Some Very Blunt Warnings from Soros, El-Erian, Setser, and Other Sensible People

Sentiment has gotten so bad even among CEOs that there is reason to expect a bounce in equities in the not-so-distant future once frayed nerves have calmed a bit, particularly given the report in Bloomberg that Bernanke & Co. are much more sanguine about inflation and therefore are perceived to be ready to make further rate cuts. Fed futures suggest another 50 basis point cut this month is possible. Normally, the logic is that bearish types have positioned themselves accordingly, so if prevailing sentiment is downbeat, further selling pressure may be on the wane. However, an offsetting consideration is that retail investors in the US have not abandoned stocks.

Another near-term bullish indicator according to analysts at the Bank of America and AG Edwards, is that stocks have to fall only another 4% to price a recession in fully. That would suggest the bottom is nigh.

But for those who don’t want to be whipsawed by the shifts in investors’ mood, and worry that markets can overshoot rational forecasts, what posture makes sense? This blog does not give investment advice, but we are keenly interested in the health and outlook for the financial markets.

Normally, the default advice is to bet on long term growth, diversify yourself by asset classes, position yourself in accordance with your risk tolerance and need for current income, and resist the impulse to fool around too much.

But are these normal times? Is the conventional stance sound? Whether or not you take continuing grim forecasts with a fistful of salt or not (the latest is Merrill saying home prices may fall another 30%), some surprising sources are surprisingly negative.

Some players who are not constitutional bears are spooked by current conditions. Consider these examples from a Bloomberg piece, where several institutional investors, who correctly bet on recovery in 2003, are staying on the sidelines now:

Institutions handling $1.5 trillion, including Baring Asset Management’s Andrew Cole, ABN Amro Asset Management’s Joost van Leenders and MFS Investment Management’s James Swanson, are holding or selling. They say stocks are riskier today than they were during that last correction in 2003, even though valuations are half as much.

“It’s a much more dangerous game today,” said Cole, 44, a fund manager who helps invest $48 billion at Baring in London. “2008 is going to be a year of preservation of capital. We’ve got a lot of cash and we’re not frightened to say so.”

Cole, whose firm favored shares over bonds or cash in 2003, said in an interview he’s “underweight” equities this year because evidence of a U.S. recession is mounting….

“The macro picture right now is much weaker,” said van Leenders, whose Amsterdam-based firm has $309 billion in assets. “Then we were recovering from a recession, now we are entering one.”

Another worrisome note comes from Brad Setser, who is a particularly keen observer of the trade/currency beat. One of the schools of thought about the current market dislocations, particularly the fall of the dollar, is that it is an inevitable part of the reversal of the so-called global imbalances, meaning having the US run very large current account deficits that are funded by high-savings countries. But Setser is not confident that things have really improved despite the fall in the US trade deficit:

The current account deficit – setting aside the bulge from $90 rather than $60 oil — is heading down. Households seem to be cutting back on other purchases rather than borrowing more as their petrol bill goes up, so perhaps the household savings rate isn’t veering into more negative territory. Painful, sure. But ultimately healthy.

I am not 100% convinced, though, that all imbalances are correcting. To me the biggest imbalance in the global economy is the gap between the current account deficit that private investors want to finance and the current account deficit the US now runs. That imbalance– at least in my view — seems to be getting bigger, not smaller. The deficit that private investors want to finance seems to be falling even faster far faster than the actual deficit.

Of course, when US investors take risk off the table and bring funds home, the dollar can rally. But the trend over the past two years has been pretty clear: as interest rate differentials move against the US, private willingness to finance the US deficit falls. And even back in 2005 private investors weren’t willing to cover the entire deficit.

But what caught my attention were the comment pieces today in the Financial Times by Mohamed El-Erian and George Soros, by both standards extremely seasoned and successful investors. Soros’ take, which we feature long-form, is that the global economy is reaching the end of a 60 year mega-cycle. If you know anyone who grew up in the Depression, their attitudes towards debt and savings are the polar opposite of what is prevalent today. The details of his argument have a good deal in common with the views of Hyman Minsky.

While Soros has a propensity for blunt (albeit well reasoned and argued) views, El-Erian, who has written from time to time in the Financial Times and the Wall Street Journal, prefers a dispassionate presentation. This section of his excellent Financial Times piece, “Fed move seen as insufficient catch-up attempt,” was uncharacteristically forceful. His point is not that the Fed’s actions are late, as some have suggested, but that they are destined to be ineffective, since they will only drive liquidity to segments of the market that don’t need any more. The only remedy is a further, and not inconsiderable, fall in asset prices:

….investors now understand better what interest rates and credit markets have been signalling for a while: that the continuing damage to the financial system is being embedded more deeply into the chain of economic relationships, increasing the overall default risk in the economy.

The recent troubles of the bond insurers serve only to reinforce the image of falling dominoes now that the major banks have taken important write-offs.

As long as this market mentality persists, the fresh capital currently on the sideline will only engage forcefully and sustainably in risk markets if valuations become excessively cheap.

Meanwhile, the Fed will be restoring liquidity to the parts of the system that are closest to it, accentuating the divergence that we have witnessed recently between a normalising interbank market (highlighted by the moves in the London inter-bank offered rate) and unstable and volatile credit and equity markets.

In this context, and in the absence of belief that a meaningful fiscal response will accompany the monetary policy loosening, valuations of stocks and other assets rather than corrective government actions will act as the main driving factor in “clearing” markets to enable them to stabilize and function smoothly again.

Prices will have to get low enough to skew the balance of risk significantly to the advantage of new investors to tempt them in. Otherwise, they will simply wait on the sidelines.

Recent developments will also accentuate the divergence between transparent segments of the markets and structured finance, where there are still fundamental concerns about methods of valuation. Liquidity and cash will remain king.

And from Soros, “The worst market crisis in 60 years“:

The current financial crisis was precipitated by a bubble in the US housing market. In some ways it resembles other crises that have occurred since the end of the second world war at intervals ranging from four to 10 years.

However, there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process. The current crisis is the culmination of a super-boom that has lasted for more than 60 years.

Boom-bust processes usually revolve around credit and always involve a bias or misconception. This is usually a failure to recognise a reflexive, circular connection between the willingness to lend and the value of the collateral. Ease of credit generates demand that pushes up the value of property, which in turn increases the amount of credit available. A bubble starts when people buy houses in the expectation that they can refinance their mortgages at a profit. The recent US housing boom is a case in point. The 60-year super-boom is a more complicated case.

Every time the credit expansion ran into trouble the financial authorities intervened, injecting liquidity and finding other ways to stimulate the economy. That created a system of asymmetric incentives also known as moral hazard, which encouraged ever greater credit expansion. The system was so successful that people came to believe in what former US president Ronald Reagan called the magic of the marketplace and I call market fundamentalism. Fundamentalists believe that markets tend towards equilibrium and the common interest is best served by allowing participants to pursue their self-interest. It is an obvious misconception, because it was the intervention of the authorities that prevented financial markets from breaking down, not the markets themselves. Nevertheless, market fundamentalism emerged as the dominant ideology in the 1980s, when financial markets started to become globalised and the US started to run a current account deficit.

Globalisation allowed the US to suck up the savings of the rest of the world and consume more than it produced. The US current account deficit reached 6.2 per cent of gross national product in 2006. The financial markets encouraged consumers to borrow by introducing ever more sophisticated instruments and more generous terms. The authorities aided and abetted the process by intervening whenever the global financial system was at risk. Since 1980, regulations have been progressively relaxed until they have practically disappeared.

The super-boom got out of hand when the new products became so complicated that the authorities could no longer calculate the risks and started relying on the risk management methods of the banks themselves. Similarly, the rating agencies relied on the information provided by the originators of synthetic products. It was a shocking abdication of responsibility.

Everything that could go wrong did. What started with subprime mortgages spread to all collateralised debt obligations, endangered municipal and mortgage insurance and reinsurance companies and threatened to unravel the multi-trillion-dollar credit default swap market. Investment banks’ commitments to leveraged buyouts became liabilities. Market-neutral hedge funds turned out not to be market-neutral and had to be unwound. The asset-backed commercial paper market came to a standstill and the special investment vehicles set up by banks to get mortgages off their balance sheets could no longer get outside financing. The final blow came when interbank lending, which is at the heart of the financial system, was disrupted because banks had to husband their resources and could not trust their counterparties. The central banks had to inject an unprecedented amount of money and extend credit on an unprecedented range of securities to a broader range of institutions than ever before. That made the crisis more severe than any since the second world war.

Credit expansion must now be followed by a period of contraction, because some of the new credit instruments and practices are unsound and unsustainable. The ability of the financial authorities to stimulate the economy is constrained by the unwillingness of the rest of the world to accumulate additional dollar reserves. Until recently, investors were hoping that the US Federal Reserve would do whatever it takes to avoid a recession, because that is what it did on previous occasions. Now they will have to realise that the Fed may no longer be in a position to do so. With oil, food and other commodities firm, and the renminbi appreciating somewhat faster, the Fed also has to worry about inflation. If federal funds were lowered beyond a certain point, the dollar would come under renewed pressure and long-term bonds would actually go up in yield. Where that point is, is impossible to determine. When it is reached, the ability of the Fed to stimulate the economy comes to an end.

Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.

The danger is that the resulting political tensions, including US protectionism, may disrupt the global economy and plunge the world into recession or worse.