There is the usual spectacle at the beginning of every year, when all manner of economic pundits and market observers give their expectations and forecasts for the year.
Things were a bit worse this year, because the year 2010 immediately drove everyone to “10 for ’10” – that is, the top 10 things for the year 2010, with numerous variations of the same theme. Being something of a market watcher myself, but lacking the forecasting skills of the great and the good from Wall Street, I now present the nine things that come back to haunt the markets from 2009 – so a “9 from ’09” list if you will. Yes, I am indeed that creative.
Perhaps some readers may have looked at the markets and wondered where all the angst and inbuilt pessimism suddenly popped up from; the answer is, of course, that all the optimism of last year was artificially induced from surging liquidity, fiscal easing and good old-fashioned stupidity (in both credit and equity markets). As I wrote in my summary for the year, (see It’s who you know Asia Times Online, December 24, 2009) there was always a risk that some of this behavior would be corrected over the course of 2010; however it is also fair to state that pretty much no analyst seems to have forecast a poor January as a result of all this built-in tension.
Alcoa: The first hit to the markets after the optimism shown during the inaugural trading week of the year came from earnings announcements made by Alcoa, traditionally the first major company to report results in the stock market. The other reason the company’s results are closely watched is,of course, that it makes a simple commodity – aluminum – that is a vital ingredient in many key industries that are themselves harbingers of overall economic conditions (automobiles, commercial construction, aircraft manufacturing, to name a few).
Cut to the chase, and what we had on January 11 was results that were worse than expected as the company slipped to a narrow loss for the fourth quarter due to rising power bills, which overwhelmed the impact of rising aluminum prices. In other words, the company could hardly pass on its cost increases to customers; hardly a ringing sign of recovering economies.
China : Immediately on the heels of Alcoa came the wobbles from China, as authorities signaled a tightening in monetary conditions through rising interest rates as well as curbs on bank lending. Fear of a slowdown in China plays right into the worst fears of the most bullish investors for exactly the reason that growth in China was the major contributor to global economic growth in 2009; driven by accelerating capital investments from the federal government. The spate of fiscal stimulus efforts were accompanied by a significant boost in bank lending that was promptly diverted to investments in properties and stocks; exactly the type of asset bubble economics that authorities most feared.
There are growing fears about the stability of China’s growth pattern, as investments relative to production are now at the highest levels seen in Asia (ahead of even the extremes seen in Japan at the end of the eighties). Combined with rampant corruption in various states, fears of massive losses in banks and the very likely decline in property prices over the next 18 months across major cities including Shanghai and Beijing, all indicators point to a very hard landing for the Chinese economy should the government turn off the pump priming tap: which is exactly what it will have to do at some stage if it wants to avoid a repeat of the Japanese asset bubble.
To clarify here, I am not a member of the “China is a bubble” crowd; but I do remain concerned about the mismatches in asset prices relative to profit-earning capacity; and the quality of bank lending and persistent corruption. All of these indicators point to the need for dramatic action at some stage, and as such are themselves a product of the failure to rein in the imbalances caused by the currency peg. Rather than a burst economy, I expect years of stagnation in China as excess capacity is worked out through asset price deflation and loan losses.
Sovereign risk: The next leg to crack in the markets – and particularly credit markets – was the lack of confidence in sovereigns, particularly those of Western Europe. While I have made my disdain for the credit risk trends of the UK quite clear in recent articles, markets have increasingly worried about the risks of other countries, including Greece, Portugal, Ireland and so on. The decision by Iceland’s president to reject a parliamentary agreement to repay the debts owed to the UK and Netherlands (acting on public opinion) also helped to inflame the situation for other sovereigns.
This week, average credit spreads of European sovereigns (about a dozen of them that are tracked through a widely-monitored credit default swap – CDS- index) moved wider than a broader index of investment-grade European companies. Typically, it would cost more to insure the credit spread of companies as against governments, but that isn’t the case anymore in Europe, as bigger companies have cut leverage and regained a modicum of financial stability even as the credit quality of governments continues to decline on the back of yawning fiscal deficits and mountains of debt.
Monetary tightening : Besides the generic risk of governments moving up, additional risks to market trends are now presented by the specter of central bank tightening, primarily through the removal of liquidity facilities that had supported the acquisition of government bonds as well as other types of fixed-income instruments over the course of 2009.
Changes to the refinancing regime in both Europe and the United States point to rapidly declining liquidity over the second half of the year; which, given the increased supply of government and quasi-government debt across both the US dollar and euro-denominated bond zone, would likely cause interest rates on long-dated assets to rise sharply. In turn, this poses challenges for mortgage borrowings in the US and other highly leveraged countries such as the UK and Spain, in turn feeding the wave of defaults by homeowners.
Tax the banks : Public opinion in both the US and Western Europe is finally coming to terms with the scale of bailouts provided to the banking sector, which in turn led to a rapid increase in profits for the sector in 2009. Instead of keeping their pie-holes shut about the gargantuan and extraordinary profits, banks decided to pay large bonuses to their staff, feeding public anger in both the US and Europe. While the US and Germany failed to follow the path of the “special” bonus taxes imposed by the likes of the UK and France, President Barack Obama has announced plans for a special tax on banks focused mainly on the biggest ones; the move is designed to raise over US$100 billion in the next few years.
It goes without saying that banks will see their economics change dramatically, which for the sector that led performance in both equity and credit markets last year, would be a dramatic comedown. Forget bonuses – banks will be back to negative cash flows at worst and sharply lower profits at best in the very near term.
Then again, banks don’t need help to lose money. A surprise profit warning from French bank Societe Generale (the same bank that lost money in early 2008 in an equity derivatives trading scandal – see Rogue and the Pogue, Asia Times Online, January 26, 2008) this week helped to highlight continued risks to profit performance from the simple act of banks employing bankers.
Government scandals: In a development that harks directly to the long-held arguments of the anti-Keynesian columnists such as myself, disclosures in the last week pointed to directives from the New York Federal Reserve when headed by Tim Geithner (now Treasury secretary) prohibiting the disclosure of payments made by the bailed out insurance company AIG to commercial banks that had traded credit default swaps with the company.
This wasn’t a “scandal” for anyone with knowledge of the markets and recent developments, but it was upsetting enough for the politically charged administration of the United States. The travails of the UK banking system rescues – particularly the politically mandated takeover of Halifax Bank of Scotland (HBOS) by an otherwise-stable Lloyds – is already well known. Then there has been a spate of other scandals in Germany that threaten to further imperil the already fragile financial system in Europe. These center on the practices of government-owned banks (Landesbanks) indulging in corrupt practices through their banking books; with significant political implications for the country’s coalition government.
Barely two years after no one in particular appointed the Keynesians to “help” the global financial system, their true colors have come to the fore. This lot is corrupt to the core, and what’s more, all too dumb, as proven by the speed at which they get caught.
Unemployment : Following from a near-flat employment picture for November that was revealed in December, the US was broadly expected to post its first month of job gains in over two years for December (as reported on January 4). Instead, the estimate for the month was losses of 85,000 jobs; even as the number of people disenchanted about their job searches and basically giving up any notion of coming back to the workforce also rose for the month.
The continued failure of unemployment puts paid to any notion that a government-led economic recovery can take place, simply because the cost of government intervention in the form of rising debt and gross inefficiency almost always overwhelm the benefits of such stimulus. This is precisely what is happening now, and with the mirage of growth in the Group of Seven industrialized nations fading quickly, so too will risk appetite across the markets.
Economic data: Directly playing into the hands of the same picture painted by unemployment came the weaker-than-expected retail sales for the US and parts of Europe for December; for the US the actual figure of minus 0.3% for the month was far worse the expectations of a 0.5% gain for the month. The same weakness is being seen in many European countries, despite significant price reductions effected for the busy Christmas shopping period.
Industrial production, inventory build-up and all manners of construction-related spending point to growing weakness in the major economies as against the much-ballyhooed economic recovery.
Cash is king: Over and above all the worries caused by the above developments, comes the indications of rising trend by large money managers to increase their holdings of cash relative to assets such as bonds and equities. On the equity front, the likes of Warren Buffett have used their own stock to purchase cash-generating utility type businesses (including railroads and electricity companies), eschewing growth-oriented companies that would require cash injections.
On the fixed-income front, PIMCO’s celebrated money manager Bill Gross wrote the following in his “Investment Outlook” for January 2010:
If 2008 was the year of financial crisis and 2009 the year of healing via monetary and fiscal stimulus packages, then 2010 appears likely to be the year of “exit strategies”, during which investors should consider economic fundamentals and asset markets that will soon be priced in a world less dominated by the government sector. If, in 2009, PIMCO recommended shaking hands with the government, we now ponder “which” government, and caution that the days of carefree check writing leading to debt issuance without limit or interest rate consequences may be numbered for all countries.
Additionally, if exit strategies proceed as planned, all US and UK asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009. It seems no coincidence that stocks, high yield bonds, and other risk assets have thrived since early March, just as this “juice” was being squeezed into financial markets. If so, then most “carry” trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their “sugar daddy”. There’s no tellin’ where the money went? Not exactly, but it’s left a suspicious trail. Market returns may not be “so fine” in 2010.
On that cheery note, happy investing for 2010.