Global Liquidity Crisis: What Now?

One major international bank after the other is collapsing and is being nationalized or sold off in sections. Although passed by the U.S. Senate, the House of Representatives has yet to approve a bailout plan for beleaguered banks.

Globally there is a sudden shortage of U.S. dollars in money markets. Central banks of major powers are injecting enormous amounts of money into money-market systems worldwide.

Japan and the U.S. are already in economic recession, while Europe is on the brink. The economy of China, which has been the major driving force behind global economic growth, is slowing down, resulting in commodity prices declining.

Understandably, equity markets worldwide are finding themselves in sharp bear markets.

The causes of the above are legion, but can be summarized as money-hungry financial institutions that lent too much money too readily to eager individuals and institutions for the purchase of overvalued assets. If the one who bought last cannot find a buyer, he, as well as the one that financed him, will be in trouble. This has a domino effect, as no one wants to buy or take over the debt.

The critical positions in which the banks find themselves have led to virtually frenzied activity in all financial markets as they tried to reduce their risks and neutralize market positions at all costs, and take out cover on other assets. This is similar to the 1920s in the US when banks allowed investors to use equities as collateral. When equity prices dropped, the investors could not repay their debt, resulting in the banks holding collateral that had no value. Many of the banks subsequently went bankrupt.

The question is: What now?

There is no doubt that everything possible will be done to resolve the crisis as quickly as possible to rescue the world from the financial chaos and thus avoid a global recession. The U.S. Congress has no other option but to accept the bailout plan in its current or amended form, as without it banks will be forced to call in companies’ credit lines in order to survive, with the resultant downward spiral of unprecedented unemployment and poverty worldwide. Although the fiscal bailout plan would contribute to ensuring greater stability in the banking sector and financial markets, it might not be over - yet.

There are doubts about whether the bailout plan, or New Deal as it was called in the 1930s, will be sufficient to stop the wave of deteriorating financial statements of banks and give them the courage to start lending money again. The main concern is whether it will result in a turnaround in consumer sentiment, especially in view of the fact that consumer spending is key to economic growth.

In order to ensure the New Deal lends enough impetus to the economy and largely prevents disinflation or deflation, the Fed and other central banks will have to relax their monetary policies considerably and reduce their bank rates aggressively. This will be necessary in especially the coming months, as inflation rates in First World economies in particular will decline sharply owing to lower oil and other commodity prices.

If a bailout plan is not accepted, the Fed and other central banks will have no option but to lower their lending rates to banks and increase their current support of banks substantially. Although such monetary action would underpin the global financial system, banks would still be reluctant to pass the lower interest rates on to consumers and would rather improve their balance sheets.

Therefore, from an economic and investment perspective, three scenarios should be considered. Firstly, a completely New Deal (”New Deal Plus”), which entails the bailout and lower bank rates, secondly, a New Deal that entails only the bailout, and thirdly, no bailout and only lower interest rates.

Outlook for asset classes

Equities: At present it is extremely difficult to project profit, earnings and dividend growth and therefore to value equities and stock markets. However, what is clear is that in the current bear market prices worldwide have declined to such an extent that the Standard & Poor's 500 Index is currently trading at a price-to-book value ratio of around 1.85 compared with an average ratio of 2.4 over the past 30 years. This is equal to the lows in 1987 and 1990.

Should the bailout plan be approved, it would be positive for global equity markets, but it would have to be followed up with lower interest rates in order to pull the markets out of the current bear phase. Emerging markets such as China would once again come to the fore as favorites.

Long-term government bonds: The decline in long-term interest rates in recent months is largely the result of fears of a worst-case scenario, namely that the bailout plan would be rejected. Should it be approved, long-term interest rates could start bottoming and rise slightly, whereas a bailout followed by lower interest rates would cause long-term interest rates to rise more markedly as stronger economic growth is anticipated.

Commodities: Commodity prices (oil, industrial metals and platinum) could recover somewhat if the bailout plan is approved, but would probably start falling again in the absence of monetary stimulus. On the other hand, commodity prices could strengthen if the accepted bailout is followed by lower interest rates.

The following table summarizes my view on the likelihood of the three possible outcomes of the bailout plan and its effect on the global economy, financial markets and currencies.

 

 

As is evident in the above table, the New Deal Plus should be the most beneficial option for the entire global community. As a result, it gets my vote. Let’s hope common sense prevails in the next few days.

Comments

[phdinsuntan...:]

what about the swiss franc and the yen for those uncertain times?

2008 Oct 03 08:50 AM

[Marc Courtenay:]

What's your opinion on short-term deflation as a result of an imploding economy already in recession? I want to believe you are right about commodities if there is a concerted worldwide effort by central banks to lower interest rates and add lots of liquidity. Thanks for your article. May all this lead to a more civilized world with less corruption...I know...I'm dreaming again.

2008 Oct 04 08:51 PM

[johnthebear:]

The problem with your analysis as I see it, is that you have not factored in the major correction coming in commercial real estate, world wide. Regional and local Banks will be failing with 60% of their loans in commercial real estate.

Capitalization rates were two low, based on expected appreciation and low interest rates. They will begin to rise with the interest rates and added risk premium due to rising vacancy. Prices of commercial real estate will be falling, as will industrial property with rising unemployment.

This means, that while residential property values may bottom in 2010, there will be a longer delay before commercial real estate will show signs of recovery. New construction might be expected in a more normal recession sponsored by government, but with lower property taxes and failing state governments (CA and NY etc) there is no source of wealth to back up the economy. Then if you really want to get depressed, what will happen as social security tax revenues fall and the system breaks down sooner than expected?

A long bitter road is ahead, better tread carefully.

Might be a that WW III will be needed to end the mess. This could all happen much sooner than you expect. What happens if there is an Iran-Israel war between the time of the election and inaguration? Get right with GOD?

2008 Oct 04 11:32 PM

[X-15:]

Iran -Israel war. The weird thing there is it would bolster the dollar.

2008 Oct 05 01:02 PM