The helicopters are coming
This post is a guest contribution by Niels Jensen*, chief executive partner of London-based Absolute Return Partners.
It is time to move on. Not that the crisis is over, by no stretch of the imagination. But it is not going to make one iota of difference if I join the blame game bandwagon. It is what it is. Allow me instead to focus my energy on what is likely to happen next. That is more productive and definitely more useful.
A can of worms
In the situation we currently find ourselves in, it is very easy to get distracted and lose sight of the bigger picture. All eyes are on Wall Street, obviously with good reason, but there are important dynamics which are being largely ignored. Let’s focus on those.
Will $700 billion be enough?
That doesn’t make Paulson’s plan a bad first step, though. In the current environment, doing nothing is not an option and all those who have opposed the plan, including the “mental midgets and moral pigmies” in Congress (quote taken from Woody Brock), should shut up and work with the Treasurer to move things forward. The United States, and the rest of the world, cannot afford for some narrow minded, re-election focused egotists to take the entire world down.
Europe is skating on thin ice
So is Asia …
Banks are obviously acutely aware of the high counterparty risk at present and their wariness is best exemplified through the recent explosion in Libor rates (see Chart 1 below).
Chart 1: USD Libor Rates
Source: Financial Times
It is critical that the inter-bank market doesn’t break down completely. If it does, lending will dry up very quickly and the damage to the real economy will be devastating. That’s why we cannot afford for Paulson’s plan not to go through. Trust in the banking system must be preserved at almost any price.
The recession is coming
That, however, is not the same as suggesting that the worst of the economic crisis is now behind us. We’d better prepare for a long and painful winter. The US economy is almost certainly in recession already (more about this later); so is the UK economy. Continental Europe is probably not quite there yet, although the very latest data suggests that France has now tipped over. It is probably fair to assume that, by the first or second quarter of next year, large parts of Europe should be in recession.
Not as strong as it looks
So what happened? It may sound strange but there is a simple explanation – the fact that oil prices rose from $101 to $140 per barrel during the quarter. In order to understand how rising oil prices can have such an effect on real (inflation-adjusted) GDP, consider the following equations:
(a) Nominal GDP = Consumption + Investments + Government Spending + Exports – Imports
(b) Real GDP = Nominal GDP ÷ GDP Deflator (The GDP deflator measures the difference between real and nominal GDP.)
Now assume that, in a given quarter, the volume of every component is unchanged. This would obviously mean that real GDP would be unchanged. At the same time, assume that import prices rise during the quarter (as was the case in the second quarter). Nominal GDP would fall as the value of total imports would rise. As a result, rising import prices lower the GDP deflator which is used to convert nominal GDP into real GDP. Therefore, as the GDP deflator was lowered in Q2, it had the effect of pushing real GDP higher. Bingo!
Prepare for a shock number
Foreign trade performs well
Chart 2a: US Trade Balance
Chart 2b: US Trade Balance
Obviously, one might argue that it is only a question of time before US exports fall off the cliff. Maybe, but that’s not where I am going with this. Much more interesting is the impact this is having on foreign exchange reserves – and therefore on global liquidity – around the world.
Reserves stand at $7 trillion
But growth has stalled …
It also explains why global bond markets have done so well in recent years despite evidence of rising inflation problems. About $5 trillion of FX reserves have had to be invested since the turn of the Millennium – much of it in government bonds. Imagine the stimulus such a vast amount of money has provided to bond prices. No wonder inflation worries have been largely ignored by global bond markets!
Don’t worry about inflation
And now to the helicopters …
The risks attached to such aggressive monetary easing are limited at this stage. The global economy is facing substantial weakening and money growth has slowed significantly in recent months – just take a look at Chart 3 below.
Chart 3: US Money Growth
The stock market should react reasonably well to such aggressive monetary easing but, to paraphrase our friends at Cardano, if anything, the Lehman bankruptcy has forced equity investors to confront the full scale of the financial crisis, which they have been trying to ignore for some time. And, despite the recent sell-off, there is still little value to be found in equities compared to the deep discounts on offer in the credit markets.
Source: Niels Jensen, Absolute Return Partners, October 3, 2008.
* Niels Jensen has 24 years of investment banking, private banking and asset management experience. He began his career at Andelsbanken (now Nordea) in Copenhagen and was part of a generation of bankers building a new industry in Denmark, following the Central Bank of Denmark’s relaxation of rules governing investments abroad in 1984.
In 1986, he joined Shearson Lehman in London, where he built up the firm’s equity franchise in Scandinavia. In 1989, he joined Goldman Sachs with a similar mandate, i.e. to establish a Scandinavian franchise for Goldman. In 1992, he became Co-Head of Goldman’s U.S. equity business in Europe, a post he held until 1996, when he joined Oppenheimer in London and became its Head of Europe.
Following CIBC’s acquisition of Oppenheimer, Lehman Brothers bought Oppenheimer’s European private banking operation in 1999, and Niels found himself back at the firm he left ten years earlier, now in charge of its European Private Wealth Management business. Whilst at Lehman Brothers, he developed the concept of investing that has now been put into effect at Absolute Return Partners.
In December 2006 Niels was appointed as a Director of Trafalgar House Trustees Limited, advising one of the UK’s leading corporate pension funds on its investment strategy.
Niels is a founding Partner of Absolute Return Partners LLP and its Chief Executive Partner. He is a graduate of University of Copenhagen with a Masters Degree in economics.
7 comments to The helicopters are coming
Performance Optimization WordPress Plugins by W3 EDGE