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Insight: Patience the virtue of difficult times

First published: Financial Times, 19/08/2008

In Othello, Iago tells Roderigo: “How poor are they that have not patience! What wound did ever heal but by degrees?” Impatience is often the undoing of Shakespeare’s characters, and the same applies to investors in contemporary financial markets. The credit crunch has been under way for more than a year, recession has been in the air if not in the data for what seems like an eternity, and it is tempting to see risk assets as cheap or oversold.

The decline in oil, copper, corn and other commodity prices is a case in point. Cheaper commodities are unequivocally favourable for the economy. And if prices stabilise or fall further, positive headline inflation surprises will cause even greater repricing of interest rate futures contracts, lower policy rates will ensue and equities will have something to shout about.

However, it is far too early to give the all-clear, because this economic downturn is unusual, and about much more than simple gross domestic product accounting. Here’s why.

This downturn is unusual because it is fundamentally about asset deflation and deleveraging, specifically in the banking and household sectors, following an exceptionally long and virulent credit boom.

This type of cycle has self- reinforcing characteristics and typically lasts for years rather than months.

The economic impact is only now beginning to become apparent in the US, Europe and Japan. By 2009 the global economy could be in recession, growing by little more than the 2.5 per cent deemed by the International Monetary Fund to qualify as one. Recession or not, there is unlikely to be any material economic recovery until after 2010.

Notwithstanding the losses taken and the capital raised to date, banks have to do more of both. Losses on traditional assets such as mortgages, credit cards and consumer and corporate loans have yet to be taken.

Central bank lending surveys, such as the US Federal Reserve’s Senior Loan Officer survey, point to high credit aversion by banks through the first half of 2009. Since April, bank asset growth has stalled or fallen. Falling house prices destroy net wealth and are weakening consumption, while more limited access to dearer credit will force a rise in household savings rates.

The sharp rise in headline inflation, globally, may now subside but it is likely to remain uncomfortably high in many emerging nations, leading to downside growth risks. Growth in non-Japan Asia, for example, is expected currently to slip to 6.8 per cent in 2009, about 25 per cent lower than in 2007. In aggregate, emerging market inflation has now risen to 12 per cent, while policy rates are barely 8 per cent on average.

Some further credit tightening is likely, although China has recently tried to refocus policy away from inflation and towards weakening growth momentum. Emerging inflation may moderate with the easing of commodity prices, but we should not allow the idiosyncrasies of food and fuel inflation to smother the tendency in emerging nations to high or higher inflation, which derives from deep-seated flaws in global monetary arrangements.

The pendulum of political economy is swinging now towards more government intervention, and more activism in economic and fiscal matters. This is simply to observe the reactions to the crises in housing and banking in the context of what was already a creeping backlash to unfettered globalisation.

Further fiscal stimulus, perhaps emphasising public spending, is expected in the US, while rising public sector financial deficits for both cyclical and discretionary reasons should be expected elsewhere too.

The scale of turbulence in the housing and banking sectors is most likely to see additional intervention by governments in areas that span recapitalisation and lending, purchases of mortgage-backed securities and help for homeowners.

Policy rates in advanced economies are likely to fall further, but we are about to enter a new phase with a focus on consumers and on spreading global economic weakness, and in which government intervention increases.

Equities may seem relatively cheap, but non- trading investors should probably keep their powder dry until the shape and nature of risk premiums and earnings profiles can be drawn with greater certainty.