It's All About Fundamentals, Again

I had written this for posting tomorrow, but with today's developments (Fed cut by an emergency 75 bp) it is more timely to post it today.

List of relevant rates, as of today:

Fed Funds: 3.50%
3m T-bills: 2.50%
2y T-note: 2.05%
5y T-bond: 2.65%

What is the fixed income market saying? Don't bet on a fast recovery.

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As global financial markets gyrate, it is a challenge to keep our eyes dispassionately fixed on the economic fundamentals. Yet, we must.

Here are the key points:

• The global recovery after 2001 was based on: (a) debt-financed household consumption, (b) debt-financed asset appreciation, and (c) the sharp rise in energy and resource prices, which created huge wealth effects in producer countries.
• The economic growth of BRICs was derivative, i.e. it was a result of (a) and (b) above, and served to further enhance (c).
  
• Ultimately, therefore, the whole structure is anchored on the excess consumption of a few hundred million westerners (US and EU), who could spend far above their earned income because they borrowed so easily and cheaply.
  

Let's examine the last point further, i.e. borrowing by western households:

• Household borrowing in the US and EU was ramped up when dollar and euro interest rates collapsed to multi-decade lows following the 2000-01 recession and the 9/11 events.
• Lenders came from: (a) savings-rich Japan looking for higher rates than available in ZIRP-yen, a.k.a. the carry trade and (b) BRICs and resource exporters that could not, or would not, spend their earnings within their own economies. This created what Secretary Paulson has previously described as a "savings glut".
• A series of financial "innovations" spread credit risk and exposure wider than ever and greatly weakened lending standards.

Let's now examine and interpret present conditions:

• The US sub-prime crisis is merely the first step of wider credit troubles in the West. The weakest borrowers went under the fastest; next come highly leveraged corporates, speculative commercial real estate and companies with excess capacity, built in anticipation of continuous good times.
  
• Vendor financing of western consumers by China and resource exporters was a blind misallocation of capital that resulted in bubbles. Instead of buying western securities, they should have invested their money in domestic social services to raise living standards widely (this is particularly true for China and Russia*). They acted as providers of concentrated, speculative "margin" money to western consumers and they thus share in the blame for the bubbles.

How are things going to proceed from here? What follows is my personal opinion which, as all views of the future, should be taken with properly-sized doses of scepticism (jumbo-pack recommended).

• Western consumers will revert to spending within their means. It is possible that they will cut even further, in order to repair their overstretched household balance sheets. Saving rates will rise in the US and EU.
  
• Fiscal policy "boost" initiatives that are based solely on tax cuts/rebates will be proven ineffective, as the bulk of the money will be saved instead of spent.
• The BRIC economies will suffer from slowdowns induced by overcapacity and bad business loans.
  
• Credit crunch and risk aversion will spread to more sectors and more economies - it will become a wider global phenomenon.
• Interest rate cuts will bring western economies closer to ZIRP and liquidity holes, instead of inducing credit expansion and consumer-lead growth.
• We will see significant further deflation in asset prices, and may even see bouts of deflation for consumer goods, brought upon by excess capacity.
• Commodity prices may decline, particularly where marginal demand is directly tied to robust economic growth conditions (energy, metals, etc.).

In the days, weeks and months to come it may become very tempting to misinterpret the temporary gyrations of share indices, thinking them guides to future economic activity. I believe times are changing, back to when real economic fundamentals determine asset and commodity prices instead of the other way around. The cart is going back behind the horse, where it properly belongs.

We should keep our eyes fixed on the real economy "horse", instead of the market "cart". Some economists and policy setters had become very lazy of late, thinking the Dow told all. It doesn't, and it's high time they started earning their keep honestly, once again...

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(*) In the case of the Gulf emirates this was admittedly difficult because of their small domestic economies. How many indoor ski centers can one build in the desert?