world was stuck in the post-crash doldrums, the Japanese economy had got back on track with apparent ease. Japanese corporations were using their high market capitalisations to finance acquisitions of foreign trophy assets. Japanese banks boasted the world's strongest credit ratings.

But what you saw was decidedly not what you got. The crisis, far from leaving Japan unscathed, exacerbated its structural problems and laid the groundwork for a far greater disaster. And it was the weak western economies, not Japan, that produced healthy investment returns over the next decade.

In reality, 1980s Japan was never going to be terminally damaged by weakness in export markets. Its current account surplus and strong fiscal position provided the macro policy leeway to make any slowdown strictly temporary. The Bank of Japan duly put the pedal to the metal and the recently deregulated banks went on a patriotic lending spree. High-end consumption boomed but the real action was in the asset markets and capital investment, which soared as a proportion of gross domestic product.

Sound familiar? It should, because the same dynamic is evident today in China and some other emerging economies.

Interest rates have been far too low for far too long. If the natural interest rate is, as the Swedish economist Knut Wicksell posited, around the level of nominal GDP growth, then China's interest rates should have been close to 10 per cent for most of this decade.

Alan Greenspan, former chief of the US Federal Reserve, has been criticised for holding interest rates too low and setting off a housing and credit bubble in the US. But if US monetary policy was wrong for the US, it was even more wrong for the high-growth countries that "imported" it. The result could only be a massive misallocation of capital.

For most of the 1980s, Japan, like China today, used government direction of bank credit ("window guidance") to overlay monetary policy. It was the combination of banking deregulation and the G7-sanctioned surge in the yen that ushered in the final manic stage of the Japanese bubble. By then there was no way out - asset market collapse and financial system wipe-out were baked in the cake.

If China continues to follow the Japanese template, the end of the dollar peg will be the trigger event, setting off a Godzilla-sized credit binge. Why would China's rulers embark on a such a disastrous course? Because the alternative - unleashing deflationary forces stored up over years of mercantilist policies - would be too painful to contemplate.

Watch out for the unwinding of the carry trade and speculative behaviour!

The famous economist, Nouriel Roubini, recently wrote an article in the Financial Times expressing his concerns about the unwinding of the carry trade (borrowing cheaply in US$ and invest proceeds elsewhere) and its impact on global markets. Here follows some excerpts from the article:

Since March there has been a massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes. At the same time, the dollar has weakened sharply, while government bond yields have gently increased but stayed low and stable.

The dollar and the sterling have weakened against a host of other currencies since the summer, promoting speculation that they could become the next carry trade currencies and supplant the yen as the ‘funding currency’ of choice.

This recovery in risky assets is in part driven by better economic fundamentals. We avoided a near depression and financial sector meltdown with a massive monetary, fiscal stimulus and bank bail-outs. Whether the recovery is V-shaped, as consensus believes, or U-shaped and anaemic as I have argued, asset prices should be moving gradually higher.

But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades.

Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

The combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

While this policy feeds the global asset bubble it is also feeding a new US asset bubble. Easy money, quantitative easing, credit easing and massive inflows of capital into the US via an accumulation of forex reserves by foreign central banks makes US fiscal deficits easier to fund and feeds the US equity and credit bubble. Finally, a weak dollar is good for US equities as it may lead to higher growth and makes the foreign currency profits of US corporations abroad greater in dollar terms.

The reckless US policy that is feeding these carry trades is forcing other countries to follow its easy monetary policy. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. The perfectly correlated bubble across all global asset classes gets bigger by the day.

But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. This renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

Out of the doldrums...

FT.com reported that the US economy grew in Q32009 by a surprising 3.5% after recording four quarters of negative growth. Alan Rappeport wrote the following report:

The US economy grew for the first time in a year as an aggressive array of stimulus measures brought an end to the longest period of contraction since the Great Depression.

US gross domestic product grew at an annualised rate of 3.5 per cent in the third quarter after shrinking in each of the past four quarters, Wall Street analysts forecast that the economy would grow by 3.2 per cent.

Boosting growth was an upturn in consumer spending, residential investment and strong government spending. The impact of government stimulus measures succeeded in jolting the economy during the latest quarter, as the soon-to expire first-time home buyer tax credit and the “cash for clunkers” car rebate programme lifted residential investment and chipped away at car inventories.

Consumer spending, which accounts for about 70 per cent of economic activity, rose by 3.4 per cent after rising by only 0.9 per cent in the second quarter, while the surge in car demand lifted durable goods purchases by 22.3 per cent. Personal consumption expenditures added 2.36 percentage points to GDP growth.

The Federal Reserve said that most parts of the US are seeing stabilisation or growth, but that the rebound has remained weak. The Fed pointed to renewed strength in residential real estate and manufacturing but expressed concern about commercial property.

Economists at Goldman Sachs argue that the recovery will be “sluggish” with inflation and interest rates remaining low. They warn that headwinds abound with small companies underperforming, the labour market stretched, state and local budgets cutting back and a persistent excess of housing supply.

Analysts suggest that unemployment, which tends to lag behind during an economic recovery, will continue to be a drag on future growth.

No quick recovery expected...

Kevin Lings, chief economist for South African asset manager, STANLIB summarised the key points from the latest IMF's World Economic Outlook (October 2009):

Overall the IMF raised the world growth projection for 2010 by 0.6 percentage points to around 3% (PPP basis) (relative to their forecast in July 2009), but highlighted that a subdued recovery lies ahead.

The global economy appears to be expanding again, pulled up by the strong performance of Asian economies and stabilisation or modest recovery elsewhere. The pace of recovery is slow, and activity remains far below pre-crisis levels. The pickup is being led by a rebound in manufacturing and a turn in the inventory cycle, and there are some signs of gradually stabilising retail sales, returning consumer confidence, and firmer housing markets. World trade is beginning to pick up and commodity prices have staged a comeback. Global activity is forecast to expand by about 3 percent in 2010 (PPP basis), which is well below the rates achieved before the crisis.

In the advanced economies, unprecedented public intervention has stabilised activity and has even fostered a return to modest growth in several economies. Advanced economies are projected to expand sluggishly through much of 2010, with unemployment continuing to rise until later in the year.

Emerging and developing economies are generally further ahead on the road to recovery, led by a resurgence in Asia. Many countries in emerging Europe have been hit particularly hard by the crisis, and developments in these economies are generally lagging those elsewhere. In emerging economies, real GDP growth is forecast to reach almost 5 percent in 2010, up from 1.7 percent in 2009. The rebound is driven by China, India, and a number of other emerging Asian economies. Other emerging economies are staging modest recoveries, supported by policy stimulus and improving global trade and financial conditions.

Looking ahead, the policy forces that are driving the current rebound will gradually lose strength, and real and financial forces, although gradually building, remain weak. Specifically, fiscal stimulus will diminish and inventory rebuilding will gradually lose its influence. Meanwhile, consumption and investment are gaining strength only slowly, as financial conditions remain tight in many economies.

Downside risks to growth are receding gradually but remain a concern. The main short-term risk is that the recovery will stall. Premature exit from accommodative monetary and fiscal policies seems a significant risk because the policy-induced rebound might be mistaken for the beginning of a strong recovery in private demand. In general, the fragile global economy still seems vulnerable to a range of shocks, including rising oil prices, a virulent return of H1N1 flu, geopolitical events, or resurgent protectionism.

Extending the horizon to the medium term, there are other important risks to sustained recovery, mainly in the major advanced economies. On the financial front, a major concern is that continued public skepticism toward what is perceived as bailouts for the very firms considered responsible for the crisis undercuts public support for financial restructuring, thereby paving the way to a prolonged period of stagnation. On the macroeconomic policy front, the greatest risk revolves around deteriorating fiscal positions, including as a result of measures to support the financial sector.

Current medium-term output projections are much lower than before the crisis, consistent with a permanent loss of potential output. Investment has already fallen sharply, especially in the economies hit by financial and real estate crises. Capital stocks levels are falling. In addition, unemployment rates are expected to remain at high levels over the medium term in a number of advanced economies.

Many economies that have followed export-led growth strategies and have run current account surpluses will need to rely more on domestic demand and imports. This will help offset subdued domestic demand in economies that have typically run current account deficits and have experienced asset price (stock or housing) busts, including the United States, the United Kingdom, parts of the euro area, and many emerging European economies.

In advanced economies, central banks can (with few exceptions) afford to maintain accommodative conditions for an extended period because inflation is likely to remain subdued as long as output gaps remain wide. Moreover, monetary policymakers will need to accommodate the impact of the gradual withdrawal of fiscal support.

The situation is more varied across emerging economies; in a number of these economies it will likely be appropriate to start removing monetary accommodation sooner than in advanced economies. In some economies, warding off risks for new asset price bubbles may call for greater exchange rate flexibility, to allow monetary policy tightening to avoid importing an excessively easy policy stance from the advanced economies.

Sending the Greeks back to school...

If you know something about investment phrases like alpha and beta you ought to know something about investment management, but perhaps not after all!

Paul Amery wrote the following blog article that was published on IndexUniverse.com:

The conventional wisdom is that ETFs and other index-tracking vehicles are designed for beta (market exposure) and that active managers pursue alpha (value added through skill). But what does this actually tell us?

Do our well-used Greek letters help us make sense of the investment landscape, or do they actually hamper us in managing money? As James Montier pointed out in an article published in 2007, as soon as you use the terms “alpha” and “beta,” you are invoking the spirit of the capital asset pricing model.
And, unfortunately, CAPM doesn’t actually work in practice.

Why not? Apart from some questionable assumptions about frictionless trading and investors having identical goals, the key problem with CAPM is that it assumes that stock returns are normally distributed. In other words, the theory requires that stock prices follow a random walk, with the price movement in one period entirely independent from that in all previous periods, and having no bearing on the future, either. This “Brownian motion” assumption produces the famous bell curve of statistics when one measures the percentage gains and losses over many time intervals.

However, while the bell curve accurately maps many phenomena in nature—people’s heights and weights, for example—many studies have now shown that it is inaccurate when describing financial market movements. Stock prices, which reflect the collective mood of millions of people, move according to far wilder trajectories, and there is plenty of evidence that markets have “memory”—which shows up in the serial correlation of returns. Even volatility tends to occur in “clusters.”

By viewing the world through the lenses of “alpha” and “beta,” you are automatically assuming a linear relationship between risk and return, with risk measured only according to a bell curve framework. Take away the framework, and the terms have no real meaning at all. So why do we persist with them? Part of the reason for the continuing popularity of the Greek letters is that we use them as a kind of shorthand—beta for passive, systematic, indexed; and alpha for active, more subjective, discretionary. And, of course, in the fund management world, while beta has meant (relatively) low fees, the claim of being able to source “alpha” has been the road to riches for fund providers.

But, just as it’s possible (and indeed, statistically likely) for the self-proclaimed alpha-seeker to deliver below-market performance, it’s just as likely that well-thought-out, entirely model-driven systematic approaches can generate superior returns over time.

I would like to see a great deal more systematic strategies offered to investors in ETF format. As ever, the challenge will be to make these investment approaches understandable and transparent, without losing their competitive edge. But there are surely great opportunities out there for those who can hit the correct fund design. Isn’t it time to send at least two of our friendly “Greeks” back to the language classroom?

How the IMF views the way forward

FT.com recently reported on how the International Monetary Fund views the economic recovery in their bi-annual World Economic Outlook:

A recovery in the world economy is now under way, the International Monetary Fund said on Thursday, but it warned there were many obstacles to sustained rapid growth. The IMF rejected forecasts for either a rapid V-shaped recovery or a double-dip recession, saying the recovery will most likely be “weak by historical standards”.

The IMF is no more optimistic about the medium-term outlook, insisting that growth prospects depend on resolving two difficult challenges: the weakness in the banking system; and the persistent unwillingness of countries with large trade surpluses to boost domestic demand and become motors of world growth.

The economic crisis, which resulted in the deepest global recession since WWII, has led to a permanent loss of output, the IMF said. Most economies now have a large amount of spare capacity which is likely to keep inflation low, in spite of the extraordinarily expansionary monetary and fiscal policies undertaken by central banks and governments around the world.

But for the first time in more than a year, the IMF’s economic declarations have not become more gloomy. It has revised higher its forecasts for world growth, reflecting its view that there was now a much lower risk of the recession turning into something even nastier.

“Strong public policies across advanced and many emerging economies have supported demand and all but eliminated fears of a global depression,” the World Economic Outlook said.
The IMF forecast that world economic output would rise by 3.1 per cent in 2010 after contracting by 1.1 per cent in 2009, an upward revision of 0.6 percentage points for 2010 from its most recent forecast in July.

Emerging economies will grow much more quickly than advanced economies, the IMF says, with growth averaging 5.1 per cent in the emerging world, even including the troubled central and eastern European regions, and only 1.3 per cent in rich countries. Central banks of rapidly growing emerging markets might have to raise interest rates soon.

In the short-run, the IMF believes the recovery will be sluggish because “the policy forces that are driving the current rebound will gradually lose strength, and the real and financial forces remain weak”. Unemployment is forecast to keep rising across developed economies, so the recovery will feel “jobless” in most countries.

World Cup 2010: How big will its impact be?

Not everybody in South Africa is that buoyant about the economic prospects of the biggest sport event in the world, the World Cup soccer tournament to be held in South Africa in 2010. Rene Vollgraaf of Sake24.com reports:

The economic impact of the World Cup soccer tournament next year could be considerably smaller than people expect. "They are just a bunch of soccer supporters," says Jeff Gable, head of Absa Capital's research division. "Although 64 soccer tournaments will be good for the country's reputation, the economy is much bigger than this. What's more, the effect of the tournament will be measured in two different quarters."

The tournament begins on June 11, that is to say in the second quarter, and ends in the third quarter on July 11. "I imagine the tournament will generate less than $1bn from soccer tourism," Gable declares."Most of this will be in the first two weeks during the group matches. Most people will go home once their teams are out of the tournament."

Research by Grant Thornton indicates that the tournament will contribute about R55.7bn to the South African economy. The estimated 483 257 tourists will spend R8.5bn-odd here, according to Grant Thornton.

Gable adds that South Africa is not necessarily a cheap tourist destination. "You have to reckon that World Cup tourists will spend considerably more than ordinary tourists would if you expect to see a massive economic impact." As far as the inflationary effect of additional spending during the World Cup is concerned, Gable reckons hotels and restaurants run the highest risk. "The average price of a hotel room in the last two weeks of June next year will be significantly higher than the normal price for that time of year."

Modern Economic Theory still relevant?

Professor PDF Strydom recently published his thoughts on why the current macroeconomic theory was not appropriate to foresee or handle the current financial and economic crisis. It appeared on the Weekly Comment published by FNB:

The present economic crisis that started in 2007 encouraged critics to raise the question whether economists could not have predicted the crisis, suggesting timely corrective measures.

A more pertinent question is whether economics, more particularly modern mainstream macroeconomics (MMM) is in a position to analyse the present crisis and able to come forward with appropriate policy measures?

Could MMM have successfully identified (flagged), understood and given early advice to counter the factors responsible for this latest crisis?

The answer to these questions is an unambiguous "no" as MMM has already for a long time not been geared for the kind of complexities that were ultimately encountered.

Markets and human behaviour

There were certainly some economists who analysed global developments prior to the present crisis and whose conclusions clearly indicated the serious consequences likely to follow if these issues were left unattended.

One example is the major international imbalances developing in recent years between saving surplus and saving deficit countries.

Another example is the exuberant behaviour of market participants in certain instances, such as the property market during recent years (but not limited thereto). Behavioural economics devoted much attention in analyzing the causes and likely effects of these developments.

In contrast, the MMM approach to economic crises makes key assumptions about the way markets operate and about human behaviour generally that did not prove realistic.

MMM sees markets as stable and basically self correcting. This view of the smooth market adjustment process implies that the forces in favour of equilibrium are always overruling those of disequilibrium. An important corollary is that government intervention in markets is destabilising. Government action is seen as disrupting the equilibrating forces and cannot contribute towards equilibrium. In the event of a disturbing experience the typical MMM approach would be to allow the distortion to develop on its own because it is easier to clean up after the event.

This analysis is not very helpful during economic crises because during such events disequilibrating forces tend to overrule. Moreover, Keynesian economics clearly argued in favour of government intervention in such circumstances, such as depressions, in order to support the forces working towards equilibrium. MMM caricatured this as fiscal activism.

Apart from a distorted perception of market functioning, MMM cannot deal effectively with crises because of its Walrasian analytical elements. The main shortcoming here is that the resulting analysis does not take cognisance of uncertainty.

In Walrasian analysis uncertainty is overcome through the means of creating a Walrasian auctioneer who disseminates information without charge. Market participants are now in a position to trade towards equilibrium and in the event of misjudgment are allowed to do recontracting.

MMM substitutes rational expectations for the Walrasian auctioneer. Thus economic agents are assumed to have full information at zero cost as displayed by the relevant economic model. Also, economic agents do not make systematic mistakes.

In essence, MMM assumes information dissemination at zero cost, thereby facilitating the introduction of the Walrasian property of instantaneous adjustments in markets. This feature of Walrasian analysis encourages the development of general equilibrium analysis dealing with the interrelations between markets in achieving simultaneous equilibrium.

Yet such outcomes have little reference to the real world where all these conditions are not met and where calendar time prevails.

Human behaviour is an important element in explaining the actions of market participants. This has been an important element in the development of economic theory. In the historic evolution of macroeconomics these elements featured explicitly in the work of Keynes and others who followed.

MMM has historically developed an intellectual framework that could not successfully conduct an analysis of the forces shaping the global economic crisis that started in 2007. Moreover, this analysis failed in developing a coherent policy framework to deal effectively with the crisis.

The worst is over...

The Federal Reserve is optimistic that the worst of the financial and economic crisis is over. Yet, they kept interest rates unchanged as it maintains the most aggressive easing monetary policy in history. Financial Times reported the following:

“Conditions in financial markets have improved further, and activity in the housing sector has increased,” Household spending seems to be stabilising, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.”

The Fed decision comes amid mounting evidence that the economic crisis is abating. Last week, Ben Bernanke, chairman of the Federal Reserve, said the US recession “is very likely over” and last month’s Federal Open Market Committee meeting minutes indicated that “economic activity is levelling out”.

On Wednesday the Fed said that businesses were still cutting back on fixed investment and staffing, but at a slower pace, and that they continued to make progress in bringing inventory stocks into better alignment with sales.

Those comments came as the manufacturing and housing markets have recently shown promising signs of life. However, unemployment, which last month reached a 26-year high of 9.7 per cent remains a looming problem and economists are expecting the rate to reach above 10 per cent before easing next year.

Analysts are expecting the US economy, which contracted at an annual rate of 1 per cent in the latest quarter, to grow by around 3 per cent in the third quarter of this year. However, many have been awaiting signals from the Fed about “exit ” plans from its aggressive strategies of quantitative easing and its agency debt buying programme.

Meanwhile, substantial “resource slack” is keeping rising costs in check and the Fed said that long-term inflation expectations were “stable” and that inflation would remain “subdued” for some time.

The day the music died...

Cees Bruggemans, chief economist of FNB, takes us back down memory lane why and how the financial crisis erupted and what is likely to emerge from all this:

Two years ago at this time, one could be forgiven for only extrapolating good times. The (SA)economy was completing its fourth year of over 5% growth, formal employment was expanding robustly, state revenue was growing in leaps and bounds making all kinds of social spending feasible even as the national debt was steadily whittled down, and the budget was heading for surplus territory.

Yet at the time a worm was already at work in the woodwork. Inflation was rising as a global commodity price surge was steadily taking shape on the back of an enormous global growth wave, much of it arising in the Asian East, but aided and abetted by fantastic credit and asset bubbles originating mainly in the Anglo-Saxon West.

It had called into being a monetary response already the year before, with the SARB since mid-2006 in tightening mode, gradually if persistently raising interest rates.

Between them, rising inflation and interest rates would within another twelve months erode household purchasing power and the means to sustain the growth wave.

Thus, instead of extrapolating the recent past at the time, it would have made eminent sense by late 2007 to have projected the end of an eight-year expansion cycle and the possibility of recession.

For long business cycle expansions rarely die of old age. Instead they get murdered, nearly always by central banks which, responding to dire need, only do it for our best will, mostly to tame inflationary impulses.

Of course, these two major undertakers, rising inflation and interest rates, would very shortly be joined by a third undertaker, electricity shortages. Its origins were 15 years in the making because of a persistent unwillingness to plan and built new generating capacity for when the operating surpluses would finally ran out. The resulting mayhem would seriously hamper industrial activity and deeply undermine confidence by early 2008.

Between them, these many forces would set in motion an economic deceleration which by late 2008 could have created a mild recession quite easily.

This was already being speculated openly about by mid-2008, yet believed by few.

For surely the long prosperity wave would continue indefinitely? Such is the momentum of good times, in which exuberance of mood rules, and in which the obvious is hardly ever recognized early.

But if all of this weren't enough, by that springtime moment in 2007 the water had already broken on an even more momentous development. Mutual trust among global banks had been brutally dissolved by the bankruptcy of a minor investment vehicle in France.

The realization dawned nearly simultaneously in many a banking boardroom that events, but mainly their own behaviour, had delivered them into the middle of a gigantic minefield from which there was no easy escaping.

Many bankers, especially Americans, British and Europeans, by then realized that, given what had happened to their own balance sheets, and extrapolating this worldwide to other banks' balance sheets, absolutely nobody's paper could any longer be trusted.

And so those with surplus cash held on to it on the day, starting an old-fashioned hoarding with unbelievable consequences, for banks in deficit on the day had to turn to their central banks, as traditional lenders of last resort, to tidy them over with needed liquidity.

Happily, modern central banks don't tend to panic and are able to lend when so many private agents are losing their heads. On that day the ECB in Europe, the Fed in the US and the Japanese central bank between them injected over $250bn into their banking systems to keep things afloat.

From that moment on, the global banking system, its capital providers and clients, and not least its many regulators, central banks and governments, embarked on a discovery process to try to understand the extent of the damage and its implications.

It would take more than a full year, to our springtime in 2008, for the full ramifications of what had really happened, to sink in and divulge its awful truth.

Throughout this discovery process, the deep confidence of the long global expansion became rattled and eroded, financial markets peaked as blue chip names went under and needed to be rescued, credit access started to tighten, and economic growth worldwide started to slide, initially only gradually, but steadily none the less.

The awful truth was that the leading banks of the rich industrial world were effectively bankrupt, brought down by two sets of behaviour, namely wild, untested, unstable financial innovation, and the greed and suspension of rules that tends to accompany such hubris.

The problem was fundamentally bigger, more complex and more intractable compared to what had gone wrong in 1929 and the subsequent years in which the Great Depression of the 1930s had its origin.

Then, a catastrophic loss of confidence giving way to panic (nothing unusual in the history of free market finance) had resulted in a run on banks, creating a liquidity squeeze, setting in motion bank defaults, business bankruptcies and spreading unemployment.

Unfortunately, neither inexperienced central banks nor inept governments at the time had the knowledge, the skill or for that matter the means or even the political will to resist these falling dominoes.

Like a simple flu can develop into pneumonia, followed by death if not treated timely with medication (in our time known as antibiotics) the economic policymakers of those days had to stand by helplessly as this terrifying financial spectacle destroyed the underpinnings of the global economy of its day, with terrible social and political ramifications worldwide.

By springtime 2008 was history to repeat it self?

This time things were far worse, for it wasn't primarily a liquidity problem at banks that central banks in the interim had learned to treat with adequate doses of their support (a simple matter of providing banks with cash).

Instead, banks had made decisions that would prove disastrous in that many of their assets would turn out to be less valuable than thought. Solvency was the main issue in 2008, not liquidity. And bank insolvency you can only treat by injecting new capital, writing off the asset losses, replace management, restore trust (that ultimate currency) and then start anew.

But instead of this happening to a single minor bank, whole banking systems crucial to the global economy had to be rescued and repaired simultaneously. This was like wanting to change all four tyres AND the engine on a car still driving at full speed.

Predictably, the panic deepened and spread, culminating in a firestorm of epic global proportions. The end had apparently come in finance, jeopardizing houses, portfolio investments, jobs and pensions of hundreds of millions of people who previously had thought of themselves as well off, even rich.

The stampede set in motion this time last year has been without equal in world history. Credit effectively dried up globally for anything, buying a house, funding a foreign trade, financing business expansion but also working capital.

When confronted by danger, we have basically two options, to fight or flee. If the danger is big enough, there is only one option, fleeing and hoping to survive to fight another day.

Across industries, across time zones, nearly instantly everywhere, being internet linked and all watching the same global television, and with industrial processes finely meshed by just-in-time calculations, managements across the globe took ultra defensive actions. Shooting first and asking questions later. Not wanting to be caught napping by events.

One had to preserve cash flow, jettison unwanted ballast, cut all spending plans, become independent of retreating banks, prevent becoming a banker to one's debtors.

And so the Greatest Recession since the Great Depression was born, around October last year, as everyone in steel, cars, chemicals, furniture, computer chips, travel, mining, transport and thousands of other activities all had the same bright ideas.

Cut production by 30%, start to reduce inventories, cut back on unneeded spending, savage capex and budget plans. Hoard cash. Survival was to be key, everywhere.

Of course, if we all do this together, it is like ritually all slashing the own throat. And as nearly everyone's output fell by 30% on the first round, everyone's sales in the second round would fall yet more disastrously, setting in motion yet another cutting round. And another. And another. Diving to the bottom entwined in a common death struggle.

These were exciting times indeed.

Private individuals are prone to the greatest fantasies, happiness, exuberance and hubris, just as they are capable of shock realizations that everything isn't quite right, the onset of fear, panic and the deep skepticism that then rules all.

In a word, we are human, emotionally, and so are the businesses and institutions we run, as they are run by human beings who have money and livelihoods at risk and try desperately to prevent losing it all.

If you are going to panic, do so early and in style, being the first out of the door. Of course, if all try doing so, the results are predictable. Very few will leave the room alive.

Governments, for all their shortcomings, have one fine characteristic. They aren't supposed to panic, not having as much personally at stake as individual economic agents.

Even better, governments represent all of society and thereby control our collective tax base and the ability to leverage debt thereon. Yet better in modern times, they ultimately control central banks which in turn straddle the money printing presses.

For in our day all currency is basically paper based, indeed only an electronic entry and transfer away.


And thus these past twelve months we have been in the grip of the greatest rescue mission in history. What it required was the political will, to mobilize society's resources and to go out and undo the institutional failures that threatened to pull all down with it.

This rescue mission of central banks and governments has not been a simple tale. For as on the first day of any war, one throws away all carefully prepared plans as unexpected eventualities decide the shape of the battlefield. Literally, they had to make it up as they went. And they did.

In the process mistakes were made, time was lost, terrible fatalities occurred. After all, some $3-4 trillion in financial assets had been lost, and the worldwide recession would incur another $6-7 trillion in output losses forever gone. Between them the bill came to the equivalent of 4000 Gautrain projects never built. You will agree: the ultimate in global opportunity loss.

There were also house price losses, and halving of equity prices, coming to another $30-40 trillion loss globally, but these were ultimately mostly paper losses for those who didn't transact.

By early March 2009, global financial markets bottomed, central banks had arrested the global freefalls, financial repair was well underway, and governments were underwriting just about everything.

The world was taking a deep breath, and trying to shake its panic. But as with all trauma this takes time. It takes time, proof, success to restore the old trust, confidence and risk-taking at the core of any successful economic system.

To regain one's lost cool isn't a simple matter. Take a deep breath, forget those anxieties, there really is life after death for those lucky enough to have survived the ordeal, now carry on as usual, governed by the old rules that shape our economic behaviour.

This is, of course, questioned at every turn, that life could possibly be the same, that it will be business as usual ere long. Yet we are organized in a certain way, success has its own logic, our behaviours tend to be rule-bound, and once we have regained our composure and our legs, it is once again off to work we go.

It is at times of great catastrophes that deep philosophical questions tend to be re-asked, and rightly so, for why waste a perfectly good crisis? So it is a perfect moment to ask a few searching questions, about the meaning of life (having just survived the ultimate ordeal) and whether the old rules should still apply.

Thus there is much seeking for renewal, reform, but also risk assurance, that this terrible thing may never happen again (as of course it will, as it has on numerous occasions in distant histories mostly only remembered in forgotten books).

But there is a deep searching going on daily in an attempt to come up with better rules, better incentives, less risky behaviour to guide our economic activity. This is all for the good, and indeed an age-old process by which we discovered the keys to long-term development and prosperity.

So how now going forward? Are there any prospects?

There certainly are. The world isn't mainly populated by widows and orphans fearfully seeking out the sidelines and forever staying there. The dance floor may have suddenly emptied last October when the balloon went up and the music died.

But since then, the music has started up again, central bank and government assisted, a few brave souls have been tempted back on the dance floor, as early fashion leaders are apt to do, and the great majority, sufficiently calmed down, seems ready to resume its role, if still somewhat shaken by it all and taking more time to fully recuperate and regain its mental equilibrium.

While this re-engagement is slowly starting up, central banks and governments need to carefully plan their coming exits in turn, as the dance floor can support only so many gyrating couples. And we don't want new accidents, now do we, such as fundamentally overheating our economic spending and resource bases and starting the mother of all hyperinflations. For that would be exchanging the fat for the fire.

The key global policymakers first had to catch the baby and ensure its safe delivery. And once accomplished they need to make themselves scarce again, reduced to their legitimate everyday role, which is much reduced from their crisis role as chief firefighter.

So with economies stabilized, if with enormous increases in slack resources, especially in Western countries, US unemployment heading for 10% whereas 4% would be normal, how does the economy start up again?

There are two sides to this question. The one is internal, the other external (global).

Internally, the deeply recessed economies today enjoy support from government spending, but also favourable incentives such as assisted credit flows and super low interest rates from central banks.

There was overreaction at the onset of crisis late last year, and its unwinding gives a needed lift to activity. Once inventory and output slashing ends, yet with final sales less disturbed than originally imagined, production can start gearing up again. This process has been underway worldwide these past six months, ensuring that economic activity didn't keep falling, spiraling out of control indefinitely.

Indeed, this quarter (3Q2009) is probably the first quarter of growth in the new global expansion cycle getting underway about now.

On a slightly more extended timeframe, postponed replacement decisions are coming back into focus. It was easy to delay purchasing a new car, furniture, appliance or whatever, greatly deepening the onset of recession.

But once less unsure and going back to more normal conditions, these replacement decisions come back into focus. If the means are there (90% of the American labour force will still be employed, interest rates are low, credit flowing again), the durable consumption will gradually come back on stream. And with a bit of time lapse, so will business investment.

It isn't good enough to say that there is much spare capacity and therefore no need to invest. Innovation hasn't stood still. The process of creative destruction very much remains alive and at the centre of all economic development, competitive impulses driving us on the replace and invest. Indeed, consolidation, regrouping and renewal are the key watchwords in today's global economy.

And so the business of risk-taking, expansion, employing and private spending resumes, for there remains much unfinished business in the world.

Which brings me to the global stage, and the real core of the growth story of our time.

The East (Asia) is poor. It is also impatient, having discovered to an ever greater degree this past generation how the few got to be prosperous.

The global banking implosion was mainly a rich world phenomenon. The emerging universe was mostly not affected directly, and some industrializing and commodity-supply parts only indirectly.

China's economy throttled back from 10% growth to 8% growth this year and next year is seen doing 11% growth again as it successfully imitates Japan of old, accelerating domestic demand into a global contraction, temporarily lessening the impact of its usual early export dependency.

China and India have reached a critical mass that allows them to play this leadership role at this juncture. It won't undo the output losses incurred in the rich countries, but it does assist the world to recover more easily from its encounter with disaster.

And thus the world, initially limping in parts, but already again racing in others, with an enormous increase in resource slack, as much spare skilled labour as physical resources, is readying itself for another cycle of economic expansion.

Given the low base from which it is beginning, the spare resources, the slow start in places, the absence of major structural risks (unless you don't like overgearing governments and central banks) and the enticing incentives, the world is probably looking at another major and long expansion.

Certainly not everyone believes this, sensing the Great Moderation and balmy economic times lie behind us, and ahead looms much more volatility, inflation, policy action and therefore business cycle interruption, shortening any growth spurts and keeping the growth down through greater inefficiency brought on as a consequence of the great financial shock and its remedies.

Meanwhile, the East is impatient as ever, and the West not necessarily populated only by widows and orphans. Indeed, all I meet daily is great white sharks on the prowl for the easy opportunity at the bottom of this great cyclical implosion. This is the essence of raw market capitalism and it certainly hasn't died.

That suggests a come-back, even though humpty-dumpty had a great fall and can't be quite put together again in the way he was before. But then doctors have a way of stitching you up and wishing you a nice day as they shoehorn you out the door.

Life goes on. The rules of the game are well known, if somewhat moderated. But it won't prevent a resumption of that great human effort known as getting rich, and less prosaically as human development.

So we are going back to global growth, fast in the East, somewhat slow in the West, surplus capital being generated probably everywhere which still will be looking for an outlet, mostly where the action is hottest (in the growing emerging universe).

A step closer towards economic recovery

Greg Robb of MarketWatch reported that the OECD thinks that a global economic recovery is not too far away, but authorities still need to wake against exiting aid strategies too early:

Recovery from the global recession is likely to arrive earlier than expected, but it is too soon to trigger exit strategies. "It is important not to get carried away. Green shoots seem likely to growth further in the near-term but will still need careful nurturing by policy if they are to become strong, self-sustaining plants."

The OECD is not expecting a W-shaped double-dip recession, but at the same time isn't predicting a V-shaped recovery. "I don't think any alphabet has a letter that envisions the economy that we have in mind. Somewhere between an 'L' and a 'V'".

The OECD forecast suggests an economic recovery is already underway in the U.S. States. Economic output, as measured by GDP, is expected to rebound to a 1.6% rate in the current quarter in the U.S. and hit 2.4% in the final three months of the year.

The euro-area growth rate should rebound to a 2% rate in the fourth quarter, with solid rebounds in France and Germany.

The Japanese economy should expand at a 1.1% rate in the third quarter before falling 0.9% in the fourth quarter.

The United Kingdom is expected to lag behind other OECD nations and show no growth this year, the forecast said.

Global trade appears to have hit bottom and is rebounding, the OECD said. Growth in China is boosting trade. The risks of an outbreak of inflation remain low, given the slack in many countries, the OECD said. On the other hand, deflation is also unlikely outside Japan.

The first step toward tightening shouldn't be taken until the middle of 2010 at the earliest, the OECD said.

Awakening The Bull

Ryan Barnes post the following guidelines on Investopedia.com when it is most likely to be the start of a bull market:

Being able to accurately spot the beginning of a bull market can be one of the most lucrative skills around. This fact alone makes it difficult to achieve, as so many well-educated and experienced investors try to spot the signposts that lead us into traditional bull markets.

Are we in one right now? Opinions vary, but the S&P 500's 45% + rise since March 2009 certainly meets the traditional definition of a 20% rise from a market low. But a better definition of a bull market is an extended period of time when markets are stable with an upward trend. The extended part is key, as it allows all investors the chance to participate without feeling like it's a race to the top.

Let's look at five signs that tend to predict the next bull market. No single one is a surefire tip, but that's just the way Mr. Market likes it: he has a nasty habit of eliminating patterns and keeping investors mystified for as long as possible.

Sign No.1 – Sector and industry leadership changes in the stock market.
In the most basic sense, bull markets come when more people want to buy stocks than sell them. Because stocks love to turn bullish before the broad economy picks up, look for a shift in demand to the stocks that benefit first from economic growth. Stocks in sectors like financials, industrials and retail often lag behind in a bear market - nobody wants them.

When a bull is approaching, these sectors often become market leaders. Large institutional investors start piling in, hoping to see the conditions of these companies improve first. So look for leadership to change from defensive sectors like utilities, healthcare and consumer staples. When investors start dumping the latter in exchange for financials, industrials and basic materials, it's a good sign that major investors are optimistic about the future.

Sign No.2 - Key economic indicators turn upward.
We get a slew of economic indicators all throughout the year, but several have been deemed leading indicators for their ability to foretell future growth in the all-important indicator of gross domestic product (GDP). When GDP is positive and growing, the bull market is already in. So look for a turn in the following key leading indicators:

•A rise in industrial production
•Several weeks of falling jobless claims
•A rise in the Philly Fed Index
•Rising durable goods orders
A true bull market should be predicated by all four indicators showing growth, or at least changing direction if they have been falling for several months.

Sign No.3 - The Baltic Dry Index turns sharply upward.
The Baltic Dry Index is a specialized measure of the rates paid by producers and shippers of key raw inputs like coal, iron ore and grains. These raw materials are purchased by the ton, so they need to be put in large carrier ships and sent all around the world to the companies that will use them to create energy, steel, food products and other consumer goods.

This index is good to watch because there's a long lead time before growth in shipping leads to higher production of goods by the end users themselves. The Baltic Dry Index is also quite volatile, so higher price action is easy to spot, and may give a clue toward future growth in the economy long before it shows up elsewhere.

Sign No.4 - Money market fund assets drop.
When investors are generally skittish, they sell their risky investments (stocks) and move cash into safer ones like bonds and money market funds. In a bear market, money market fund assets will rise and rise, building a bubble of pent-up demand. After all, money market funds may be safe, but they won't earn you a solid return.

The Investment Company Institute publishes weekly figures on the aggregate amount held in all types of funds - stock funds, bond funds and cash funds. Look for a sustained drop in money market fund assets, and a corresponding rise in stock fund assets. This will signal that investors are making their way back into the stock market. The higher that money market assets grow in a bear market, the more gunpowder is available to fire back into the stock market when the bull is back.

Sign No.5 - Stock indexes stabilize.
This last sign may sound overly redundant, but don't be fooled by its simplicity. Stock market indexes need to form a bottom that can be recognized by all participants. They then need to form a stable upward trend over weeks and months, rather than a volatile zig-zag that threatens to turn south just as much as north. The more stable the trend of the broad indexes - like the S&P 500 - the more confident investors can become, especially those who have been patiently waiting on the sidelines for obvious signs of safety before dipping their toes back in.