The indicators are there: credit spreads narrowing, cross-border capital beginning to flow, GDP numbers surprising on the upside… Ninteen months into the down cycle and we are happy to have finally turned the corner on one of the longest bear markets in recorded history. The swiftness of the turnaround, however, baffles the lot of us. But to term it as a bear market rally, may be the safe but mistaken thing to do.
If you have been waiting for a solution to the very serious structural issues, especially in the US as a pre-requisite to a recovery, you will be dissapointed. A lot of observers have traced the current malaese to what has come to be known as the Greenspan Put – the US Fed’s proclivity under Greenspan to bail out its banks in any crisis. This theory holds that the risk banks are bearing is not getting priced in, leading them to indulge in the worst form of moral hazard. Needless to say, given the severity of the current crisis, there are a lot of takers for this theory. And equally, with the large bail outs of banks again there should be no doubt that the Put has only been repriced and rolled over!
The other theory talks to the unsustainable debt led consumption in the US, supported by a savings glut in Asian economies. Now this is a compelling argument but untangling this equation would mean a kind of short term pain that no economy is in the mood for. There is some welcome development in that the US domestic savings rate has gone up from a negative 3% to a positive 4%. This is a change of mamoth proportions, for those familiar with US spending habits! The American consumer is scared but equally, credit taps have been turned off to achieve this dramatic shift in a short time. What is more, the ony wealth building avenue the American Consumer knows – his house, has negative equity which makes him feel poor in a very real sense and hence pull back his spending. This is the October Shock that we saw translated to a precipitous destruction of demand across the world. This also alarmed policy makers into thinking that any changes to the system has to be done with the engines running, the alternatve was just too painful, especially for the Chinese – the chief beneficieries of the debt led US consumption. China capitulated, reassuring its faith in the US treasuries and as a consequence the Dollar. The Obama administration in turn went about putting money in the consumer’s ATM (US housing) by targetting a 30-year-4% fixed mortgage, one of the lowest in history, to jumstart the economy. It is therefore clear that we simply don’t have the stomach for the structural changes required to be put in place.
The third important factor, off course, is that this is a stock market led rally, a leading indicator. There is, therefore, no contradiction in saying that the real economy will take a few more quarters to find its feet. The economy will bounce back and work without making the underlying structural changes because it has been working that way for the last 10-20 years now, it can certainly go on for a few more. It should be no surprise then that we have postponed the solution to another day to go back to our old ways and that this stock market rally is for real!