Sunday, 4 December 2011

Back To The Future?

(click on chart for larger image)

Looking back over the last 52 weeks, and using the Dow Jones index of the New York Stock Exchange as a guide, it is possible to track in broad strokes the effects of the Sovereign Debt Crisis on that crucial stock market.

The chart above (which indexes the Dow Jones based on the week of 19th September 2011 as 100) starts in November 2010 just as the 85 billion Euro bailout of Ireland was agreed accompanied by the toughest budget in the Irish Republic's history. This action itself followed on from an E110bn Greek bailout in May 2010 also accompanied by austerity measures. Following the rescue of the Irish banking system we saw the Dow Jones steadily climb until mid-February 2011 to the first of three market peaks, each of which turned out to be shortlived.

A further bout of market pessimism, despite the EU agreeing to the setting up of the E500bn European Stability Mechanism to replace the temporary European Financial Stability Framework in 2013, sees the market decline again in March.

A second peak in the Dow Jones is reached in late April, but once again Eurozone worries, with the Portuguese government admitting it cannot deal with its finances without EU help (resulting in a E78bn bailout in May) sees the market drop and economists also begin to talk about Greece being forced to leave the Eurozone.

However, the market begins to recover for a third time as new austerity measures are imposed upon the Greeks, despite huge levels of civil unrest, accompanied by the EU agreeing a second E109bn bailout. The market reaches a third peak in July.

But the respite is short-lived as August brings further doubts about the ability of the Greeks to remain in the Eurozone, and, again, opinion begins to be voiced as to whether it would be better if Greece defaulted, as concerns about contagion in the sovereign debt market lead to yields increasing on Spanish and Italian bonds.

An announcement by the European Central Bank that it will buy government bonds does not prevent a severe drop in the Dow Jones which is followed by a period of doubt and uncertainty with the market seeing alternating triple-digit falls and rallies.

Eventually, in October, a certain degree of bullishness settles into the market that the worst of the crisis is over, as an E130bn bail-out of Greece combined with a partial voluntary default on some private sector debt is agreed. This is accompanied by the appointment of an unelected technocrat to power in the cradle of democracy. A similar technocratic appointment in Italy, seen as the next domino in the bail-out stakes, accompanied by yet more austerity, sees the Dow Jones climb by some 14% before dropping back a little over the last week or so.

After a year that has saw three separate peaks, with the last followed by a major decline into a period of intense market volatility, there are those who suggest that the recent rally in the Dow Jones will be sustained - that the worse is over.

This scenario sees the Eurozone area experiencing a relatively moderate recession, and the UK and US a few years of moderate growth, but that the BRICs and other emerging nations will soon pull the World Economy back to the levels of growth experienced pre-crisis.

That might be a little optimistic.

Because we may have been here before.

Below is the same chart as above but I have now added a second set of data. This too is for the Dow Jones Index but this time covering the 52 week period up to the week of 28 April 2008 (with the week commencing 19th February 2008 set at 100).

(click on picture for larger image)

This time the chart begins in April 2007 by which time concerns about the subprime mortgage lending market in the United States were beginning to have major effects. By June, Bear Stearns announced the failure of two of its hedge funds and soon after the Dow Jones reached it's first peak in before declining.  The hedge funds' collapse was seen as an intensification of the subprime crisis rather than something deeper, however in August the European Central Bank stepped in to offer liquidity to banks.

The Dow Jones then began to creep up again, reaching a new, second peak, and its highest ever recorded level of over 14,000 in October.  But by this time the UK had seen its first run on a bank since 1866 as customers queued around the block to get their cash out of Northern Rock whilst banks like UBS and Citigroup now announced $3bn losses to subprime, with Merrill Lynch reported to have exposure of almost $8bn.

Nevertheless, perhaps buoyed by the IMF forecast of only slightly reduced World Economic growth of 4.8% in 2008 followed by 5.1% in 2009, the Dow Jones peaked for a third time in early December.

However over the Christmas period and into January, as worries about liquidity and the subprime exposure of individual banks increased, the Dow dropped by over 10%.  This did not prevent Wall Street from awarding itself $32 billion in bonuses of course.

Just as now, there then followed a volatile period in which the market seemed to change direction depending on conflicting news headlines and/or pure speculation.  Increasing commodity prices (Oil had been forecast to drop in price by 20%, but would instead increase in price by almost 50% by July) added to the mix, whilst the Federal Reserve reduced interest rates to 3.5%, and then, a week later, to 3%.  Meanwhile in February, the nationalisation of Northern Rock by the British government was finalised.

A key moment came on the 11th March, when the share price of Bear Stearns collapsed. After a weekend of frantic negotiations a company that had a market value of $18bn a year previously was sold to JP Morgan for $1/4 billion.

Just as in November 2011, the apparent resolution of a problem with an insolvent entity (for Bear Stearns read Greece), seemed to calm the market.  Over the next nine weeks, the Dow Jones steadily rose, even after the IMF published its Global Financial Stability Report estimated potential losses due to the crisis at $945 billion.  By the end of April, the nine week rally saw the Dow Jones hitting the 13,000 level again, which although still short of the 14,000 it had hit in October, seemed a good indicator that the global economy - and the financial system - would soon return to business as usual.

Comparing the two 52 week periods, the track of the Dow Jones show, in both cases, three separate peaks, followed by a decline.  There then followed a period of volatility, followed by a "recovery" when it was felt that the worse was over and the "bad apple" problem (Bear Stearns, Greece) had been resolved.

The difference is that for 2008, we now have the benefit of hindsight, and we can look back at 2008, and see what happened next.

(click on picture for larger image)

What came next, was, of course, the nationalisation of the US government-chartered mortgage institutions colloquially known as Fannie Mae and Freddie Mac, the collapse of Lehman Brothers, the nationalisation of RBS, the $700bn US government asset purchase system, the bailout of AIG, etc, etc, etc.

From a level of 14,000 in October 2007, the Dow Jones dropped to 6,600 by March 2009. Similar effects were felt on Stock Markets around the globe as $50 trillion worth of assets were destroyed. The effect in the real economy saw millions made unemployed as the world experienced its first year of negative growth since the end of World War II. 

The OECD countries saw a drop of almost a trillion dollars in private fixed investment between the beginning of 2008 and the end of 2009.  In the UK, by the first quarter of 2010, GDP had dropped by £18.6 billion with over £10 billion of fixed investment lost, while personal spending saw a decline of over £8 billion as people tightened their purse strings.

In response, politicians have inflicted austerity cuts on those least culpable whilst many of those individuals and corporations who benefited most in the years of boom continue to take advantage of tax loopholes to avoid paying taxes of between £35-£220 billion per year in the UK alone - tax revenues that could otherwise protect frontline services like healthcare, education, and welfare.

The fact that the Dow Jones in 2011 has unerringly retraced the ebbs and flows of the Dow Jones in 2007-08 does not in itself mean that we are about to have a global recession as we had in 2008/09.  Past performance is, after all, no guarantee of future performance.

But there is a feeling amongst many that the financial crisis further revealed the underlying weaknesses of the current financial system that already been exposed by the Asian banking crisis and the default of Russia in the late 90's. It has demonstrated the unsustainable nature of a global economic system in which massive trade imbalances are sharpened by private consumption.  Private consumption that, due to wage repression, is itself reliant on debt creation fueled by massive credit transfers from producer countries and historically cheap interest rates. 

The response to the $1.4 trillion subprime mortgage shock of bailing out the banks has merely served to transfer an unsustainable debt problem from private banks to the public sector where it has exacerbated an existing problem caused by politicians caught in the trap of promising both low taxes AND decent levels of public services.  In comparison to subprime, the combined sovereign debt bill of Portugal, Ireland, Italy, Greece and Spain is in the region of $4.8 trillion, and financial institutions are placing bets on the yields from government bonds for the PIIGS just as they did on mortgage backed securities and their derivatives in the subprime mortgage sector.

It now seems that because major reforms to the global banking system have largely failed to materialise, allowing banks and other financial entities to continue with business as usual, it is likely that another global recession, one potentially even more devastating then the first, may be about to hit the world's economy.