Thursday, May 28, 2009

Don't Know Much about Recovery

Insight: Recovery not as easy as U, V, W
By Gillian Tett
Published: May 28 2009 20:09 Financial Times

Are you expecting a “V” shaped recovery this summer? Or do you anticipate a scenario more like a “U” or a “W”? That is the question I have been asked repeatedly this month, as the debate about “green shoots” roars on.

Personally, though, I suspect that none of the letters in the Roman alphabet quite captures what is most likely to go on. To be sure, the last year might seem to correspond to the start of a “V”, “U” or “W”

Last year, the financial system clearly fell off a cliff, like the downward slope of a pen. But this year, some form of reprieve got underway, marking a seeming turning point. Most notably, in the real economy, the data is looking a touch more optimistic, not least because western companies are restocking, after slashing their inventories late last year. And in the financial sphere, investors appear to have spotted the “floor” to last year’s crash – and started to jump back into the markets again, rediscovering their appetite for risk.

But the problem centres on what happens next. Optimists in the market – or those who like to parade the “V” scenario – argue that this rebound has a long way to run in both the real economy and financial sphere. For the sheer scale of government support seems set to spark a fully-fledged recovery – or so the argument goes.

But I find this scenario hard to accept. Right now, it is certainly hard to imagine a new round of banking collapses, given the current level of government support. It is also difficult to see deflation taking hold when central banks are being so hyperactive. Morgan Stanley, for example, calculates that the scale of excess liquidity sloshing around emerging and advanced economies is now “at a record high”, relative to gross domestic product.

‘The problem is there is still a vast amount of deleveraging and restructuring that needs to be done and that process could take years’

But while all that government support – and liquidity – might be enough to stave off collapse, it does not guarantee the rebound will prove truly dynamic.

The essential problem is there is still a vast amount of deleveraging and restructuring that needs to be done, after the recent credit bubble: and on current evidence, that cleansing process could take years.

Europe’s corporate landscape, for example, is currently littered with heavily-indebted companies in dire need of restructuring, but which are somehow still staggering on because their creditors are unwilling to pull the plug. Ineos, the chemical giant, is just one case in point. In America, consumers remain laden with debt which they have barely begun to pay down. On both sides of the Atlantic, numerous banks remain neither dead nor fully alive, propped up by government support.

Most pernicious of all, the government bond world is threatening to dampen any cheer. Until now, Western governments have found it relatively easy to sell debt, even as projected issuance has surged. But this week’s activity in the treasuries market suggests that investors are getting jittery.

And surveys echo that. Last week Citi, for example, polled European investors and discovered endemic concern about rising government debt. Separately, Barclays reported that 30 per cent of Japanese investors now anticipate a US credit rating downgrade.

My best bet is that the economy in coming months will look like the first half of a W, but then flatten out into a straight-ish, horizontal line

And while these predictions may be over-blown, this gnawing sense of unease will make it hard to create any aura of financial stability anytime soon. Moreover, in a practical sense, any rise in bond yields threatens to neutralise some – if not all – of the reflationary impact of the rate-cutting efforts by central banks.

So where does that leave all those “V”, “W” or “U” arguments? If you add the different elements of the picture together, my best bet is that the coming months will look like the first half of a “W”, but then flatten out into a straight-ish, horizontal line – meaning that after an initial, small rebound, there is likely to be a long, bumpy period of “flatlining”, as the forces for reflation and deflation pull in opposite ways.

That scenario may be overoptimistic. If government bond jitters turn more serious – say, if some auctions fail or there is serious political instability – it is entirely possible to imagine a far darker scenario, in which faith collapses in government finance. If that occurs, we would face both currency upheaval and more bank turmoil, as investors lost confidence that the state can keep propping up the banks.

But if that government bond crisis does not materialise – which remains an “if” – then by a happy coincidence the resulting outlook looks rather similar to a symbol that is already plastered all over my notebook.

Many years ago, when I was a rookie reporter, I learnt the Pitman system of shorthand. And it just happens that the half-squashed, assymetrical “W” pattern that I am struggling to describe is almost identical to the shorthand sign for “bank” (see right).

So there you have it: as long as we avoid a government bond crisis, my best prognosis is for a “bank” shaped recovery-cum-stagnation, at least as depicted by shorthand. It is a fitting twist for a crisis that started with the shadow banks; perhaps the Gods of finance (and journalism) have a sense of humour after all.

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