Credit Suisse recently issued a report detailing several reasons to remain bullish (see here). Among these reasons was an overreaction to the credit fears in the markets. They claim that this is not a “Lehman-style environment”. Specifically, they said:
“We are not in a Lehman-style environment
The recent rise in the LIBOR spreads (to 53bp, from a low of 13bps in March) has raised concerns in investors’ minds that we are in Lehman-type environment. Yet, we think the situation is meaningfully different: for one, banks are now better capitalised than they were in September 2008 (UK banks, for example, now have triple the liquid assets and double the Tier 1 capital they had pre-Lehman). Moreover, when the Lehman default occurred the economy was heading into an ever deeper recession (which had officially started in December 2007), which would turn out to be the worst Western recession in 65 years. This time round, on the other hand, we are only barely three quarters into the economic recovery – and on only on two occasions in the last 100 years (1920 and 1981) has a recession started within two years of the end of the previous one. Moreover, central bankers now know what to do to stimulate growth: if there is too much fiscal tightening, then QE would be renewed everywhere!”
There are many excellent points made above and investors must attempt to keep a level head while also being realistic about the potential outcomes that lie ahead. It is very true that the banks are in better condition than they were in September 2008. If there is one thing the bank bailout achieved it is that it helped bolster bank balance sheets. Unfortunately, this was the ultimate form of “trickle down” as Bernanke falsely assumed that banks were reserve constrained and simply needed healthier balance sheets before they would lend. Of course, that myth has been proven entirely wrong as the banks have recovered and Main Street continues to struggle. Lending, unfortunately, is like the tango – it takes two….
So, while the banks are stronger (a relative term) it matters little as the consumer continues to struggle. We’ve basically kicked the can. The continuing weakness across the private sector puts the banks at substantial risk of future weakness. If housing double dips or the consumer tightens substantially the strong bank balance sheets will once again become fragile….Monetary policy will be shown for the farce that it is.
CS also notes that the economy is stronger. This is also true. On the other hand, investor psychology has been shattered. At the end of the day a market is nothing more than the summation of the decisions of its participants. If those participants are risk averse and psychologically fragile you have a potential recipe for disaster (or you get “flash crashes” and wild daily volatility). Richard Koo says psychology is of the utmost importance during a balance sheet recession because any subsequent dips have the potential to be substantially larger than the first. We’re seeing clear signs of mistrust in the market as the “flash crash” is just one more market debacle on top of several others over the last few years.
I attribute much of this psychological deterioration to moral hazard. When participants feel cheated (by bailouts and handouts) the game looks rigged. When the game looks rigged participants are less likely to play. The equity markets look more and more like a system by the banks for the banks. A true capitalist market would not have played out over the last 18 months as it has. But the endless government bailouts and “no one loses” capitalism is having a disastrous and unquantifiable psychological impact on the market. In the end, the system is weakened in my opinion – much like a species that never allows natural selection to take its natural course. So, the “stronger” economy might be here for now, but the fragility of market psychology has only worsened the long-term market outlook.
Finally, CS says we “know what to do”. Ah yes, the old magic bullet. But do we really have the magic bullet? I would argue that monetary policy has failed. Credit Suisse says we just need to reach into the quantitative easing bag of tricks. As Richard Koo has argued, quantitative easing is the “great non-event” (and Koo would know – 6 years of QE had no impact in Japan). After all, when there is little to no risk of inflation (as is the case now) QE is really nothing more than an asset swap. Deposits get transferred in place of some other asset. The bank balance sheet is altered, but nothing has changed in the real economy. The added reserves haven’t made the bank more likely to lend (which is 100% crystal clear in today’s environment where borrowing remains very low).
As I mentioned above, there is clearly no inflation despite endless chirping and fear mongering from various market “experts”, pundits and websites who don’t really understand how the monetary system works. Koo is 100% correct – QE has been a great big “non-event” despite all the fear mongering over “money printing” and hyperinflation (QE isn’t actually money printing, but it sounds scary when you phrase it as such). QE hasn’t cured anything. In fact, it hasn’t done anything for the real economy. All it has done is clear a few bank balance sheets so they can crank up the Enron banking system and continue raping the U.S. consumer at every possible twist and turn. Of course, banks are never reserve constrained so a strategy such as QE is pointless to begin with. Apparently we still haven’t learned this lesson two years after the fact.
Bernanke has been pushing on a string for two years and yet here were are still discussing this horrid credit crisis, the potential of a double dip and rising unemployment. They (those in charge) don’t “know what to do”. That’s why the global economy is still a mess. The politicians are as clueless as the bankers (though at least the bankers have fooled us all into thinking that the show can’t go on without them). Unfortunately, the market is realising that our leaders are clueless. Investors are realising that policymakers don’t have a good solution. In fact, the market appears to be realising that most policymakers are entirely inept. This was most evident in the market calling the EMU’s bluff in less than 48 hours….
So the question remains – is this another Lehman Brothers? No one can be certain, but I would venture to argue that the potential is there for a crisis far worse than Lehman. The global economy, arguably, has never confronted such massive hurdles. The Euro appears fundamentally broken. As I’ve repeatedly stated the problems in the Euro are inherent within the currency. The solvency crisis is simply a byproduct of an inherently flawed currency system. In addition, investor sentiment is incredibly fragile. And finally, those in charge don’t appear to have a grasp on the actual problems at hand and have failed to provide a viable solution despite two years of constant meddling. It’s impossible to know whether these issues will turn into something larger than Lehman or whether they will simply go away quietly only to meet us at a later date. But the one thing that appears certain is that the risks in this market remain extraordinarily high and the very fact that there is the potential for another Lehman (or something worse) should have us all concerned – not to mention furious.
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