Hopes for a quick recovery built on shaky foundations

By David Roche Published: May 19 2009 16:39 Last updated: May 19 2009 16:39 The current rally in global equities and other risk assets has been massive, with investors and commentators in a feeding frenzy over morsels of economic data that support the end of the Great Depression scare. But there are three key flaws to panglossian hopes for a bull market and a V-shaped economic recovery. The first flaw can be simply put. If excess leverage in the US household sector lies at the core of the credit crisis and global imbalances, little has been done to address the problem. Since the start of the credit crisis, US household debt has risen. Indeed, as US net household wealth has fallen nearly 20 per cent, leverage has risen sharply in relative terms. To rejoin the mean of the trend line of household debt to gross domestic product, household debt should fall 17 per cent from current levels. In order to keep the trend intact, it would have to contract by nearly 30 per cent. The second flaw follows. If excess consumption lies at the core of the credit crisis, the problem has been made worse by government adding leverage to help households sustain their own unsustainable levels of debt. The credit bubble financed excessive US consumption by hefting asset prices and creating fictive wealth gains. Household savings collapsed because nobody needed to save from income when soaring asset prices were doing the job for them. But now the US national saving rate has to rise relative to investment. As the US public sector dissaving rate is likely to double this year and stay there for years, the heavy lifting of the national savings rate must be done by households turning thrifty. This implies a rise in the household savings rate to near 10 per cent of disposable income from today’s 4 per cent. The household savings rate can be lifted painlessly without detracting from consumption if household income grows. US household income growth so far has been due to government handouts and tax cuts. But that will fade in the second half of this year. So any further increase in the household savings rate must reduce consumption. The third flaw reminds us of the original problem. If excess credit creation and financial sector leverage caused the crisis, the problem has not been dealt with by the authorities. The authorities believe the crisis is due to a lack of liquidity that has driven down asset prices below their “true” value and not due to the insolvency of the assets themselves. The conclusions of recent stress tests in the US supervisory capital asset programme reveal that. The tests concluded that the US banking system was solvent and needed little extra capital, which it could raise under its own steam. But the tests were based on very sanguine assumptions about the economic future: namely that the housing market, economic growth and employment would all recover sharply in 2010. If you don’t believe that, then you can expect much higher losses on bank assets across credit markets and less banking revenue to absorb them. The US Federal Reserve reckons the top 19 banks that hold two-thirds of US banking assets need just $75bn of extra capital. On the same regulatory criteria used by the Fed, we reckon that the whole US banking sector needs more like $240bn (the International Monetary Fund says $275bn). A potentially more serious issue concerns bank liabilities and funding. Though there has been some thawing, the private sector wholesale funding market is still mostly closed. But the 22 largest global banks monitored by the IMF have to finance more than 50 per cent of their balance sheets from the money markets and longer-term debt. The funding gap is currently over $20,000bn and will rise above $25,000bn by 2011. Today’s interbank markets would finance only 10 per cent of this gap if the current volume of transactions persists. And public sector funding would cover only 35 per cent of the problem until 2011. So a return to healthy credit growth is far less likely than the advent of a Japanese-style “zombie” banking structure. All these flaws in the V-shaped recovery argument leave investors liable to disappointment. The writer is president of Independent Strategy, a global investment consultancy