Ever wondered what the US economy might look like should there be another Lehman Brothers-style bank collapse? Well, it would not be pretty.
Unemployment could jump to 13 per cent, recalling the breadlines of the 1930s. The Dow Jones industrials might plunge 50 per cent to 5,668, a level last reached before the dot.com boom in the mid-1990s. At the depths of a brutal year-long recession, output might shrink at an 8 per cent annualized rate, wiping out two whole years worth of growth.
Anyone lucky enough to have a job or cash left after the carnage could snap up a home at November 2000 prices.
This dire picture is what the Federal Reserve wants US banks to imagine when they test their balance sheets for resiliency against a major economic shock.
Yields are back down to their GFC levels. In 2011 that is also going to be a function of outright investor demand for Aussie debt, which is apparently very, very high. We are one of the few trusted AAAs that is yielding something decent.
The Aussie is also continuing to get hammered, and is now trading at 96 US cents. The long-term yield curve inversion combined with a falling dollar will provide additional stimulus for the local economy.
The question is this: does cutting rates in December do anything to solve bank funding problems (only guarantees and liquidity facilities will), and will the banks pass on any cut given the turmoil in overseas funding markets?
I personally think a better policy response is to guarantee, one way or another, bank access to funding, and keep rates stable for the time being. The RBA knows that the ultimate Euro response to all of this could be Eurobonds, debt monetisation, and inflation.
After yesterday's remarkable construction-work-done data, which trumped market expectations by an order of magnitude and which will individually add about 1.7 percentage points to Q3 real GDP (not annualised), it's clear the domestic economy is not in the hole that so many pessimists claim. The only rationale for cuts at this stage is the offshore environment.
OUTGOING Commonwealth Bank chief executive Ralph Norris has warned that the European debt crisis has entered a dangerous phase, likening the current turmoil to the global financial crisis of three years ago. Mr Norris said global money markets ''effectively froze'' this week as Germany failed to sell the entire stock of €6 billion ($8.2 billion) worth of long-term bonds.
His comments came as the leaders of the euro zone's key economies, France and Germany, met in France overnight to resolve differences over how to handle Europe's debt crisis. But Mr Norris, who retires next Wednesday after more than six years in the role, cautioned that credit-crunch conditions were returning, which is threatening to choke off funding for banks around the world.
''This has potential to be significantly worse than the Lehman Brothers collapse and the subprime crisis because now we are talking about nation states,'' Mr Norris told BusinessDay.
The longer the economic crisis goes on, the less credible sticking-plaster solutions become. Four years in, Europe is heading into a nasty recession, China is flirting with a hard landing and the Bank of England is warning of a systemic banking crisis. The US is the one part of the world where the news has been better recently, due to signs of life returning to the housing market and a fall in unemployment.
What's happening in the US - where the Federal Reserve has used two rounds of quantitative easing (QE) to boost the money supply and announced its intention to keep rates low - has encouraged the belief that recovery will eventually come, provided the policy response is big enough for long enough. It remains to be seen whether this is the case, since there have been false dawns galore since the financial system froze in 2007. The real strength of the US will be revealed early next year, when tax breaks supporting consumption and investment are removed and the world's biggest economy starts to feel the impact of the slowdown on the other side of the Atlantic.
An alternative way of looking at the crisis goes like this. We now inhabit a world of the living dead: a euro zone that will not collapse but cannot be reformed; banks that are kept alive by gigantic quantities of electronically-generated cash but do not lend; homeowners who are sitting in homes worth less than they paid for them but are able to stay put because interest rates are so low and lenders have no desire to crystallise losses; and policy that is neither one thing nor the other.
David Dredge of global hedge fund Fortress has built a career studying, predicting and protecting against the world's major financial crises. The recent convulsions in global share markets are "just the beginning" of a painful adjustment as money drains from the emerging market economies, he says.
"August 2015 will go down in the record books much like July 2007 or July 1997 as the beginning of the coming contractionary cycle," says Dredge who is the co-chief investment officer of Fortress Convex Asia Fund.
He's a believer that markets move in long cycles "that despite all efforts to the contrary, central bankers have not by any means gotten anywhere close to eliminating."
"Like weathermen have not eliminated seasons," he says.
Singapore-based Dredge says the current volatility in financial markets is in the early stage as markets react to a correction of global imbalances that will last 18 months to three years.
The global economy is made up of nations with a deficit of capital - the West - and those with a surplus of capital - the East and emerging markets, he explains.
"The flaw is that those with the surplus have all tied their currency to the main protagonist on the deficit side – the US."
"So monetary policy is determined by the deficit of capital side and flows through the currency linkage and you end up having some form or another of the same monetary policy on both sides with economies that are 180 [degrees] diametric to each other."
The financial links to easy-money policies in the US have unleashed a burst of credit expansion in emerging markets that has proved unsustainable and is now in the process of unwinding.
That is forcing a painful "market-induced tightening" that will impact the growth of emerging markets as credit expansion is halted and reverses.
The "simplest measure of these imbalances" is foreign exchange reserves which have swelled in the last few years but are now being liquidated, tightening financial conditions in emerging markets.
"When the hose is on and credit is pouring from the deficit to the surplus side, the FX [foreign exchange] reserves increase and are indicative of the growing size and the location as to where the imbalances exist - because that's where the most money is going."
China's foreign currency reserves peaked at $US4 trillion ($5.7 trillion) in mid-2014 but have run since down to about $US3.6 trillion.
"Each crisis occurred at the peak of FX reserves. The emerging market FX-reserves graph looks exactly like the US debt to GDP because they are just in the inverse of the imbalance."
Dredge says that differentiating among emerging economies misses the point of what is occurring. Capital is draining from the emerging markets as conditions have tightened and has been since the 'taper tantrum' of May 2013.
"In December 1999 the point wasn't whether you should invest in Apple or Microsoft. The point was they were both going down [as the tech bubble deflated]. And that's where we are now."
"The [credit] contraction might be triggered in China with retail margin lending in the equity market, or in Malaysia with recognition of corruption."
"But the trigger is not what we are trying to compare. It's the potential risk which is the excess credit creation in the last cycle. In that sense Brazil, China and Malaysia are all the same."
Dredge co-manages the Convex Asia fund, a "volatility fund" which manages around $US200 million and seeks to deliver outsized gains in times of market stress.
He says he's attempting to stay ahead of the spreading fire and that means looking for cheap exposures to volatility. Interest rate volatility is low and while foreign currency volatility may have risen it is below many of the peaks reached over the last five years. Corporate credit spreads too are around post-financial crisis lows despite a fair sized correction in corresponding equities.
"This is indicative we're just at the very beginning of this," Dredge says.
September 7, 2015 - 7:17AM Jonathan Shapiro and Jemima Whyte
One of the country's most high profile economists Saul Eslake has challenged claims that markets are entering another global financial crisis, arguing the turmoil will be confined to equities markets and is unlikely to infect other assets classes.
"I don't believe the turbulence we've seen in the equities markets in the past couple of months – initiated by events in China – is the beginning of another significant global crisis," said Mr Eslake, who left his role as Bank of America Merrill Lynch's chief economist in June this year.
"I don't think there have been the sort of signs of a more generalised flight to quality or panic associated with financial markets. If anything – and it's not a close parallel – it's more like the tech wreck of 2000."
He said that was one of the reasons bonds had not performed as strongly as many had expected, adding that bonds had also been "pretty richly valued" coming into the correction. He also added that he expects the US will increase interest rates, which was also curbing any rally in the market.
"I still think it's more likely than not the US will pull the pin, though I'm not persuaded it is September. It's a question of when, not if," he said.
Stocks are the only game in town, aside from gold of course. Stocks offer a moderate return above zero if you can pick the right ones, a bit less if you go in a fund that clips you a percentage. Everyone has been herded into stocks for the last few years probably because it's one of the easiest forms of wealth to tax and can be easily stolen in a market crash.
This is not the time to be seeking a return on Capital. The old game of inflation is over, these are the years where you need to keep capital safe.
"Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works." John Stuart Mill
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