Appearances can be deceptive. So how can you tell if a break in the clouds is the start of a summer? John Stepek explains.
Recession fatigue has well and truly set in. As Sir Stuart Rose declared last week, people are “fed up with being fed up”. After a long daily diet of grim headlines and tales of horror about the financial crisis, anyone who has so far avoided losing their jobs might now be wondering what all the fuss was about. After all, it’s just a recession. It’s not World War Three; it’s not the Black Death.
Comparisons with the Great Depression are by no means an exaggeration in terms of raw economic data. But the images conjured up by that era – of erstwhile Masters of the Universe reduced to selling apples on street corners, and families trying to eke out a living in the dustbowl – suggest a desperation that most people in the West simply don’t feel, thanks to modern innovations such as the welfare state.
As Lucy Kellaway put it in the Financial Times this week: “the human spirit does not find it agreeable to stay down for too long”. Having accepted that we’re in recession, people are now deciding it’s really not that bad. Combine that with signs that the rate of collapse in the global economy is easing off, and it’s small wonder many have been tempted to throw off their tin hats and celebrate a new dawn. Goaded partly by the utter lack of interest available on most savings accounts, investors are piling back into the stockmarket. Some are even looking at getting back into the property market.
So should you join them?
The state we’re in
There are undoubtedly some signs of improvement in parts of the financial system. Credit conditions have relaxed somewhat, with various key lending rates now back to levels not seen since before the collapse of Lehman Brothers rocked the markets. And despite a year-on-year 6.1% fall in US GDP in the first quarter of 2009, US consumer spending picked up by 2.2%, compared with a drop of 4.3% in the fourth quarter of 2008.
Meanwhile, manufacturers have slashed production rapidly in reaction to global demand falling off a cliff, so a boost from an element of restocking – as people buy things they now need to replace – seems likely in the coming year.
But this crash happened so hard and fast that a fall in the rate of decline had to happen eventually. As Robin Aspinall of Halkin Services says, if something can’t get any worse, “it must get better”. More to the point, in the FT’s words, “signs of credit-market stress remain at high levels”. As for that consumer-spending bounce, Sheryl King at Merrill Lynch reckons it’s a “one-quarter wonder”. Consumer spending was boosted by both tax cuts and lower petrol prices. With oil prices now stabilising, and unemployment still high and rising, it’s “hard to see where consumers will find the money to support significant increases in spending”.
So is the worst behind us? “In a word. No,” as the FT’s Martin Wolf put it last month, pointing to figures from the Organisation for Economic Co-operation and Development (OECD), which expects the OECD region to shrink by 4.3% this year and 0.1% the next. Now, like most economic bodies, the OECD’s forecasting record is hardly without blemish. It didn’t see the crash coming, so there’s perhaps no reason that it would see any recovery. But it’s hard to disagree with its glum prognosis.
As Wolf notes, we’ve barely started dealing with the problems that led to the crash in the first place. In America, for example, “total private-sector debt rose from 112% of GDP to 295% at the end of 2008. Financial sector debt alone jumped from 16% to 121% of GDP over this period.” Yet during 2008, “leverage rose still further”. So there remains a lot of saving and debt repayment to be done.
Here in Britain, the picture’s just as weak. Lending growth is continuing to slow – lending to individuals rose by just 2.2% in the 12 months to March, down from 9% the year before. A record of nearly 30,000 people in England and Wales went bankrupt in the first three months of this year, up 19% on the year before. Nearly 5,000 firms went bust during the same period, up by more than 50%.
As Alan Tomlinson of insolvency practitioner Tomlinsons says, these “statistics firmly squash the notion that there are any green shoots of recovery out there. Since last autumn many of the companies we are seeing have suffered significant drops in turnover they’ve been unable to replace.” And as James Ferguson points out in the box below, the banking crisis is still unfolding, so we can expect banks to continue keeping a tight rein on lending to both businesses and consumers.
Governments are also becoming increasingly entrenched in their countries’ economic and financial systems. There are, of course, the waves of money being printed by central banks, while interest rates are abnormally low across the world. Meanwhile, from China to the US and Britain, the state is directing lending policies and deciding which firms (banks and car makers) are spared, and which go to the wall (retailers and small businesses).
But as the influence of the public sector expands, so the private sector – which ultimately drives growth – is squeezed out. As Tim Price of PFP Wealth Management notes, “whether businesses survive or fail during this recession will be a function not of the market, but of whether government wants them to. That is not an economy that most entrepreneurs will want to play much part in, and it throws the bear-market rally into a sharp and uncomfortable focus.”
Reversing this position will take a long time, and won’t be easy. As Wolf sums up: “The brutal truth is that the financial system is still far from healthy, the deleveraging of the private sectors of highly indebted countries has not begun, the needed rebalancing of global demand has barely even started, and, for all these reasons, a return to sustained, private-sector-led growth probably remains a long way in the future.”
What about stocks?
But a weak economy need not mean a declining stockmarket. Indeed, “the green shoots are much more prevalent in the market than in the economy”, says Edward Hadas on Breakingviews. The FTSE All-World Index is up about 30% from its lows. The S&P 500 has rallied by nearly 35% since early March. And plenty of respectable investors are now calling the bottom. Fidelity’s Anthony Bolton has called the end of the bear market with increasing confidence, while Crispin Odey, a hedge-fund manager who made a lot of money by selling the banks in the credit crisis, now suggests that we could be at the start of a long bull market.
But before you pile in, bear in mind that it’s always important to take the views of those who are already in the market with a pinch of salt. Just as the estate agencies behind most of the property indices will try to present house-price data in a broadly favourable light, so people who profit from rising stockmarkets can’t be considered neutral observers.
There are plenty of reasons to suspect that this isn’t a new bull market. For a start, it’s not unusual to have strong rallies within a wider bear market. As Albert Edwards of Société Générale points out, the “current pop” is “not dissimilar to the many bear market rallies between 1929-1933”, where hints of recovery led to “strong 25%+ rallies… this optimism was subsequently crushed.” For another thing, it’s been led by the same stocks that led the crash – financials in particular and also resource stocks. People are still acting on the basis that these stocks have fallen so far that they “must be cheap” by now – the same attitude that bit investors during the post-tech-bubble collapse. David Rosenberg of Merrill Lynch points out that “you know it’s a low-quality rally when the top 50 most heavily shorted stocks are the ones that outperform the most.”
We also haven’t seen many of the signs that usually precede a new bull market. Simon Thompson in Investors Chronicle points to Russell Napier’s study of major US market bottoms, Anatomy of the Bear. This found that at the end of a bear market there tends to be “a final slump in share prices on low trading volumes (as investor selling becomes completely exhausted) and confirmation of the bull market is then signalled by rising prices on expanding volumes”. But “volumes have been modest” during the current rally. So the short-term indicators aren’t good.
Stocks face plenty of headwinds in the longer run too. Investors are going to have to absorb a lot more shares. Just as firms swapped equity for cheaper debt during the boom years, that process will reverse as firms, locked out by high debt-raising costs, need to raise money through rights issues instead. As John Waples notes in The Sunday Times: “We still have dozens of fund-raisings to come, and billions of pounds that need to be refinanced in financial markets where the supply of new capital is thin on the ground.”
The government’s presence in the markets will also have an impact. “As the invisible private hand of Adam Smith begins to resemble more and more the public fist of government,” says Bill Gross of bond fund manager Pimco, “then asset values should be negatively affected.” As an example, he points out that “if FedEx deserves a p/e of 12, wouldn’t the value of the [state-owned] US Post Office be substantially less”?
What should you do now?
We’d suggest using this rally to sell any cyclical stocks you still hold, rather than buying back in. Yet for many investors, this is the most dangerous period. They’ve already seen their net wealth hammered by the original crash. When the rally starts, they ignore it. But as it continues and stocks climb steadily higher, it becomes harder to watch those gains being made without taking part. Investors who’ve already been burnt by the original crash are particularly vulnerable – they start to hope that by taking part in one big rally they could make back some of their losses. So they pile in, usually just as the rally is coming to an end – and they get wiped out again.
The good news is that you don’t have to stay out of the market. You just have to do what smart investors always do: buy solid assets at good value prices. On that score, there are still opportunities out there.
As James Ferguson points out below, during Japan’s slump, government bonds did well because of demand from banks. We would be less keen to buy gilts right now, simply because of the level of uncertainty over what the government and Bank of England might do next. However, there are other lessons we can learn from Japan’s experience.
Andrew Lapthorne of Société Générale points out that buying stocks with high dividend yields and solid balance sheets produced strong returns. In particular, as David Stevenson highlights in Investors Chronicle, “picking stocks with a low price-to-book ratio versus their history proved to be a winning strategy”.
More to the point, these are the sorts of stocks that have been underperfoming in the rally so far. So on the one hand they still look cheap, and on the other, if the rally continues, then they’ll get lifted along with the rest of the market. As Graham Secker at Morgan Stanley notes, there are “good absolute valuations on offer” – not to mention solid dividend payments – from the likes of telecoms giant Vodafone (LSE:VOD), which is yielding 6%; pharma giant GlaxoSmithKline (LSE:GSK), yielding 5.7%; tobacco group Imperial Tobacco (LSE:IMT), on a yield of 4.3%; and power company Scottish & Southern (LSE:SSE), currently yielding 5.75%.
If this is recession, why does it feel so good?
I was talking to the sixth form at a London school the other day about how serious the economic situation was and how it had all the signs of being the worst recession since World War II, writes James Ferguson. I could see the mere mention of the war had them immediately thinking ‘boring history lecture’ and I realised that, of course, none of their parents had lost their jobs. No family summer holidays abroad had been cancelled. No friends had had to leave the school, or move house.
This recession may have decimated City bonuses and pushed unemployment up from 5.2% last May to 6.7% now, but it has left many unaffected. This is the feel-good recession (at least until you go and change your sterling into euros on holiday this summer). But harbingers of doom like myself aren’t worried about what this recession looks like right now. We’re looking at what has happened in the past when you have a banking crisis. And the first conclusion that positively leaps out at you is: this banking crisis, at least in terms of how it will affect the average person in the street, hasn’t even really begun yet.
Why do I say that? Banking crises occur when there is a huge disruption to the distribution of credit in the economy and often reflects an over-extended banking system finding its insufficient capital eroded, or even wiped out, by losses relating to bad loans. Of course, we can’t know if the banks’ capital is going to get wiped out this time until after we’ve seen what default and, more importantly, recovery rates are like. But we can have a go at working it out using past banking-crisis recessions.
The International Monetary Fund (IMF) has just finished two large studies investigating these topics. The first, the World Economic Outlook, investigates what financial crises look like. Its findings are sobering. Financial-crisis recessions are deeper than typical recessions, lasting about 40%-50% longer, and with a much slower recovery.
In short, that means we can expect a minimum of 18 months of deeply negative GDP, followed by three more years of only marginally positive GDP. The second IMF report, entitled the Global Financial Stability Report, then embarks on its own ‘stress test’ of the world’s banks. The report finds that, retained earnings aside, and working on loan loss assumptions garnered from previous recessions, the Western world’s banking systems will have eroded their capital bases to near zero by the end of next year.
This rather shocking conclusion is the reason the IMF believes Western governments still have to inject huge sums into their banks. It’s also a stark reminder that while policy response has been fairly swift and substantial, the main requirement for fixing a banking bust is that the banks repair their balance sheets. So what does that involve? What banks have too much of after a credit bubble is risky loans, those that might default, as opposed to risk-free loans that can’t default, otherwise known as gilts.
So what banks do once a crisis has hit is de-risk the profile of their balance sheets by replacing risky loans to the likes of you and me with risk-free assets in the form of gilts. So claims on government are set to rise sharply, while a matching drop in claims on the private sector will keep the credit crunch alive and well for some years to come as banks continue to reduce lending.
Professor Tim Congdon charts many examples of this process at work during the balance-sheet rebuilding phase of bank crises. In Japan, once the government injected capital into the banks and they started aggressively addressing their non-performing loans, bank lending fell at a compound rate of 2.6%. From 1997 to 2003, Japanese banks’ loan assets fell by nearly ¥70trn (around $700bn).
Over the same period, their holdings of Japanese government bonds trebled from under ¥30trn to over ¥90trn – almost a straight yen-for-yen swap. Similarly, in the 1932-1937 period, the US banks bought 75% of all new government debt issued (around $10bn), while at the same time private-sector loans shrunk by 25%. And it was the same in Britain, where in just two years – 1932 and 1933 – gilt holdings rose 78% from £301m to £537m, during which time private-sector bank lending also fell.
These multi-year balance-sheet restructurings of the banks are why banking-crisis recessions are more serious than ‘normal’ recessions. The conclusion must be that the credit crunch that beset the financial markets in 2007-2008 will turn into a multi-year credit crunch on the high street from 2009 onwards. The reason this recession hasn’t yet hit the households of those school children I was talking to is not because they have been lucky, nor because the severity of this crisis has been overblown in the press. No, it’s mainly because, as far as the person on the street is concerned, it hasn’t even begun yet.
Property: there’s a long way down yet
The other market that has drawn plenty of ‘green shoots’ comments is the British property market. Mortgage approvals have recently picked up from record lows. According to the Bank of England, approvals for new home purchases rose to 39,230 in March, up from the 37,937 seen in February. Meanwhile, the Centre for Economics and Business Research (CEBR) issued a relatively bullish new forecast on house prices. The group expects house prices to fall another 8% from here, but reckons that prices will rise by 6% during the course of 2010 and 2011.
So is it time to pile back into buy-to-let? Well, let’s put this into some sort of context. Mortgage approvals may have picked up, but they are still down 33.5% on an annual basis. Perhaps more to the point, even in the early 1990s crash, monthly mortgage approvals never slipped to below 60,000. So last month’s approvals were still a good third off the level seen at the very nadir of the last property bust. That one took six years from start to finish, while someone who bought at the peak in 1989 would have been waiting until 2002 to break even, accounting for inflation, according to Adrian Ash on Bullionvault.com.
As for the CEBR’s prediction, in common with many other commentators, the group failed to see the current crash coming. So it seems likely that the latest prediction may be no more accurate than previous calls.
The reality is that – far more so than stockmarkets – housing markets take a long time to turn. You just need to look at America: house prices over there began falling a year to 18 months ahead of those in Britain. Prices are still falling at near-record levels, yet the pundits have been itching to call the bottom of the market almost since the collapse began. You can be sure that every sign that prices are stabilising will be leapt on – as the rapturous reaction to Nationwide’s report of a lower-than-expected 0.4% fall in prices in April showed. However, for every sliver of good news, there’ll be disappointment hot on its heels – as the Halifax’s report of a 1.7% fall in prices for the same month shows.