A bailout a week keeps the economy weak. That is the likely routine for the US in the next couple of years or possibly longer. The biggest signal from the US treasury’s bailout of the two home mortgage corporations a week ago is that the mother of all great depressions could follow in the next few years. Of course, most of us would dismiss this as scare-mongering. The problem is in figuring out if the counterpoint represents a forecast or wishful thinking.
As the US blinked at the threat of foreign sovereigns making good their losses, the power and limitations of sovereign wealth funds (SWFs) have come to the fore. The US had to make explicit the implicit guarantee of government backing for the two federal home loan enterprises. It blinked at the prospect of potential lender reaction. It did not ask the debt-holders — SWFs — to absorb even partial costs of the restructuring of Freddie Mac and Fannie Mae. Yet, far from restoring confidence, this would enhance the power of extortion. The risk of eventual exchange rate and trade frictions has now gone up substantially.
One of the sovereigns that invested substantially in US treasury and agency debt was Russia, and the West has sought to isolate it in the last two months. The rapid decline in the fortunes of the Russian stock market and those of the rouble in the past few weeks cannot be solely attributed to normal investor reaction to the Russian retaliation in response to the unprovoked hostilities initiated by Georgia. The market reaction appears well orchestrated. This will have consequences. Another chain of events has been set in motion here.
Next, the bailout has raised the estimate of the US fiscal deficit for the next two years and, statistically, for the next decade, under certain assumptions. Goldman Sachs writes that the uncertainty surrounding the estimates for the US budget deficit by the Congressional budget office is entirely to the upside. Foreign central banks are unlikely to finance it with the same enthusiasm as they had done in the last five years and in the light of the inflationary consequences in their own economies.
A combination of rising fiscal deficit, diminished investor appetite and low interest rates ought to be gravely negative for the currency. Despite the valiant and irrational rally of the last two months, the dollar’s dog days are not over. In fact, they have just begun.
August retail sales numbers, now that the inflated effects of consumer price inflation are coming off, were rather weak and there was downward revision to the July retail sales figures too. With unemployment rising and job prospects remaining bleak, consensus opinion appears too blasé about the ramifications of the balance-sheet deleveraging of US households.
The decision of the European Central Bank to impose a higher margin on European banks accessing loans from it, while technically correct and prudent, would inevitably lower growth. But the blame must be laid not on this decision but on the behaviour of the banks that led ECB to impose higher margins. The financial industry in the developed world has learnt nothing and forgotten nothing.
In the middle of all this, American stock markets are so flagrantly manipulated. Every single bailout is leaked well in advance and the market stages inexplicable rallies from hopeless intra-day situations. No one believes in the integrity of the US stock market any more and it would continue to decline in a slow motion way. How far it would decline would be determined by how long analysts remain hopelessly optimistic on the earnings prospects for American corporations.
Even as leading indicators of economic growth slow sharply in major regions of the world, analysts continue to expect that earnings per share for S&P 500 stocks would be about 25% higher next year at around $105 per share. If they come down to a more realistic estimate of around $60-65 per share, as they must, then even applying a historically high multiple of 15 times to such earnings brings the S&P 500 index outlook to around 900. This is optimistic. Incidentally, this would mean the kiss of death for emerging market stocks.
If we put all this together — rising US fiscal deficit, low interest rates, synchronized growth slowdown, massive household deleveraging that has barely begun, falling confidence in the American market and its capitalism, needless Western antagonism towards Russia (an important oil and gas producer), excessive earnings optimism and high stock market valuations — the denouement is clear. Either the world muddles along at stall speed for so long that it feels like eternity or it falls into a depression. What if Bare Talk is wrong and the world economic growth is successfully revived? Then, welcome to a world of resource wars and higher inflation. Readers can take their pick.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore.These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org