Friday, March 20, 2009

Micro as important as the macro

All the talk of the global downturn always seems to focus more on the macro numbers and what governments need to do in order to help to stabilise economies.

In fact, it would seem as if the whole world has shifted from the reliance on the market economy, and has now placed responsibility for development on governments, leading many to say that the era of the market economy is over as the market has not proved to be an efficient tool for development. The argument is always" see what it has done. It has set us back decades." Of course nothing could be further from the truth, but that discussion is for another time.

In discussing the macroeconomies and what role governments must play, we must remember also the importance of the micro sectors - businesses and individuals. Many times we forget that the macro economy is nothing more than the accumulation of all the micro players in it. So, for example, when we speak about the national debt of over J$1.1 trillion, we tend to forget that the debt is made up of thousands of individual borrowers and recipients of those debt funds.

Options faced

The government cannot accumulate debt if personally we do not spend more than we earn and/or if we are producing more than we consume. The demands for government expenditure are in the final analysis to support our own total consumption. One could argue, though, that the government's role is like the father who should ensure that he implements fiscal discipline on the children to ensure that they spend within their means rather than mortgage the house to support their unacceptable lifestyle.

The point therefore is that dealing with the economic downturn is more going to be about how we deal with it individually rather than what financial support government can provide. We can, for example, support behaviour that is continuing the excessive use of resources above what we earn, but that is certain long- term destruction.

It is therefore important that the correct fiscal policies be put in place to cause a shift in consumption and production behaviour patterns. This structural change in behaviour will no doubt be forced on individuals as the economic situation forces change. As an example, as economic activity slows down it means that there will be less disposable income, which in turn means that people will be able to afford less and businesses will get less money, causing the start of the cycle all over again. Faced with this situation, we can choose to do one of three things:

1. We can seek to borrow money to afford the luxuries we are normally used to, such as high-end cars etc;

2. We can adjust our lifestyle by reducing our debt and not spend on unnecessary acquisitions; or

3. We can seek to produce more at our individual levels and so maintain our income levels through greater production.

Obviously the third option is the most desirable, but it is going to take some time for that behavioural change to take hold. The first reaction of many people will be to see if they can borrow more to maintain the lifestyle they have become accustomed to, and this includes businesses as well. My advice would be that in our current economic situation this would be the wrong choice for long-term sustainability. The best action is to first put in place option two above, shortly followed by option three. The reason why people seek to act on option 1 first is because for sentimental and other emotional reasons they try to hold on to what they know.

It is because of this why I have been saying that the world not only faces economic challenges but also psychological challenges which must be addressed. This is why it was refreshing for me that the RJR Group put on the "Yes you can survive in 2009" public seminar last week. They correctly identified that a wide cross section of professionals, including bankers, psychologists, and accountants, are necessary in oder to open this debate with the public. More important than the stimulus support that governments put in place will be our own behavioural changes to determine whether or not we are able to cope with the changed economic structure of the future.

Looming transformation

Let us not kid ourselves, Jamaica and the world are going to see a forced transformation of the economic structure. The boom in credit that we have become used to is at an end, and with that we will see a change in the face of businesses and a tempering of economic activity. Even after economies have stabilised and started to recover, for a very long time people will stay away from debt as they restructure their own portfolios.

This is as much a wake-up call for businesses as it is for individuals. When people call me about what to do with their businesses, as they have seen a significant decline in activity, I advise them the same way I would an individual. They need to speak with a professional and have that person lead them in at least a two-day strategic retreat where they look at their business and determine (1) its viability given what changes will happen; and (2) if there is a way to restructure their companies to take advantage of a changing marketplace.

If they determine that it is not possible then there is one best option. The worst thing to do for an individual and a business is to hold on to something that cannot survive because of sentiment. The long-term effect is even more devastating.

In addition to the current situation, I expect that there are going to be some more challenges that consumers, particularly in an open economy like Jamaica, will face. At the start of the year I indicated that I expected two global events to happen this year - (1) that oil prices will go back up, because of supply concerns and an indication that demand is returning to the US; and (2) that the US dollar will devalue against the other major currencies. Therefore, based on this, I see that the world could see another round of inflationary pressure.

Both expectations are starting to happen. Oil prices are slowly inching back up and I think as early as 2009 to 2010 we could see oil prices back at US$100 per barrel, and the US dollar has already started to lose value. And if the US dollar goes above the 1.40 to 1.41 mark against the Euro, then it could easily trade back up closer to 1.60. Both these factors will prove to be inflationary and if prolonged we could see people shying away from the US dollar as a reserve currency. This is even more dangerous if China decides to unload the US debt they hold, having already expressed concern about the stability of US debt.

Bernanke's move to indicate that the Fed will be buying back over US$1 trillion of US government debt will also mean increased money supply, lower borrowing cost, and higher inflation. This move by the US to get the economy going with an emphasis on credit is a wrong long-term strategy.

In the final analysis though, while stimulus packages can help to stabilise economies by providing much-needed economic activity, the ultimate solution is going to come from how we act as individuals.

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.