Disclaimer. After nearly 40 years managing money for some of the largest life offices and investment managers in the world, I think I have something to offer. But I can't by law give you advice, and I do make mistakes. Remember: the unexpected sometimes happens. Oddly enough, the expected does too, but all too often it takes longer than you thought it would, or on the other hand happens more quickly than you expected. The Goddess of Markets punishes (eventually) greed, folly, laziness and arrogance. No matter how many years you've served Her. Take care. Be humble. And don't blame me.

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Thursday, March 12, 2009

V-Shaped recessions (and such stuff)

There are at least three different kinds of recessions -- though no recession is 100% purely of one kind. One happens because of the bursting of an asset price bubble. That is the kind that has happened in the US. House prices rose too far, too fast. People borrowed heavily – and banks were happy to lend to them – in the expectation that this would continue indefinitely. The stupidity and greed of those involved is exactly comparable to the follies shown by speculators in previous asset price bubbles, starting with the Tulip mania in Holland in the early 17th century, and frequently repeated since. Recovery from this kind of recession is slow and difficult – though it always occurs! Bank balance sheets have to be restructured. Individuals have to repay debt (or go bankrupt, which worsens the banks’ difficulties). This takes time -- years, usually

Another happens because inflation starts to rise as free capacity in labour and equipment is reduced by a strong economic expansion. Central banks tighten policy in response to the rising inflation and often overdo it, producing recessions rather than growth slowdowns. The recessions of the 70s and 80s were of this kind.

The third kind of recession occurs when, for whatever reason, inventories are seen as being too high. Often the reason can be because of one of the other kind of recessions, but the "trade cycles" of the 19th century were usually inventory recessions, often triggered by a banking panic (does that sound familiar?) Imagine, for example, a company producing and selling 100 units a month of some item, while keeping one month’s worth of production/sales to hand. Now suppose its sales fall 10%, and it decides to cut production to keep it in line with sales. Production must fall 10%, right, to 90 units a month? Wrong. Because now the company must keep just 90 units in its inventories (the new level of sales per month), but actually has 100, production must fall by 20 units, temporarily, i.e., twice as fast as the fall in sales. Once the adjustment period is over, production goes back up from 80 to 90, because desired inventories now equal actual inventories. Of course, it’s not as simple as that, because one company’s orders are another company’s sales. As each company responds to the downturn, the decline is sales and production is exacerbated by feedback. But – and this is crucial – inventory recessions inevitably end, because inventories reach desired levels, production and orders start to rise, and the whole process reverses. The inventory cycle produces “V”-shaped recessions – a sharp drop off in sales, output and employment is followed by an almost as sharp recovery.

The Chinese economy and its suppliers and markets (Japan, Taiwan, Hong Kong, Thailand, Malaysia, South Korea) are suffering a savage inventory recession right now. Industrial production, imports and exports are declining by dramatic amounts. But these countries have not got failing banks or overgeared consumers. The Asian countries learned the hard lessons of their 1997 crisis, a result of overborrowing and overinvestment leading to credit and exchange rate crises. They have been more prudent since. In China the personal savings rate is 40% (in the US about 3%, up from zero), forex reserves are two trillion dollars (equal by some estimates to the amount needed to recapitalise US banks), and consumers have no consumer debt and only very moderate mortgage debt all based on loans made at very conservative ratios to valuation. Asian countries which are not networked into the Chinese industrial machine (India, Indonesia and Pakistan) have to date had to endure merely a moderate slowing in their industrial output, because they have not had the inventory recession taking place in China and its trading partners.

At some point quite soon, the steep industrial declines in China and the economies linked closely to it will end. The Chinese PMI index suggests that this has begun, though IP and exports still look soggy. Car sales have rebounded, fixed investment is up sharply. Even without massive stimulus in China (and the government has already announced a trillion-dollar support program and cut interest rates sharply), inventories will reach desired ratios to sales, production will stop falling and then start rising, and the world economy will bottom. Remember that these countries, at 23% of the world economy, are together larger than the US which is only 21% of the world economy. Asia as a whole is now 30% of the world economy.

Even in the US there are tentative signs of hope. Retail sales in February were flat after a big rise in January. The ISM indices for January and February have lifted off their low points, contrary to the expectations of the gurus. These indices, by the way, are very reliable pointers to the state of the economy.

This is not to say that trends aren’t still down. They are. The US economy will continue to slide for many months more. But the slide has slowed. In mathematical terms we are at a flexion point, where the rate of descent is diminishing, though the descent itself continues. Yet the probability of a rapid recovery is low. The problem at the core of the crisis, the housing market, remains unresolved, and is likely to remain so until the administration nationalises the major banks. Similar problems face other economies where the Anglo-Saxon model of a housing boom fuelled by indulgent government policies was followed, economies such as the UK, Ireland and Spain. In all these countries, the recovery will be slow. But for once the gurus are probably right: the low point for this cycle will be in Q2 or Q3. Which means the low for stock markets may well be happening right now.

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