The situation is very serious, there's no question about that. But I actually think that Paulson and Bernanke deserve considerable credit for what they've managed to do so far. They've been proactive, reacting very quickly to each situation. The only way to solve these problems is by acting fast. In this sense the U.S. government is doing the right thing. In Japan we ended up taking ten years before we really started to tackle nonperforming assets.
There's no magic solution. It will take a case-by-case approach. I realize that some markets players have been accusing Paulson of inconsistency. He decided to help AIG but let Lehman Brothers go under. But that's not really inconsistent. Lehman was on the verge of insolvency, but the possibility of its collapse didn't really pose a risk to the system as a whole. AIG did. You have to make those distinctions. Paulson understands these things. He knows the market well. We're lucky that he's the secretary of the Treasury right now.
Contrary to popular belief, so far this hasn't really been a banking crisis. The institutions that have gotten into trouble handle a broad range of financial instruments. Lehman Brothers, AIG—these aren't banks in the sense of institutions that use their deposits as the basis for settlement transactions. Real banks, in this sense, are the sinews of the economy. If they become affected, then we'll find ourselves in an even more serious stage of the crisis. Then the economy as a whole could begin to seize up. We experienced that sort of systemic threat here in Japan in 2001-02. It's the kind of situation where you have to be very tough. But we're not there yet. I don't think we've seen the end of this turmoil—not at all—but the overall situation isn't quite that bad yet.
In Japan everyone likes to talk about the possibility that "public money" may have to be used to save troubled companies. The Japanese media use that term in very messy ways. What almost never gets mentioned is that "public money" can be used for very different purposes—either to provide liquidity or to prevent insolvency by providing injections of capital. In the case of Bear Sterns the Fed helped by providing financing or loans that boosted liquidity; the same with AIG. But the government shouldn't be in the business of injecting capital into insurance companies just to save them from bankruptcy. Where capital injections make sense is in the case of banks—and not for the purpose of saving the banks, but in order to preserve the settlement infrastructure. If that becomes damaged it's going to be very hard for the economy to work properly.
The first point to make—which we have been making loudly all week—is that the U.K.'s banks are well capitalized and well run. That said, business is global, and the current economic downturn is a global phenomenon.
In the U.K., this has resulted in the merger of our two major retail banks at an accelerated rate—the speed of events we are still getting used to.
A bubble has burst, and that is never a pleasant experience in any market. We need only look back to the market rout of dotcoms at the start of this century.
Some of the traders who have just come back from their holidays will never have seen a real economic downturn. A 40-year-old who joined a bank from university will never have witnessed a recession in his or her professional life.
They will also be schooled in efficient market theory and program-trading as a norm. Electronic screens tell you everything and when they turn red few are brave enough to do nothing. Fear breeds fear and panic breeds panic. It is fairly clear from this week's events that a company's share price under these circumstances does not necessarily relate to the underlying soundness of the business.
Hopefully we are now entering a more reflective period of this downturn. The denial stage was brief and has long passed; the anger stage is likely to be more protracted with the search for "who is to blame." Now we are moving toward an acceptance that financial services are experiencing a unique series of challenges and may well change significantly in the future.
Most of our activity of late has been to ensure the regulatory response to all of this in the U.K. is appropriate—and crucially, looks to what is happening elsewhere. Precipitate action drives business away: one only needs to look at the effect of Sarbanes-Oxley in the U.S., or the U.K.'s gold-plating of some EU directives. Our prime minister has vowed to "clean up" the financial system, and has helpfully said that this needs to be done globally rather than locally.
Looking to the future we can be assured of a stronger banking sector. The U.K.'s banks have already strengthened their capital bases. Now we can work together to strengthen the global regulatory environment, recognizing that failure to make the right changes now would lead to years of uncertainty, doubt and missed opportunities for banks and their customers alike.
The renewed turmoil in financial markets is bad news for the eurozone, as it is for the world as a whole. It adds to the risk that the economy, which seems to be stagnating at the moment, could soon fall into a mild recession. But the eurozone will likely not suffer as much as the U.S. or the U.K.
In many parts of the eurozone, consumers tend to save more than they do in the U.S. and the U.K., where the personal savings rate is virtually zero. Most eurozone consumers are less indebted, depend less on easy access to bank credit and react less to sharp swings in house and equity prices than their British and American counterparts. Remember that, after the first wave of the financial crisis hit in August 2007, the eurozone economy continued to expand rapidly for more than six months. In the end, it took a dramatic spike in oil prices, a major surge in the euro exchange rate, slower growth in many trading partners as well as a downturn in domestic real-estate markets in some eurozone countries such as Spain and Ireland to finally put an end to the eurozone upswing this summer. The credit crunch did not play the major role in the slowdown.
So far, the eurozone does not seem to be at the center of the current financial storm. Its impact could still be felt if major trading partners now succumb to recession and if, amid the turmoil, eurozone companies decide to play it safe by postponing investment decisions and hiring fewer workers. For an economy already struggling with stagnation, even a modest extra burden could tip the scales toward recession.
But not all recent news for the eurozone has been bad. Amid the financial storm, oil prices and the euro exchange rate have fallen back sharply since mid-July. Over time, these two moves will give eurozone consumers the chance to spend more on other goods and services as their energy bills come down. Eurozone companies will find it easier to compete on the global market at a less overvalued exchange rate, which had started to price many of them out of their markets.
The risks are grave. But for the eurozone, the probability is high that the turmoil will be contained mostly to the financial markets themselves. The average citizen will get more help from lower oil prices than he or she may be hurt by a possible further tightening of credit standards from a bank at home.
For Europe, the determined efforts by the U.S. authorities to tackle the financial crisis, and the additional liquidity injections by key global central banks, are good news. Details of the U.S. Treasury proposal to buy at discounted prices distressed mortgage-backed securities off the balance sheets of U.S. financial institutions still need to be worked out. But seasoned observers remember that, from 1989 to 1995, the Resolution Trust Corporation charged with working out the debris from the S&L crisis helped to stabilize financial markets and contain the spillover into the real economy in the U.S. and the world.
Equity markets of the world have been and still are gripped in an epic financial panic right out of the late 18th and early 19th century. History teaches that crisis spells opportunity for long-term equity investors. In fact, the panics of a hundred years ago savagely massacred speculators, were short, and didn't do permanent damage to the economy. Today I believe markets are in the frightening and ugly process of putting in a major bottom, and that the gloom about credit, equities and the global economy is in the process of cresting. My hunch is that shortly a 10 to 15 percent rally will emerge from the wreckage. It's too soon to say if a new bull market will follow.
The financial world still has a number of serious problems. However, time and money will eventually heal them. Other economies, most notably Sweden in the recent past, have effectively dealt with issues of comparable magnitude. Of course what terrifies investors currently is the precedent of Japan, which, when faced with somewhat comparable difficulties in the 1990s, blundered into a long period of economic stagnation and massive wealth destruction. I believe the U.S. is not repeating those errors, and certainly this time the Federal Reserve and the Treasury are on the case.
That said, in all probability the world economy is slipping towards 2 percent real GDP growth, which is technically a recession. Purchasing Manager Indexes, the best leading indicator, have turned down everywhere. House prices in the U.S. and around the Anglo-Saxon world have fallen and are still falling. Some famous banks have gone bankrupt. The credit markets are in horrendous disarray. However none of this is a secret and, in fact, is front-page news every day. Remember always that stock markets are discounting mechanisms that peer into the future.
Here's the bull case for equities. Markets have already had declines consistent with a serious bear market. The U.S. is down 25 percent from its 2007 peak, Asia and Europe about 35 percent, and some of the previously hot markets such as India and China are pushing 50 percent. Even the developed markets are far below their highs of 2000, and adjusted for inflation are down 40 to 50 percent. Absolute valuations are very cheap. The U.S. is at 12.5 times forward earnings, Europe at 9.1, the U.K., and the emerging markets at 9. Moreover relative to interest rates (what is called forward yield gap analysis), valuations are at record extremes.
Meanwhile, investor sentiment is deeply depressed. Our sentiment measures are at oversold levels consistent with previous bear market bottoms. Hedge funds, according to prime broker surveys, have never had so much cash and have a net long of around 22 percent of their equity—again, a record low. They have materially reduced their leverage, and most are having a lousy year.
As for the global economy, everyone now knows that activity is declining as ordinary people's incomes are diminished by higher oil and food prices and rising inflation. Increasing unemployment and the wealth effect from the fall in stock and house prices is sapping confidence and the propensity to spend.
However, relief is on the way. First, the sharp break in oil prices in the last few months is a huge gift to consumers in oil-poor nations around the world. Second, inflation is peaking as agricultural and industrial commodity prices decline. As a result, real wages (inflation adjusted) will soon be rising again. Third, the Fed has been cutting interest rates for about a year, but other central banks are just beginning to. For example, China cut rates this week. Official rate cuts and liquidity injections spur economic activity, but with a lag of at least a year.
The effect of these factors should be that economic activity first in the U.S. and then elsewhere will begin to revive by the spring of 2009. Historically, equity markets have anticipated an economic recovery six to nine months in advance. The developing world is still a huge engine of growth.
In the long run, equities are the place to be. Over the last century in the U.S. they returned 6.9 percent a year adjusted for inflation. That means the purchasing power of an investor's money doubled every 10 and a half years. The old investment adage is buy sheep, sell deer which translates into buy stocks low, sell them high. In the past few days, equity markets have rallied. It's not too late to do some buying.
In Asia, the perspective is that the global financial turmoil has affected the financial sector here only … I wouldn't say marginally, but not so much. That is because Asian financial institutions have very little direct exposure to sub-prime loans or structured financial products. Although our financial markets are globalized and stock markets in Asia have been affected, Asia's financial system is bank dominated, and the commercial banks have not been affected so much. For those reasons, the impact on the Asian financial system is still limited. Of course, the global economic slowdown that started in the United States would inevitably [cloud] the economic outlook in Asian countries. But the [expected] slowdown—1 to 2 percent this year—would not create a recession or serious economic problems in the countries of the region. So from the Asian perspective, the global financial markets have probably overreacted a bit. What really concerns me is inflation, which in the double digits in most Asia countries. Inflation [will remain] unacceptably high this year as well as next year, so the number one challenge for Asian economies will be inflation rather than sustaining economic growth or keeping the financial sector functioning.
Is it time to buy emerging markets? It depends on the holding period. Because we're still in a situation where there is great uncertainty about the financial system in the United States and Europe, and the risk of economist and analyst forecasts is skewed to the down side, that creates a problem unless you have a very long holding period. But I don't see anything that has materially changed the underlying story about emerging markets and economies performing better. There are some exceptions that have to do with the cyclical positions of [some] economies. Those that are borrowing a lot in order to finance existing levels of activity will have a hard time continuing to do that in this environment, and that has been reflected in the performance of their bond spreads and sometimes their currencies. There's another worry, which is that as you get weakening economic activity in Europe and the United States, that some of the concerns that people had about tariffs and restrictions to international trade once again surface. There's been a strong reaction to commodity prices, and a focus on food security and energy security, which is not helpful for globalization. When you focus on those you're more or less explicitly saying "look, I can't trust the market." And yet it is important to remember that it is the market that has allowed for the technology transfers that have spurred growth and innovation in emerging markets.