'Oxen know they will succeed through hard work and sustained effort and find no truth or benefit in concocting get-rich-quick schemes...' (Chinese Calendar describing the forthcoming Year of the Ox)
Markets are limping exhausted to the end of a tumultuous year but before I look at the likely shape of markets in 2009 and beyond in forthcoming posts, it's crucial to take stock of where we currently are and how we got here. The narrative of the recent market crash and global recession is not as simple as it is often presented. The bad guy in this horror story isn't simply a greedy US consumer splurging on stuff he doesn't need with money he doesn't have. China and the US have been locked in the economic equivalent of a drunken embrace for years, and it was only a matter of time before huge global imbalances in trade and savings were going to revert to a sustainable mean.
The shameless greed of sub-prime mortgage originators and the banks that securitized their loans and parcelled them around the world was fed by a global excess of savings funnelled from the merchandise and energy exporters into Western capital markets, artificially depressing risk premia on assets from emerging market debt to mortgage securities. That excess liquidity, bloated by reckless central bank policy after the Dotcom crash and 9/11, was like financial helium, and ultimately generated simultaneous, overlapping bubbles across several asset classes. Throw in historic lows in volatility, sprinkle with lax regulation and simmer gently for a few years until you smell burning money.
I think two key policy mistakes in 2008 hugely exacerbated the scale of the inevitable crisis. The first was ignoring the wild speculative bubble in commodities and allowing it to grow to such a destructive extreme rather than choking it off with increased margin/regulatory requirements. The second was killing off Lehman Brothers (LEHMQ.PK), causing systemic meltdown that accelerated the downturn in the global economy. Both policy failures were driven by ideological dogma; the market's always right and rational, except it manifestly isn't. One of the drunks has now collapsed to his knees in exhaustion, but China is still staggering and about to keel over without the US to lean on.
In 2008, recognizing where the consensus was most clearly exhibiting crowd psychology was an easy path to profits, whether shorting 'supercycle' commodities or 'decoupled' emerging market equities from the spring, or US equities in the autumn. I had a very good contrarian year, and if I have regrets it is in underestimating the scale of the risk aversion bubble in Treasuries and also being somewhat premature in calling a fundamental bottom in energy recently, as the market remains obsessed with demand destruction while ignoring medium term non-OPEC supply destruction in terms of shelved investment and rising geopolitical risks of instability in key producers.
Although most measures of market risk aversion have been retracing steadily in recent weeks, there is no question that the current deleveraging process will take several years to play out fully both for financial institutions and economies at large, and governments can at best make that process as orderly as possible rather than attempting to sustain the economically unsustainable, from US household consumption and consumer leverage to China's export growth.
At this point the important thing is to ask the right questions. I note that Russian state media are loudly airing the views of ex KGB political scientist Igor Panarin, who foresees civil war and breakup for the US in 2010; maybe he should look closer to home for social collapse. Like the recent extension of the Presidential term to 6 years, levels of anti-American propaganda not seen since Stalin's day reflect the paranoia of Putin's Kremlin as the Russian economy and Rouble collapse after years of rampant corruption and incompetence and civil unrest grows.
On 11 August, I wrote regarding the Georgian invasion:
It all smacks of reckless hubris. A commodity crash would have dire implications for the dysfunctional Russian economy, beset by demographic decline, low productivity, 15% inflation and a fragile consumer boom that is vulnerable to a reversal in commodity export prices...Russia is still a Potemkin village that flatters to deceive. In particular, the Kremlin is not the monolithic power it appears, but referees a shifting coalition of clans, from energy barons to the security services and regional bureaucrats, whose sometimes violent rivalries have so far remained misunderstood by many naive foreign observers.
Watch Russia become increasingly unstable in 2009.
Will we see de facto trade wars develop, as merchandise exporters such as China and Germany refuse to reflate their domestic economies sufficiently? It's ominous that the European and Chinese central banks are clearly so behind the curve and playing the blame game. Will a renewed dollar slump be precipitated by a Treasury funding crisis? Or will the dollar benefit from the US being first to stagger out of recession within a year? Will China see growth slump to near zero? Will the fight against deflation ignite medium term inflation and make assets like TIPS a bargain? Are we on the verge of a shooting war between nuclear armed India and Pakistan?
Lots of questions, so few answers...yet. But stay posted, because I'm thinking about it. I suggest you do the same.