Friday, March 06, 2009

Deciphering the global downturn

As the global crisis continues, it seems with the new indicators each day that the situation is worsening. The ADP employment numbers out of the US this week shows that an estimated 697,000 jobs were lost in February. This is ahead of the more important Non-farm payrolls jobs report, which will come on Friday, when job losses are expected to come in at 650,000 for the month of February. US unemployment is also expected to rise in February from 7.6 per cent to 7.9 per cent. The week has continued to see a fall off of GDP around the world also, with Sweden, Australia, and the Euro-Zone showing quarter over quarter declines of 0.3 per cent, 0.5 per cent, and 1.5 per cent respectively.

Both the Bank of England and the Euro-Zone are also expected to cut the central bank target rates to 0.5 percent and 1.5 percent respectively. The rate cuts around the world is in a desperate attempt by central banks to add liquidity to the system by allowing for easier access to credit but this has not been, and expected so, having the effect because the global challenges is one of more than just interest rate affordability. The real challenge is one for massive loss of wealth. Even with the rate cuts access to credit remains difficult and the cost of credit is higher.

Falling equity markets

The Dow Jones Industrial Average (DJIA), for example is below 7,000 at 6,850, and the technical and economic indicators are showing that the market may actually fall some more. The market could in my estimation hit the 6,500 mark and if it falls below 6,300 could be well on its way to the 4,500 level. This trend is consistent with equity markets around the world, which is likely to continue. Even though commentators on the business channel seem to be desperate to talk a bottom into reality, the fact is that the fundamentals do not support a bottoming at this time.

Equity prices are fundamentally determined by a company's current and expected earnings and the fact is that both scenarios remain bleak. We see where AIG, for example, recently lost US$61 billion over three months and the auto industry continues to go back to Congress for more support. All of this while consumer confidence is at its lowest for over a decade and personal consumption expenditure, although slightly up over January, remains very low. So in this environment of rising unemployment, falling confidence, and very low expenditure how does a company increase earnings. The only way for one to see value in a company in this environment is looking at the balance sheet value and making a determination as to whether the book value per share is way in excess of the currently traded price, if one expects that the company will remain resilient. However, institutions such as AIG have shown that even the managers themselves do not know the true state of their balance sheets.

It is because of this uncertainty of earnings and balance sheet values why investors have been shying away from equities and rushing to acquire US treasuries and Gold, what is referred to as a flight to safety. So in this type of mood consumers are not inclined to engage in the type of spending that can boost economic activity, content instead to spend on basic requirements.

So globally the world seemed destined to an economic slump for at least another few months, into 2010. Because even though we might start to see signs of recovery at the end of 2009 the fact is that consumers will take some time to build back the massive amounts of wealth lost, which on equity markets alone (globally) was over US$35 trillion when the DJIA close to 10,000 and since then fallen off by approximately one-third. This implies that between October 2008 and now wealth losses from the equity markets may have been down an additional US$10 trillion.

Failed stimulus plans

In order to try to address the problem the US government, first through Bernanke and Paulson, and now more though Obama and Geithner, have tried to address the problem through various forms of a fiscal stimulus package. As I had indicated from when Paulson and Bernanke announced their package, it would not revive the economies and at best would only ease the pain slightly. The current situation is like the common cold that can only be relieved by medicine, but has to run its natural course. But his would depend on the form the stimulus packages took. And to date the only one that has some form of resemblance to understanding the real issue is Obama's package that includes assistance for those behind in their mortgages.

The fact is that from last year when this great hurrah was being made about bailing out failed financial institutions, I indicated that would not work and all that was needed was for the governments to assure depositors and other customers that their money would be guaranteed by the government, similar to what Ireland did to bring back some confidence to the markets. Allocating large sums of money to the financial institutions was, a waste of money.

And the constant courting of Congress for further bailouts is proof that there is no end to this bottomless pit. My own view is that there should have been an orderly liquidation, or better mergers, of these financial and other institutions. Not in the way that they allowed Lehman to fail on its own, but an orderly break up and mergers of the good parts of the business and winding down of the bad parts. This approach would have saved the US, and the world, much grief.

But it didn't happen and finally a package comes from Obama that seems to correctly recognise that solving the problem cannot be done by bailing out financial institutions but rather has to hit at the heart of where the problems truly are, the consumer and more specifically addressing the problem of the housing market. The fact is that the underlying problem is that the US economy is based 70 per cent on consumer spending and bailing out financial institutions without bringing back consumer demand for goods and credit cannot solve the problem. And this is why the money given to financial and other institutions will not make the equity markets and economic activity better. It will only lead to a waste of taxpayers' money.

To properly address the problem, one must look at reinvigorating consumer demand, and the only way to do so is to provide the consumer with some amount of relief of their debt burden when compared to their wealth, which the real problem is the fact that house values have gone down significantly causing a freeze in credit markets (on which most loans were based) and a drastic slowdown in economic activity leading to job losses. The housing assistance plan by Obama should therefore be of greater assistance to the US economy than the bailout of these irresponsible financial institutions who do not even know how much value they have on their balance sheets.

Even though I have some confidence that the real problems are now being considered, the fact though is that there has been such a significant loss of wealth globally that it will take a while for consumers to start spending on discretionary items again, and even more importantly we will not for a very long time see a return to living standards of two years ago.
What this means for the world is that there will be less money being spent globally for a very long time.


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