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WELL, what a year 2008 turned out to be! Long-standing readers of this column will recall my comments on how much I dislike bull markets, not least because of the unpleasant way in which they end.
I was twitchy and my fellow writer David Sylvester even more so. However, when it comes to forecasting anything this disagreeable, the crown belongs to a New York-based professor of finance, Nouriel Roubini.
At the start of 2008, he provided a detailed 12-step outline of the unravelling of the credit crunch. This showed that subprime debt was merely a trigger as the architecture of the US and global financial systems becomes increasingly fragile.
Capitalism's weak point is its financial system. This is because the sole incentive to review its architecture - bearing in mind that frequent tinkering leads to instability in the system - resides with authorities.
Some more humorous examples are provided by the Michael Lewis essays posted to my blog.
Nevertheless, comments that "capitalism is dead" are completely ridiculous when contrasted with the complete and consistent failure of socialist economic philosophies.
A more constructive approach would be to regard the financial system as a public benefit, and manage it accordingly.
Monetary policy
Roubini pointed out that aggressive monetary easing would be required early on to start fixing matters. This is indeed what happened. He highlighed two consequences which would result from that.
Firstly, a disorderly fall of the US dollar as foreign investors become sceptical of financing US deficits (despite the fact that US debt is dollar-denominated - a benefit of holding a reserve currency).
Secondly, monetary policy would become relatively ineffective in stimulating the economy because there already is a glut of assets like housing, durables and cars.
It will take years to clear the glut and we must look at what I call the "post-debt economy" which in future may see somewhat muted household risk-taking.
To get to such a point, there has to be a period of much lower consumption, before things can revert to a higher, sustainable level. It is unrealistic to expect a slow reduction in household debt appetite and bank credit extension after recent events.
Roubini also noted that banks would look for much higher interest rates to compensate for far higher risk levels.
In addition, large capital losses would substantially reduce banks' capacity to lend. This is why current trouble asset relief programmes are focusing more on lending to healthy banks than failing ones, because healthy banks have the biggest capacity to lend.
Unfortunately, the 20%-plus fall in US home prices infers a reduction in household wealth in the order of $4 trillion, which of course means that the home ATM is something of a rapidly receding memory.
Even though banks have had some recapitalisation, there is no way that their capacity to expand credit again can match this sum.
Sadly, there are further factors coming in 2009 which are a matter of concern. One is that mortgage resets (from so-called teaser loans) are still likely to come through to torture the market.
Roubini correctly points out that the banks would do better to simply freeze resets and take a write down, but he also correctly points out that this rational solution is unlikely to be adopted and will only come to the fore when, frankly, it's too late.
The risk of transparency versus the need for truth in recognition of losses is also an issue. On the one hand, people want certainty as to where losses actually reside, so that the balance of their transactions can be done with confidence. On the other hand, massive levels of marking to market can lead to a spiral of asset price deflation.
At the end of the day, it may well be that banks have simply become too intricately structured; this is the problem with the investment banks in particular.
There was a time when no investment bank was listed at all - they were all partnerships and the partners shared in the risk. This created a natural handbrake that prevented excessive speculation.
For my own part I will watch with some interest what President Obama has to offer us on January 20. My personal hope is that instead of consumer tax cuts that wind up being just one more example of pushing on a string, Obama goes out and aggressively offers tax concessions for accelerated depreciation to those corporates engaging in capital expenditure.
In the case of SA, we obviously cannot afford to be complacent. However, sound banking systems and depreciation of the rand put us in a relatively steady position.
Like most emerging markets, we at least do not suffer from the pushing on a string problem, namely that when you cut interest rates, you still get a response from consumers.
I wouldn't plan my emerging market investments on what I think developed markets will do. If emerging markets now diverge strongly from developed markets, it wouldn't be first time this has happened!
- Warwick Lucas is an industrials and quants analyst at Imara SP Reid.
Bona fide questions may be mailed to: warwick@ispr.co.za.
- Fin24.com
