By GRAHAM FROST 25/11/2008
Over the last three months markets have tested their lows as expectations of the global economic outlook have been dramatically reduced. Emerging markets are no longer perceived as having stand alone long term growth potential but rather as being too sensitive to the world economy. Developed markets are viewed as debt laden dinosaurs. Commodity prices have been trashed as trade in goods will cease. Commercial property, suffering from oversupply, falling rents and too much debt, can never recover.
There is no doubt things have got considerably bleaker since Lehmans was allowed to go bankrupt in mid September, but are we really staring into the abyss? The decline in stocks is amongst the worst in history and equity market capitalisations as a percentage of GDP are back at mid 1980s levels. Credit spreads have blown out and company debt is trading at levels associated with default rates and recovery rates arguably far worse than the 1930s Depression, when the size of the US economy halved in nominal terms. Unlike the Depression, governments are tackling the financial problem is a systematic way, recapitalising the banking system, supplying massive liquidity where banks or countries have been caught short of reserves, and cutting interest rates aggressively. Now fiscal policy is being added to the mix, whether by tax cuts in the short term or accelerated infrastructure spending in the longer run. Are these actions all doomed to fail under the weight of the historically high debt burden in the western world?
Chancellor Alistair Darling presented a fiscal stimulus package yesterday, which is being followed by other countries to a greater degree. Markets jumped as a result, by a record 10% in the case of the FTSE 100. His £20bn package, 1% of GDP, mostly via tax cuts, is aimed at limiting the severity of the recession in 2009 and encouraging some growth by 2010. Such an optimistic outlook is unlikely to be shared by many. In the long term, it has to be paid back thereby limiting growth in the future and in the short term there is likely to be a lot saved by consumers rather than spent. High tax rates for high income earners will erode the UK’s competitiveness over time. Markets will have to cope with a huge amount of borrowing via government bond issues. More may be needed if this package proves too timid.
Nevertheless, yields on investment grade corporate debt of over 7% and on non investment grade debt of around 20% compare favourably with the diminishing returns of bank deposits. Those levels would imply that equity earnings are going to fall precipitously as economies collapse. Given that the length and depth of the recession remain far from clear, corporate debt currently offers a better risk return profile than equities. Dividends get cut before bond holders lose income, and in the event of bankruptcy bond holders retain a residual interest in the assets but equity holders lose everything. You will not necessarily see capital gains in corporate bonds in the short term but you get paid to wait. A rally in credit markets is also likely to presage firmer equity markets.
Perhaps more significant than Darling’s efforts was the bailout of Citibank over the weekend. This package was interesting in its structure:.an injection of $20bn in capital at a non penal rate of 8% (although there was a ‘fee’ comprising another $7bn of the same paper) and acceptance of up to 90% of Citi’s bad debts. This seems to have overcome a problem that has been worrying markets - how to neutralise the toxic assets on bank balance sheets. Now the taxpayer is taking the risk. Expect a long line at this particular trough.