Thursday, February 19, 2009

This is not a recession. This is a depression.

I think few people truly appreciate what is going on in the global economy today. Many people think that what we are going through is just a short-term recession, like those of the last decade. They think that after a short period of contraction, our economy will bounce back quickly. They think that the stock market will start rising soon and that the housing market will recover soon.

But very few people alive today have lived through an economic deterioration of today's proportions. Very few people alive today will ever live through another economic downturn of today's proportions. What we are looking at is a downturn of unprecedented proportions, unseen since the Great Depression of the 1930s. But don't take my word for it. Take it from Alan Greenspan, take it from the IMF Chief, take it from investment heavyweights like Marc Faber.

My first quote comes from the IMF Chief, who warned earlier in January that the world faces a global crisis:
World Faces Deepening Crisis, IMF Chief Warns

January 21, 2009

-IMF head says economic prospects even worse than previous projections
-Warns of risk of social unrest in some hard-hit countries
-Says more governments expected to access IMF lending

The world faces a deepening economic crisis, with the slowdown in advanced economies now spreading to major emerging markets such as China, India, and Brazil, Dominique Strauss-Kahn, IMF Managing Director, warned.

He said the IMF would significantly adjust downward its forecast for world growth for 2009 when the 185-member international institution announces a revised assessment of the global economy on January 28. In an update released last November, the IMF had said that advanced economies would see a contraction in output in 2009—the first since World War II—but that growth in major emerging markets would still enable the global economy to advance by 2.2 percent in 2009.

Deteriorating outlook

But Strauss-Kahn said in an interview with the BBC's Hardtalk program, broadcast on January 21, that economic prospects had worsened over the past few months and the IMF would announce lower numbers at the January 28 press conference in Washington DC.

"So 2009 will not be a good year for the world economy, even if we see recovery at the beginning of 2010," he said.

Prospects were worse than expected not just in the United States and Europe but also in major emerging market economies such as China, India, and Brazil, which would experience very low growth compared with recent historical trends.


More on spending side

A number of governments around the world have announced stimulus plans, including in the United States, Japan, Europe, China, and India. But Strauss-Kahn said he did not think enough had been done so far. "In Europe especially, they are still behind the curve," he said. "There needs to be more done on the spending side, especially because the reaction of the economy to more spending is quicker than the reaction to a decrease in taxes."

The European Commission said on January 19 it expected that the 16 countries using the euro would see their economies shrink by 1.9 percent in 2009.

Strauss-Kahn warned of the risk of social upheaval and unrest in some countries worst affected by the downturn and said he expected additional countries to seek IMF help, not just in Eastern Europe, but elsewhere in the world, including Latin America where some countries were "just on the edge."


Meltdown avoided

Strauss-Kahn said the world had avoided a total meltdown of the financial system as a result of coordinated intervention by major central banks last October. "We were very close in September to a total collapse of the world economy," the former French finance minister revealed.

He defended the IMF's different prescriptions for different economies, arguing that while major advanced economies could afford to boost spending and run up larger deficits to help get out of the recession, other crisis-hit countries, particularly the emerging markets of eastern Europe, do not have the same budgetary room to maneuver because inflows of capital had dried up and their currencies were under pressure.
A second quote is written by Marc Faber in the Wall Street Journal, who describes the global nature of the boom and bust:
Synchronized Boom, Synchronized Bust
Bad U.S. monetary policy had global consequences.


The world has gone from the greatest synchronized global economic boom in history to the first synchronized global bust since the Great Depression. How we got here is not a cautionary tale of free markets gone wild. Rather, it's the story of what can happen when governments ignore market signals and central bankers believe in endless boomss

As a consequence of this expansionary cycle, the world experienced between 2001 and 2007 the greatest synchronized economic boom in the history of capitalism. Past booms -- of the 19th century under colonial economies, or after World War II when 40% of the world's population remained under communism, socialism, or was otherwise isolated -- were not nearly as global as this one.

The cracks first appeared in the U.S. in 2006, when home prices became unaffordable and began to decline. The overleveraged housing sector brought about the first failures in the subprime market.

Sadly, the entire U.S. financial system, for which the Fed is largely responsible, turned out to be terribly overleveraged and badly in need of capital infusions. Investors grew apprehensive and risk averse, while financial institutions tightened lending standards. In other words, while the Fed cut the fed-funds rate to zero after September 2007, it had no impact -- except temporarily on oil, which soared between September 2007 and July 2008 from $75 per barrel to $150 (another Fed induced bubble) -- because the private sector tightened monetary conditions.

In 2008, a collapse in all asset prices led to lower U.S. consumption, which caused plunging exports, lower industrial production, and less capital spending in China. This led to a collapse in commodity prices and in the demand for luxury goods and capital goods from Europe and Japan. The virtuous up-cycle turned into a vicious down-cycle with an intensity not witnessed since before World War II.
And finally, a third piece quotes Alan Greenspan, former Chairman of the Federal Reserve:
Recession will be worst since 1930s: Greenspan
Wed Feb 18, 2009 5:22am EST
By Kristina Cooke

NEW YORK (Reuters) - Former U.S. Federal Reserve Chairman Alan Greenspan said on Tuesday the current global recession will "surely be the longest and deepest" since the 1930s and more government rescue funds are needed to stabilize the U.S. financial system.

"To stabilize the American banking system and restore normal lending, additional TARP funds will be required," Greenspan said in a speech to the Economic Club of New York. The U.S. Treasury's Troubled Asset Relief Program designed to help bail out banks has been partially successful, he said.

Despite his prognosis on the current downturn, Greenspan said the pace of economic deterioration "cannot persist indefinitely."

He reiterated, however, that a housing recovery is a necessary condition for the end of the financial crisis, and said that "the prospect of stable home prices remains many months in the future."

The stock market, meanwhile, is being suppressed by "a degree of fear not experienced since the early 20th century," Greenspan said. "Certainly by any historical measure, world stock prices are cheap. But as history also counsels, they could get a lot cheaper before they turn."
As you can probably tell, I am not bullish about the global economy. I am not bullish about the stock markets nor the housing markets. I think those who think we have reached a bottom and are currently hunting for value in the markets are likely to be caught in a "value trap" - when asset prices look cheap relative to recent valuations but are actually in a secular downtrend brought about by prolonged recession.

The value mentality was extremely useful in the past decades when the global economy was in a secular uptrend, and downturns could be expected to turn around relatively quickly. Recessions were relatively short and markets turned from bust to boom relatively quickly. But this is different. What we are seeing is debt deflation and a collapse in the credit system. What we are seeing is a fundamental unwinding of the banking system and the asset bubbles that cheap credit spawned in the last decade.

And I don't think that the stimulus package passed by the US Congress is going to be much more than a band-aid. Nor is the new housing plan unveiled this morning going to do much to stem the continued correction in housing prices. What will be needed will be bold, corrective action taken to fix the credit system - not the weak TARP ideas that Paulson and Geithner have been trying in the past few months, which simply try to prop up ailing banks with liquidity but that do little to fix the underlying credit problems facing banks.

Hence, I think stocks, housing and other prices still have some way down to go. The following chart, courtesy of the New York Times, illustrates this point:

At its current level of about 15, the P/E of the S&P 500 using a 10-year average of earnings certainly suggests stocks are much cheaper than they were a in years past. But “cheap” depends entirely on the context we view the valuations. It is certainly true that stocks are now priced lower than at any other time since 2000, when the current period on contracting valuations began. But it is also true that stocks remain at least 50% over-valued compared to previous long-term valuation lows seen in the 1930’s, 1940’s, and the early 1980’s.

The argument that we should buy stocks now because they are “cheap” is questionable investment analysis because it ignores the current economic environment we are in and the possibility that stocks could still get much cheaper than they are now. We know they can because it has happened before, and there is every possibility that the markets could easily decline another 20-30%.

On the economic side, I have already articulated my thoughts on the impact on Singapore's economy. Unlike Tharman Shanmugaratnam, I think that Singapore's economy isn't bouncing back any time soon. Thus, I'm sitting in cash and tightening my belt to wait for what might be a forthcoming investment opportunity of a lifetime.

As a final note, I think we should all heed the warning of economists Reinhart and Rogoff, who are working on a paper called "The Aftermath of Financial Crises"
Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of severe financial crises share three characteristics. First, asset market collapses are deep and prolonged. Real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years. Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment. Third, the real value of government debt tends to explode, rising an average of 86 percent in the major post–World War II episodes. Interestingly, the main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system. Admittedly, bailout costs are difficult to measure, and there is considerable divergence among estimates from competing studies. But even upper-bound estimates pale next to actual measured rises in public debt. In fact, the big drivers of debt increases are the inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged output contractions, as well as often ambitious countercyclical fiscal policies aimed at mitigating the downturn.

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