Urgent Credit Reform Needed to Ease Recessions

In a recent article “Stimulus Package Rebuilding Same Myth of Debt Fueled Economic Growth” I suggested sustained economic growth could only be achieved if excess money supply over and above the real economic worth of society was applied to new investment, rather than consumption or financial transactions. I also suggested in a following article “Two Asset Classes in Times of Turmoil: Risky and Risk-Free” that the incorrect allocation of excess money supply to financial transactions and consumption created at best a zero-sum scenario for the global economy with the increase in demand for goods and assets leading to inflation and price bubbles, not sustained real economic growth. The article concluded that investors, in the current environment of increased global economic synchronisation, had little opportunity to protect the nominal value of their risky asset portfolios as the correlation between most risky assets, gold a notable exception, increased sharply in times of economic and financial turmoil.

In the third and final article of the series, I will draw on extensive International Monetary Fund research which clarifies the reasons why systematic failure in the financial sector causes recessions to be longer, more severe and more contagious across international borders.

The IMF analysed 122 country specific recessions since 1960 across a sample of 21 advanced economies. Some countries, Ireland, Sweden, Norway, Japan and Canada entered only three recessions during the 50 year period. Switzerland and Italy suffered nine each. New Zealand led the sample with 12 instances of at least two consecutive quarters of economic contraction (the official definition of a recession). The US and UK suffered six and five recessions respectively.* Not surprisingly when the US was in recession the contraction had significantly more impact globally and during five of the six US recessions, more than ten of the 21 sampled countries also fell into recession.

Also provided by the IMF were details of the average duration of recessions, recoveries and expansionary periods since 1960. A recovery is defined as the length of time the economy takes to re-capture the GDP output level of the previous peak. Including contractions prompted by a financial crisis the average recession lasted 3.64 quarters. The average recovery period was 3.22 quarters and the average expansionary period lasted 21.75 quarters. Analysing only the contractions caused by systematic financial failure, the average length of recessions increased to 5.67 quarters. The recovery period also lengthened to 5.64 quarters on average. Interestingly the period of economic expansion following a financial crisis recession also increased to 26.40 quarters, possibly due to the introduction of much needed economic reform which inevitably follows systematic failures.

My wording clearly implies a financial crisis causes a recession to be deeper and longer. But could it be the case that deeper recessions cause a financial crisis? The IMF kill off this suggestion.

The fund researched credit availability, consumption, employment levels, nominal wages, house prices and equity prices in the expansionary periods leading to recessions and a clear and disturbing pattern emerged. Prior to a financial crisis recession (relative to other recessions); credit was more freely available, consumption was higher, the employment rate was higher, nominal wages were higher and house and equity prices were at more inflated levels. Unfortunately, unemployment levels took longer to improve as well following a financial crisis. The IMF went further and highlighted a strong relationship between country specific deregulation of credit markets and the depth and severity of the following recession. To put it simply, if you unleash cheap money and easily available credit you will get a very nasty recession when the bubble bursts.

The above findings support my more simplistic analysis which suggested debt, and its misallocation, above all other reasons is the cause of both the boom and bust economic cycle and the severity of the current global recession.

The IMF concluded its research with a discussion relating to the effectiveness of monetary and fiscal stimulus. Non financial recessions responded better to monetary intervention. Financial crisis recessions responded better to fiscal stimulus. In all instances the recovery was accelerated when both fiscal and monetary action was taken, rather than just one of the two. There was no evidence that monetary easing or fiscal stimulus delayed or damaged a demand led recovery.

The solution is clear, fundamental reform of credit markets is urgently required including the introduction of legislation limiting the availability of debt for speculative financial transactions and consumption in periods of economic expansion. My conclusion would be vulnerable in isolation, but combined with the IMF research it’s increasingly hard to argue against massive reform of credit markets.

*The US actually suffered seven occasions of at least two consecutive quarters of economic contraction but two separate instances in the early 1980’s were so close, I have defined them as being part of the same prolonged recessionary period.

Data source: International Monetary Fund

IMF Analysis of Recessions 1960 to 2009

Europe Pays the Price for the Pursuit of Paper Wealth

Europe continues to trail the field in the race to escape recession. The US, Asia and UK all appear better equipped to formally report positive GDP data, before the Euro-zone. The reasons for this are many. A single financial and monetary framework, for the 16 member states of the Euro-Zone, has created a one size fits all policy which inevitably fails to address the unique needs of individual countries as diverse as Ireland, Cyprus and Finland. In particular, the process of establishing a single Euro-zone interest rate across such a large economic region is just an efficient recipe for the manufacture of asset prices bubbles, and as now, a sustained recession. The Irish property market bubble is the easiest example to highlight, though the same can be said of the price of homes and commercial land in Spain. Both countries enjoyed an inappropriately lax monetary policy for years. This incorrect policy combined with flawed banking sector risk controls made the recent property price rally, and subsequent crash, inevitable. Credit (mortgages and loans) should be cheap, but difficult to obtain and only provided extensively to proven and prudent borrowers or those with significant collateral. Incorrectly allocated (and priced) credit always leads to economic turmoil as it corrupts the perceived fair value of risky assets. The reason is simple but often forgotten and is worth investigating.

Although the financial system contains innumerable types of financial instruments there are only two distinct groups; risk free assets and risky assets. Risky assets need to offer a premium to the buyer, a potential of excess return above the risk free rate, to compensate investors for the possibility they will lose all or some of their capital. In times of high confidence and strong economic growth buyers are generally willing to take a lower premium as the probability of loss is theoretically smaller. In periods of uncertainty and economic weakness investors seek a higher premium to reflect the increased possibility of capital erosion. The exact premium over the risk free rate will depend on the individual characteristics of the risky security. For example, the risk premium of shares in a newly listed technology company with growth potential but unproven revenue needs to be higher than the risk premium embedded in the shares of a mature utility company with secure cash-flows. The principle is the same however. Investors need to understand the risk of a transaction, correctly identify a likely return, and decide whether the risk/return profile is attractive relative to the return provided by a risk free asset, such as cash. Investors as a whole have consistently failed to accurately identify the risk/return profile of risky assets.

There is also widespread confusion between creation of real economic wealth and financial paper wealth. Few financial transactions create economic wealth. (The velocity and circulation of money is a different issue). Sustained economic growth is achieved via the creation of real wealth. A financial transaction, for example the buying of gold, listed shares or in-circulation bonds is not the creation of new and real wealth. It is the transfer of wealth (an investment opportunity cost) from those who executed the transaction at an unfavourable time to the opposite party who bought/sold at a time where the asset was mispriced in their favour. Let’s use Microsoft shares as an example. The company is listed. If you buy Microsoft shares from your broker, Microsoft doesn’t get the money. The seller of the shares receives the proceeds. Post-transaction there are only two scenarios. The shares will go up or down. If they go up the buyer is profiting at the expense of the seller (who should have held). Wealth has not been created, all things being equal. Likewise if the shares fall, the excess profit above fair economic value, received by the seller is off-set by the buyer’s losses. If there are more buyers than sellers then the price will rise, but new real wealth is not being created. It’s just paper wealth. Nominal paper wealth, unless supported by real assets of similar economic value, is always vulnerable to collapse.

Now add into this paper wealth environment banks with weak risk controls, who lend consumers, investors and institutions cash some of which is used in the purchase of paper assets. Buying increases, asset prices are inflated, bubbles are generated and the only winners are the few who through luck or rare judgement sell their assets at the inflated (incorrect) prices.

Of course some financial transactions, a minority, can potentially create wealth. When a financial transaction gives entrepreneurs or companies additional cash and that cash develops a new product, a new drug or an asset that produces a new revenue stream then real economic wealth is created. But most financial transactions do not. Successful stockbrokers, who trade in listed securities buying and selling assets at the optimum time, are therefore not creating new economic wealth. They are reallocating society’s existing wealth from shareholders who buy or sell at the wrong time, to their clients.

Some economists will nominate the circulation, or velocity, of cash generated by these paper financial assets as having economic benefits. My response is the circulation of cash in mispriced financial transactions is less useful, in fact it’s positively harmful, when compared to the other option available which would be to circulate the cash through the economy via consumption of goods rather than in flawed ‘asset bubble’ investment practices.

In conclusion, returning to the examples of Ireland and Spain. Both countries, burdened with an inadequate Euro-zone monetary framework and a flawed banking sector, allowed the manufacture of paper wealth to out-strip real economic growth by a dangerous margin. In the depths of a European recession, the ECB is evidently ill-equipped to identify the difference between paper wealth and real economic wealth or tackle the problems generated by the gap between the two.

The Global Economy – 1st May 2009

UK Focus The FTSE 100, like the US equity market, enjoyed a very strong April on the back of improving risk appetite. The index closed the month 8% up and is around 20% higher since its early March low. Banking stocks and cyclical high growth potential shares have been the primary winners though the ‘rising tide’ has helped more defensive plays as well. Market volatility has also eased. Perhaps the most noticeable stock winner is Barclays, which briefly touched 50p earlier in the year and is now 275p, at the time of writing. Clearly the stock was significantly oversold. Maybe now it is overbought, at least in the short term, with so much weakness in the global economy still apparent. Indeed, all banking shares have been back in fashion in recent weeks, though bank chiefs are still under focus for their role in the recent chaos. The Treasury Select Committee in a statement this week suggested Royal Bank of Scotland and HBOS were the “principal authors of their own demise” and that they had made an “astonishing mess” of their industry and the economy. The Committee also blamed regulators suggesting they had proved themselves incapable of protecting the public from banking sector systematic risk; low praise indeed for the financial services industry supervisory bodies. In response, the BBA (British Bankers Association) highlighted that not all banks had demonstrated incompetent risk controls and the requisite measures were being introduced where necessary to protect the sector and economy in future.

Also in the UK, company insolvencies rose sharply in the first 3 months of 2009, relative to the year before. Almost 5,000 firms were forced into liquidation up from approximately 3,150 in Q1 2008. Personal insolvencies also rose significantly to almost 30,000, a 39 year high, with around 2/3rds seeking bankruptcy, the remaining pursuing voluntary arrangements with creditors. Increased failure to meet debt payments due to unemployment or an inability to re-finance current obligations are the leading causes for individuals. Other data included a smaller than predicted increase in March mortgage lending to £757m, relative to a £1,600m consensus forecast. Home loan approvals totalled 39,230 compared to 100,000 often seen during 2007 months. Looking forward the Bank of England Monetary Policy Committee will therefore need to fine-tune its quantitative easing strategy, designed to flood the economy with £75bn of liquidity as though some signs of improvement are evident (in short-term interbank lending), there is no quantifiable progress to be seen in the residential property and mortgage market.

Ryanair Global recession, record fuel prices in 2008, increased security costs, swine flu, sector downgrades, environmental pressures, oppressive regulation. Owning shares in a low cost airline can be stressful. Managing one must be a nightmare. So you need to be tough as old boots to build a business in the sector. Enter Michael O’Leary and Ryanair. Launched in 1985 with a single 15 seat aircraft, Ryanair through the sheer force of the management team’s personality have built the carrier to presently service more than 800 routes via 26 countries. Orders for 111 more Boeing aircraft are planned for delivery over the next 3 years to supplement an existing fleet of 181. Ryanair clearly retains ambition. But pan-European bureaucratic challenges are likely to persist that may hamper the new aircraft from fulfilling their revenue potential. O’Leary is all but at war with European regulators over the alleged restrictions and disadvantages applied against the discount airline. Most obvious example is the long running grievance relating to anti-competitive practices adopted by the airport authorities at Stansted (and Dublin), despite some positive moves by the UK Competition Authority in its ruling to break up the BAA monopoly. Also undermining the ability of Ryanair to take more market share are the continuing government subsidises given to Air France, Lufthansa, Olympic and Alitalia which ensures the survival (and therefore slot occupancy) of rivals who would quite possibly disintegrate without domestic government hand-outs. O’Leary and Ryanair without a doubt provide the most entertaining annual report, plain in packaging but rich in opinion and gripes. Regulators, politicians and the competition must wince when O’Leary targets them with sound-bites. For investors, owning Ryanair stock is likely to offer a financial roller-coaster ride for some years hence but I wouldn’t bet against O’Leary or RYA shares delivering more than could be reasonably expected again in the future.

The Global Economy 30th April 2009

The US equity market closed the month with strong progress banked despite the grim economic data, discussed below, and the growing threat of the Mexican swine flu. The S&P 500 index, the most appropriate measure of equity risk appetite for large capitalisation stocks gained 11% in April, its strongest monthly performance since 1991. Market speculators are usually content to look long into the future to justify today’s buys and the trend of accumulating high-growth potential equities before the first green shoots of an economic recovery have surfaced, has occurred again in this recession, like recessions before.

Even the weak US GDP news, released Wednesday, failed to dampen April’s performance. US economic activity in the first quarter contracted 6.1%, annualised, a faster rate than predicted as businesses ran-down inventories and exports sunk on weak demand. The disappointing data was noticeably worse than the consensus 4.9% reduction anticipated, and within a whisker of the 6.3% contraction suffered in Q4 which commentators hoped would represent the trough in the economic cycle. The US economy has now been in recession for 16 consecutive months and if the trend continues for a further month would result in the longest period of negative economic activity since the 1930’s. A return to positive growth is expected by the 4th quarter 2009 as factories increase output to meet industrial and retail re-stocking. The US Commerce department identified over $100bn of reduced inventories during Q1 which accounted for around a 1/3rd of the fall in Q1 GDP. Exports slumped 30%, following a 23.6% fall in previous quarter whilst corporate investment dived almost 38%. On a more positive note consumer spending stabilised in the period help by the first growth in durable goods spending in a year. US mortgage applications remain at severely depressed levels.

Market liquidity and the willingness of banks to lend to each other are improving. The 3-month USD, EUR and GBP interbank rates have all fallen consistently over the past 4 weeks with Sterling enjoying an unprecedented sequence of successive daily declines in the key borrowing rate. The improvement, from distressed levels, is further evidence of the willingness of investors and key institutions to take on risk. The Euro and Dollar rates have retreated to the lowest level since September 2008, when the global banking sector was on the verge of collapse. The interbank rate is fundamental to the economy and lending as it is the benchmark against which many corporate loans and financial products are priced. Lending beyond 3-months remains stressed with interbank borrowing beyond 90 days very illiquid, but there are definite signs of improvement especially for short duration loans. A similar picture of recovery and increased confidence can be seen in the US municipal market, the source of much US state borrowing. Yields on marketable state debt have steadily reduced with bond prices rising, as more investment managers have been prepared to re-enter the market. Yields should fall further when economic data improves as the spread, the difference between the Federal Reserve official rate and the interbank rate, is still exceptionally wide in relative terms.

In Europe, some of the countries suffering the most from the global recession are countries, like Ireland and Lithuania, which grew the quickest in the preceding 10 years. Forecasts for the Irish economy are being downgraded with alarming frequency with the Economic and Social Research Institute now predicting a 9% contraction in the current year, downgraded from the previous negative 4% forecast. Unemployment, now at 11.4%, is to worsen to 16% during 2010, whilst property prices are vulnerable to a 33% fall from the 2007 peak. Increased emigration, which assisted the economy during previous recessions by offering employment opportunities to those who were unable to secure work at home, is now less of a viable solution. Many of the traditional destination markets for Irish job-seekers, such as the UK, Australia and Canada are also suffering due to the high synchronisation of the global downturn. Lithuania is in an even worse mess with GDP falling 12.6% in the quarter, relative to the Q1 2008, a near 40% annualised contraction, giving the Northern European state the unenviable title of the fastest shrinking economy in the E.U. Thing’s don’t look so bad in the London suburbs after all.

UK Company Focus Rio Tinto PLC (RIO). Rio Tinto, the international mining company, has a wealth of interests across the commodity extraction sector including copper, coal, uranium, diamonds, gold and iron ore. Rio shares grew strongly into 2008 and the stock reached a peak of £70.78 before falling to earth like a weapon of monetary destruction (to £10.49), late in 2008, magnifying the collapse in market-wide investor sentiment and resource prices. Investors also sold off the stock, bored with the ‘will they or won’t they’ BHP Billiton acquisition saga which seemed to last so long investors could be forgiven for nostalgically trying to find first mention of the planned deal in the Bible. Since the December 2008 stock price low, Rio has bounced more than 150% but is still some way off its average 2008 price let alone its high, which occurred less than 12 months ago.

2008 was such a contrasting year for Rio share holders with substantial success in H1 the polar opposite of an appalling 2nd half, any rational discussion would require a book to adequately discuss all the global and domestic influences contributing to the price volatility. Rio Tinto is after all, like other FTSE 100 stocks, supposed to be the meat and drink of ‘medium’ risk diversified equity funds which grace the portfolios of million of UK unit trust and pension fund investors. ‘Medium’ risk? The very phrase seems sarcastic, in retrospect.

During the first few months of 2009, Rio has worked hard to tighten the business model; cutting costs, divesting non-core assets, realising $2.5 billion in the process as well as proactively avoiding any measures that would result in a significant increase in net debt. Production strategy in response to the global recession is harder to assess as productivity improvements have partly off-set deliberate reductions in output elsewhere and the production picture varies greatly from resource to resource. Q1 2009 saw uranium output steady at approx 3.4 million pounds relative to the same period a year earlier. Iron output was 15% lower year-on-year, whereas copper and coking coal output were up 33% and 32% respectively. The Rio Tinto CEO, Tom Albanese, stressed throughout the Q1 update, a continued focus on cost reduction and a determination to adjust supply through 2009 to more accurately meet demand, which is expected to stay weak through Q2 before recovering later in 2009. Rio’s eagerness to complete the Chinalco transaction and to negotiate the deal through the global regulatory mine-field remains a priority. Such is the volatility of the stock, often moving more than 5% on a single day it will remain a favourite tool for day-traders as well as buy and hold investors retain a bullish view on the resource sector over the medium to long term.