For the last 80 years or so, there hasn’t been a recession and recovery cycle in the UK that hasn’t been V-shaped. Things have tended to get bad very quickly but then bottom out fast and recover quickly too. This explains why, for the last two months, the market has been obsessed with what the financial industry calls the “second derivative” – the slowdown in the rate at which economic statistics are getting worse.
In a V-shaped cycle, given that markets are supposed to discount things in advance, the correct response to the first sign of any kind of slowing in the rate of a decline is to assume that it will soon bottom out and turn positive again and therefore pile into the market. If you want to steal a march on other investors, it makes sense to jump the gun: not to wait for things to get better to invest, but to buy as soon as things stop getting worse at the same rate as before. And the faster things have fallen, the quicker you want to get in when collapse slows.
All this goes some way to explaining why markets are up 35% since early March – investors saw the second derivative beginning to turn and, with recent history as their guide, they figured they’d better get buying.
But there is a problem with this strategy. As the Japanese, the Swedish, the Norwegians, the Finnish, the Thais, the Malaysians and the Mexicans will tell you, not all recoveries are V-shaped. Instead, as the International Monetary Fund (IMF) has just pointed out in one of its reports, recessions connected to banking crises are both deeper and 50% longer then normal recessions. They also come with slower recoveries and are hook-shaped rather than V-shaped: things fall very fast and recover slowly.
Why? Because monetary policy doesn’t work as it is supposed to. The way out of a normal recession – as the IMF study confirmed – is through stimulation (cutting interest rates and flooding the system with liquidity). But in a banking crisis, the banks are too busy repairing their balance sheets to either want to or be able to pass on government largesse to the rest of us – and hence to get us investing and spending. With their balance sheets already a mess and defaults rising and likely to continue doing so, they can’t help anyone else. Who, for example, is going to want to lend into the buy-to-let market (or lie-to-bet market as it is now known) when arrears rose 300% last year and are still on the climb?
The Bank of England thinks it has set rates at 0.5%. Most of us think interest rates are 0.5% (particularly if we are trying to get a good rate on our savings). But try going to your bank and asking to borrow £10,000 at 0.5%, or even 1.5%. You won’t get far: the cheapest loan available on the comparison websites comes from Sainsburys Bank, at 7.9% for the “typical” borrower, whoever he or she may be.
Then look to the US, which is up to a year ahead of us in terms of working its way through the credit crunch. There, the real cost of debt, as measured by investment-grade corporate bond yields, is now at a 24-year high of 8.3%. And as a testament to just how hard companies are finding it to negotiate with their bankers when they need money, James Ferguson, chief strategist at Pali International, points to the fact that there are several examples of companies raising money in the US via the corporate bond market at 9% with the stated aim of using the funds to pay down bank debt. Interest rates may be low but that doesn’t make credit cheap or easy to get access to. So much for monetary stimulus.
Mervyn King, governor of the Bank of England, has become the first of the heavyweights (the IMF aside) to recognise all this in the Bank’s quarterly inflation report out this week. He pointed out that this is not a typical recession, stressed that the outlook for growth is not improving and said that the banks will “naturally behave in a risk-averse way” for some time.
The implications of this on the equity markets are clearly huge. If there is no V-shaped recovery underway, there is little reason for the stock market to continue its monumental rally for much longer.
The chances are that history will reveal that the rally of the last two months has been one of the “biggest ‘get out of jail free’ cards ever,” says Ferguson. Anyone holding the junk stocks that have driven it – the banks, perhaps – would probably be wise to take it. And if you are worried that getting out now will mean that you miss some returns, you can comfort yourself with the fact that the second derivative factor is at work here too: prices have risen very fast indeed but there are signs they are slowing (note the 2% fall in the FTSE after the inflation report came out) and that they will soon turn around, giving us, if nothing else, an upsidedown V-shaped stock market cycle. When this rally turns around, it will do so very suddenly.
• This article was first published in the Financial Times