Fair value

IN a wonderful column on Wednesday, Greta Steyn discusses how a deflationary environment turns conventional economics on its head.

I want to explore some of the monetary processes and implications of the proposed fixes.

The banking crisis was a liquidity crisis; now, it's a solvency crisis.

Central banks may well start buying corporate debt or even equities. This wouldn't be the first time.

Hong Kong bought stocks aggressively in the 1997 financial crisis in order to fend off a currency attack, and it proved the right course of action.

Is it valid to compare the current situation with the depression of the Thirties, or Japan's horrendous decade in the Nineties?

The Great Depression featured a flexible economy and rigid monetary system (the gold standard).

Economic rebound

Japan had a flexible monetary system, but the economic system was rigid (lots of government intervention).

The US has a flexible economic and monetary situation. A reasonable supposition is that the economic contraction coming in the US should be more severe than that of Japan, but shorter and overall not as severe as the 1930s.

A reasonable economic rebound might even be followed by a prolonged period of low growth.

The peak in the household debt to GDP ratio in 2007 was just over 100%.

If we assumed a decline down to say 80%, debt will be reduced by $2.8 trillion. The banks have not been dropping their lending rates in line with the Fed, and Americans are starting to save.

Thus, the multiplier effect of a fractional reserve banking system is now starting to swing the other way - liquidity is savagely contracting.

As a result, the Fed is now in the position that it can't cut rates below 0% and it is starting to buy government bonds to supply liquidity to the system.

For now, there is little risk of triggering inflation because of the contraction in the private sector.

Note that there are three requirements to generate hyperinflation: there needs to be a massive printing of money; huge trade and fiscal deficits as well as large government debt.

The US has all three in spades, so Steyn's admonition that the Fed has to be very careful in managing inflation when it finally turns up is a most important point.

Improperly managed, runaway inflation could easily take off in the US and it's not over-dramatic to say that the Fed will operate on a knife's edge for some time to come.

Feasible contrarian play

This brings us to the discussion of President Barack Obama's infrastructure plans. The normal and correct argument against large state programs is that government often accidentally or by design crowds out the private sector.

Given the massive reduction in activity in the private sector currently, this programme will make use of idle capacity and provided productive and sensible investment is made, prove a feasible contrarian play.

My interest, of course, is what this all means for stock market investors.

Earnings growth in the last few years globally has been unsustainably robust, forming a high base from which it is precipitously falling. Therefore, equities might only be fair valued, not deeply discounted, as one would suspect after such falls.

Equities should also price for risk, so aggressive investment seems unjustified at this stage. A decline in risk, or some kind of earnings recovery would need to be in prospect.

For some hope, we should look east for the spark of future recovery.

Also, a South African - or indeed any emerging market investor - who based their entire investment policy on what's happening in the US, needs their head examined. When Europe and the US were wallowing in the misery of the Great Depression, Latin America and Asia did better.

The Chinese economy will undertake a two-pronged assault consisting of a four-trillion renminbi infrastructure programme and a boost to consumer spending.

With regard to consumption, China will be introducing basic health care coverage. As China doesn't have a social safety net, the country's savings rate is extreme. By switching the provision of health care from self-funded to pay-as-you-go insurance, it should release consumption.

The high savings rate will also be able to fund infrastructure for some time - vital, since the Chinese export markets are in ribbons.

The Chinese economy is responding to monetary stimulus; loan growth and money supply have picked up in the last two months. Some steel production is resuming, suggesting that de-stocking may be ending.

While these are all positive signs, it is too soon be sure that China's economic growth has bottomed.

The debate in the US over the levels of the renminbi is somewhat dangerous, since one way that China can revalue the renminbi is to sell its US bonds and repatriate the proceeds back to China. US Treasury Secretary Timothy Geithner had better beware what he wishes for.

At times like this extreme ideas come to the fore.

"Capitalism has failed" - shriek the left!

"Only a complete and utter economic enema will save us all" - roar the right!

The truth will - as always - lie in the middle. Obama has commented soundly on the matter, namely that markets are the best wealth-creating mechanisms known to humankind, and yet are subject to frailties that beg examination.

I believe that one should look at the time ahead as a tremendous challenge, which should be used to refine and improve capitalism, and not only challenge the role of the private sector, but also challenge the role of government.

We need to ask ourselves: how much do we want government to rule us, and to what extent government should be a guide, providing a useful helping hand to better the lot of all?

This topic I will discuss in greater detail next time.

- Warwick Lucas is an industrials and quants analyst at Imara SP Reid.

Bona fide questions may be mailed to: warwick at ispr.co.za.

- Fin24.com