Opinion

Will green shoots take root?

Finance | Heather Lamont | 29 Jun 2009

Heather Lamont asks whether the recent stock market revival reflects a sustainable economic recovery, or a return to boom and bust.

After an extended period of share prices declines, especially over the winter of 2008-09, this spring equities at last began to show an improvement. What investors want to know now is whether the recent rally marks the beginning of a sustained recovery, or whether we should be bracing ourselves for a relapse.

It is logical to focus our attention on the key factors which act as barriers to recovery, and to consider what evidence we need to decide whether these barriers are being broken down. For me, there are three key areas.

Banking activity

From the onset of the credit crunch in 2007, and most dramatically after the collapse of Lehman Brothers in September 2008, the flow of funds between banks came almost to a standstill. Institutions were so reluctant to release cash from their own fragile balance sheets, and so wary of each others’ credit status, that the tap was effectively turned off.

This may sound somewhat remote from the real economy, but if cash isn’t moving between the banks, it isn’t moving into businesses and households either. So the normalisation of interbank lending will be a key sign that the liquidity needed for economic recovery is being restored.
Do we have any evidence that this is happening? Well, yes we do: the ‘price’ of interbank funds, taken as the difference between the wholesale LIBOR rate and official central bank rates, has fallen back roughly to where it was before Lehman’s failure. A lower price is associated with greater supply, so it’s clear that interbank flows have loosened up considerably.

However, there are several complicating factors which may affect the volume of interbank lending. For example, banks are still trying to understand their own balance sheets (we don’t even know who owns the estimated $1.5 quadrillion of derivatives in the market); while the impact of new regulatory requirements, and of the nationalisation of some major UK banks, will not be clear for some time yet.

Trading and consumption

Similarly, Lehman’s collapse triggered a precipitous fall in what were already declining levels of consumption and trading activity. New consumer credit all but disappeared; manufacturing order books plummeted in old and new economies alike; unemployment spiked upwards.
Since the turn of this year, several important indicators have suggested a recovery in these activity levels. However, these indicators need to be treated with some caution. For example, while order books have picked up substantially, this is largely caused by retailers and manufacturers replenishing their shelves, having previously run down stocks rather than place new orders. It doesn’t necessarily presage a return to pre-recession consumption levels.
Western households are highly geared by historical standards. It is to be expected that they will seek to reduce debt, and that process is necessary, but it has the painful consequence of delaying a resurgence of economic activity. There is capacity in the economy for an increase in consumption without triggering inflation. The question is how long it will take for consumers to become less fearful of indebtedness, and become more willing to spend rather than pay down debt.

Risk appetite

Another indicator that consumers and businesses are seeking to pay down debt and stabilise their balance sheets is a resistance to holding risky assets. Over the winter of 2008-09 this risk aversion was reflected in a reluctance to buy equities, even when these looked to be good value relative to ‘safe haven’ assets like government bonds. The availability of capital is an important factor in companies’ ability to revive economic activity, so we would be looking for an increased risk appetite among investors as an indicator of sustainable recovery.

Since March, share prices have recovered significantly, and the corporate debt market, though still sticky, has relaxed slightly.

However, as money comes out of gilts in favour of equities, bond yields and hence commercial borrowing rates will tend to rise. It is by no means certain that the economy is strong enough to withstand the dampening effect of higher borrowing rates, so any recovery could be snuffed out.
Furthermore, some investors’ enhanced risk appetite has been stimulated by a desperation to increase their returns, persuading them to accept more risk than they are naturally inclined to do. Although interest rates are set to stay low for longer than markets expect, it would not take much to frighten such an investor back to the apparent safety of cash and government bonds.

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Who's Who: Heather Lamont