Central banks can’t stop the next Great Recession

This is a rare moment in economic history, says hedge fund manager Hugh Hendry. Our problems have become “greater than the ability of the politicians to respond”.

Hendry is talking about the fast-worsening eurozone crisis. But his views could equally apply across the rest of the planet. The global economy is in crisis. Growth is slowing fast. Major developed countries are heading for recession again. Stockmarkets are waking up to the risks, and warning that this time round could be even worse than the 2008/2009 Great Recession.

Recent attempts by Western politicians and central bankers to prevent this have fallen flat, and investors are clearly losing faith in the abilities of the authorities to provide never-ending bail-outs. It’s getting to the point where they are pinning their hopes on Chinese growth to get the world out of a hole.

Yet China has its own problems. And trying to remedy these, not bailing out everyone else, will be its first priority. So what’s gone wrong? And is there any silver lining for investors at all?

QE hasn’t worked

To understand why central bankers have proved unable to kick-start the global economy, we need to look at the root cause of the trouble – the ‘boom’ of the mid-2000s. This wasn’t a real boom at all. Thanks in great part to central bankers keeping interest rates too low, credit was far too easy to obtain. This borrowed money pumped up the prices of assets like shares and property. That simply couldn’t last. The bubble burst – as bubbles always do – giving way to the credit crunch that began in 2007. Then, when the highly leveraged (ie, over-borrowed) investment bank Lehman Brothers collapsed in 2008, markets panicked.

So how did the financial bigwigs try to sort the problem? Did they curb excessive credit to restore the world’s finances onto a sounder footing? No chance. Insanity is often defined as doing the same thing again and again, and expecting a different result. Officialdom’s response to the credit crunch was to institute more of the same policies that sparked the debt boom in the first place.

Plenty more free money was supplied to the banking system. Official interest rates were slashed to all-time record lows. And when that didn’t do the trick, central bankers opted to print more money via quantitative easing (QE). The idea behind QE is that central banks push more money into the system by buying bonds. This drives up bond prices, meaning yields and long-term interest rates fall – the cost of borrowing is cut even further. The theory is that investors and bankers will then put the cash they made from selling the bonds to work somewhere else. They’ll buy other assets, perhaps, or even lend more money out. It’s supposed to get the economy’s wheels moving.

So has QE worked? In America, the Federal Reserve (the US central bank) has injected about $1.7trn into the US banking system. Meanwhile, the Bank of England has put £200bn into Britain’s. But QE hasn’t done much good in these countries. Stocks got a boost to begin with, but that’s since worn off.

More importantly, bank lending hasn’t recovered. Economic growth is anaemic. And a clutch of key indicators suggests a ‘double dip’ is on the way. Worse, some of the extra liquidity created by QE has done real damage. It’s leaked out into the commodity markets, driving up the cost of food and fuel. In turn, that’s pushed inflation higher.

Why hasn’t QE achieved what was hoped for? Simple. All those boom-time borrowings haven’t gone away. They’ve just been dumped on a different group of people. And they’ve grown bigger too.

The big transfer

After waves of bad debts blew out bank balance sheets everywhere, governments decided to use taxpayers’ money to stop the banks from going bust. So the private-sector debt burden was simply “transferred to the public sector… to prevent the adjustment to the depression-era reality that the debt-unwind would undoubtedly have brought about”, says Albert Edwards at Société Générale. “Yet those debts are as unsustainable in the hands of the public sector as they were in the private sector.”

Until that debt is repaid – or defaults – it will hang over economies and financial markets like the sword of Damocles. Growth will at best stay sluggish while governments and consumers ‘deleverage’, ie, pay off their borrowings.

 

Central bankers can’t change that. That won’t stop them trying. The Fed’s latest wheeze, ‘Operation Twist’, involves the Fed buying long-term Treasury bonds (IOUs issued by the central bank) and funding this by selling shorter-term Treasuries. The extra demand from the Fed should push up the prices of longer-dated US bonds, thus lowering the yield.

Again, the aim is to reduce long-term interest rates across the US economy. It may sound clever. But here’s the snag. “Long-rates are already at multi-decade lows, so pushing them even lower isn’t going to make much difference,” says Irwin Kellner at MarketWatch. “Without the aid of fiscal policy [more government spending] to jump-start the economy, it’s like trying to push on a string.”

Now, even if you believe that more government spending would do the trick, and many dispute that, the problem is that for the US it’s a non-runner anyway. America has already run up against its debt ceiling – what it lets its government borrow. After a big political spat, a temporary extension to this has been approved until 18 November. But then a budget must be passed, or another stop-gap measure agreed. In other words, lifting the debt ceiling is not a done deal. Even if it is raised, the country’s scope for spending more will be severely curbed.

The fact is, people don’t want to borrow anyway. “Most people are so worried about their jobs that they’re trying to reduce debts and increase savings… Many businesses see no reason to borrow since they’re not seeing enough sales to justify expanding.” So it’s little wonder the markets were unimpressed with Operation Twist. As Buttonwood puts it in The Economist: “If that’s all the Fed can do, investors may be thinking there’s no hope left.”

 

America isn’t the only one in trouble

Britain is facing similar problems. Here, the Bank of England is mulling over another bout of QE. But this could do more harm than good, reckons former-Bank rate-setter Andrew Sentance. As he notes in the FT: “These policies haven’t boosted growth… Rather, they’ve led to relatively high inflation. More stimulus is likely to result in more of the same.”

And what of Hugh Hendry’s great fear, the eurozone? As so often, Europe has been behind the curve set by America. But now, in finding ‘solutions’ to its own debt crisis, it’s trying to catch up fast. Why? Greece is broke. Portugal is in the same boat. And because its government stood behind its busted banks, so is Ireland. All three have needed bail-outs, and will probably need more. Spain and Italy are also over-borrowed, though they’re hanging on in there for now. But Europe’s banks have lent a lot to all of these countries. So their balance sheets are full of holes. In other words, a continent-wide banking crisis is developing.

The European Central Bank (ECB) had been the only major central bank trying to protect the value of its currency. It raised interest rates twice this year. And it’s shown tough love towards the eurozone’s more wayward members. The message has been clear: it’s your job, not ours, to get your spending and revenues into much better balance.

But in a U-turn earlier this month, the ECB trashed this policy. It said it’s now prepared to pump extra cash into the system. There are rumours the next move in interest rates will be down. Leading EU politicians are trying to put together a €2trn bail-out package by boosting the powers of the existing EU bail-out fund, the European Financial Stability Facility (EFSF).

So will this bail-out solve Europe’s problems? That’s unlikely. A €2trn fund might limit the immediate damage to the banking system. But again, it will just shift the debts from one place to the other. Ultimately, Europe needs growth, and lots of it, to pay the interest bills on all the debts built up by these countries. But along with the rest of the developed world, such growth isn’t on the agenda. That’s because of that huge debt overhang again. While this is being reduced, either by deleveraging or default, Europe’s economy will go nowhere fast.

Indeed, as Jeremy Warner puts it in The Daily Telegraph, “the over-indebtedness of the periphery is going to come bouncing onto the balance sheet of the core” – Germany.

Why China can’t save us

In other words, the rest of Europe will be dragged into the mire with the heavily indebted periphery. Unless there’s a silver bullet, this recession could be even nastier than last time. That’s why eyes are turning to China. Post-Lehman, Beijing upped government spending by $600bn. That helped to power near-double-digit growth in the Chinese economy.

But don’t expect a repeat performance. In short, “right now, China’s economy doesn’t need more stimulus and its leaders are wary of making bad bets on European debt”, says Emily Kaiser for Reuters. “If conditions worsen in the US or Europe, China would respond only if and when trouble shows up at home.” And even then, “the most China can realistically do for the struggling global economy is to ensure its own growth holds up, and that won’t be nearly enough to lift the world”. To offset the impact of a 3% drop in American and European growth, China would need to increase its own growth by 18%, notes Jun Ma at Deutsche Bank.

To recap, then: the world economy is in a horrible mess, and central banks are basically powerless to help – their actions in fact may even have extended the crisis. There’s no chance of true economic stability until excessively high debt levels worldwide are repaid, or written off. Sure, this will be a very painful process. But trying to repair a burst debt bubble by creating lots more debt will only lead to an even bigger crash at some point in the future.

As Sentance says, “central banks need to stop pretending they can remedy all the deficiencies of the economic system by providing unending amounts of stimulus. Historical experience suggests that continual injection of demand stimulus to counter weak growth leads to persistent inflation amid financial instability.”

There is a silver lining. There could be several more months of stockmarket carnage. But good investments will be dragged down along with bad ones, throwing up some great opportunities. We tell you what to look for below.

Five stocks to pounce on in the dips

Most investors probably don’t realise this, but during bear markets, stocks spend more of their time going up than down. As most world stockmarkets are now into bear territory (they’ve fallen by more than 20% from their recent peaks), it’s key for investors to understand how this will affect them.

Yes, another major recession is looming. This is very likely to send share prices significantly lower over the coming months. But the really sharp falls are likely to happen fast – often within a few trading sessions. Then, as talk spreads about the next central bank intervention or bail-out package, there will be a series of rallies. And in time terms, these rallies will last a lot longer than the drops.

During those rallies, the bail-out cheerleaders will tell you everything has been fixed. And they’ll be very plausible, so it’ll be tempting to believe them and get back into the market. But don’t be fooled. When the next sharp drop occurs, you’ll wish you hadn’t listened. The moral is: wait for the really bad days to buy.

So what should you be looking to snap up when the chance arises? We’ve consistently favoured defensive, good-value shares with better-than-average dividend yields. And we’re certainly not changing our tune now. British energy suppliers National Grid (LSE: NG/) and Scottish & Southern Energy (LSE: SSE) are already yielding at least a prospective 6%, as is big pharma firm AstraZeneca (LSE: AZN). So if you get the chance to pick up these stocks at even cheaper prices – that is, on even higher yields – on a really bad day in the markets, take it. The same applies to those near-8% yielders Vodafone (LSE: VOD) and insurance giant RSA (LSE: RSA). Locking in that level of yield just has to make sense.

What about gold? It’s certainly had a bad week, plunging by near-enough $400 an ounce from its $1,920 high to around $1,530 at one point. Just as when a similar crash happened in 2008, there are several reasons for this: institutions selling off profitable positions in gold to offset losing positions elsewhere; those betting with borrowed money being forced to close positions due to higher ‘margin’ requirements; and fear in the markets leading to a rush for US dollars, which almost automatically hits the gold price. But we’d still be happy to hold gold.

Nothing has happened to change the fundamental case for allocating part of your portfolio to the metal as insurance. Bail-outs and money printing add up to uncertainty and possibly even higher inflation, as we describe above. Central bankers and politicians remain keen to devalue their currencies, and with even the hard-line European Central Bank looking likely to cut interest rates, the ‘currency wars’ can only get more ferocious. It also seems unlikely that the Fed has exhausted its bag of tricks with Operation Twist. If the selling pressure on Wall Street gets heavy enough, objections to more QE from Ben Bernanke will fade into the background.

And if we’re going into a vicious de-leveraging spiral, bankruptcy will be what people most fear. Gold is about the only asset that can’t go bankrupt, and this will hold up demand for the metal. Gold’s bull market will end when things are about to get better for almost every other asset class. At that point, it can go back to being the quiet little pot of insurance at the back of your portfolio. But sadly, we don’t think we’re at that stage yet.

Category: Market updates