David Rosenberg is chief strategist for Gluskin Sheff + Associates Inc. and a guest columnist for Report on Business
Memories are short, especially when it comes to trauma. So it is not surprising the investment community appears to have been oblivious to the long list of serious risks still lurking in the global economy and capital markets.
The most obvious risk is the amount of debt still being supported by questionable collateral, as well as the cash flows required to service them. The current Dubai debacle is just one example. But it's not just Dubai World. In the past week, Russia and Switzerland have intervened in the foreign exchange markets (Japan is probably not far behind), Mexico was downgraded by Fitch Ratings, and the European Union is trying to figure out what to do with Greece. For its part, Vietnam devalued its currency and dramatically raised interest rates in a classic beggar-thy-neighbour policy that conjures up the Thai baht devaluation of mid-1997, which was the launching pad for the Asian meltdown.
One wonders how China will fit into all this with a dramatically undervalued currency, a property market heading further into a bubble, and a banking sector now being forced to improve capital ratios.
We went into this latest round of turbulence with tremendous complacency in the marketplace. Rallies were still on light-volume, volatility receded to its low for the year, the bull/bear share of the sentiment surveys hit late-2007 levels, and the trailing price-to-earnings ratio for the S&P 500 sat at 27, while the forward P/E was 17-times earnings. There is no margin for error in an overvalued equity market - one priced for nearly 5-per-cent GDP growth. Remember that in the fourth quarter of 1987, a quarter that saw earnings soar amid 7-per-cent GDP growth, the S&P 500 cratered 30 per cent.
While the equity market was busy this year re-pricing an era of minimal risk and maximum growth, what was lost in the violent up-move was the credit issues left over from the bubble that burst in 2007.
Moody's credit card delinquency rate rose to 6.12 per cent, well above the rate a year ago.Freddie Mac's measure of delinquency rates rose to 3.54 per cent, and has jumped by more than a percentage point since the spring.
In addition, according to the U.S. Federal Deposit Insurance Corp., the number of "problem" banks in the U.S. swelled to 552 (with nearly $350-billion U.S. in assets) in the third quarter - a 33-per-cent increase from the second quarter. Not to mention the 124 banks that have already failed this year.
The range of possible macroeconomic and market outcomes in the aftermath of a credit collapse is usually very wide and resolutions rarely occur quickly. Just go to the U.S. Federal Open Market Committee minutes and see the wide divergence of views over the macroeconomic outlook.
How big is the range of GDP estimates? It looks like this:
2.0 per cent to 4.0 per cent for 2010
2.5 per cent to 4.6 per cent for 2011
2.8 per cent to 5.0 per cent for 2012
The differences are huge when you consider the U.S. is a $14-trillion economy -- we're talking about differences that amount to $300-billion!
The range on the unemployment rate forecast for 2010 is 8.6 per cent to 10.2 per cent; for 2011, it is 7.2 per cent to 8.7 per cent; and for 2012, the band is 6.1 per cent to 7.6 per cent. These ranges are massive. And for the inflation rate, the range for 2010 is 1.1 per cent to 2.0 per cent; 0.6 per cent to 2.4 per cent for 2011; and for 2012, 0.2 per cent to 2.3 per cent.
So, consider that within the Federal Reserve Board, there is one official that sees the potential for a return to full employment by 2012; and another that sees the prospect of deflation. These views are worlds apart and attest to our assertion that the band around any particular forecast in a post-bubble credit collapse is massive.
Buying call-options on volatility has rarely looked as attractive as is the case today if the Dubai situation turns into something even fractionally similar to what happened in places like Thailand, Russia or Argentina. Once the complacency is shaken out of the market, it is going to give those who have been skeptical over this "liquidity-induced" rally a chance to take out our rulers and sharpen our pencils.
1990S DEBT CRISIS
Currency markets in Asia are hammered as the market loses confidence in the so-called "tiger economies." Thailand, Indonesia, the Philippines and Malaysia were the most seriously affected. Stock markets across the world suffered. China overhauled its banks and wiped billions of dollars of bad debt off their books. Indonesia, which was among the hardest hit in Southeast Asia, was given a $43-billion (U.S.) rescue package by the IMF.
Russia devalues the ruble and defaults on $40-billion of debt. On Aug. 17, Russia abandoned the floor value for the ruble to the dollar; banks shut and refused to give people their money. The IMF lent Moscow $4.5-billion to pay old debts and avoid a confidence-cracking default.
The New York Federal Reserve Bank helped broker a $3.5-billion private sector bailout for hedge fund Long-Term Capital Management, which was teetering on the brink of collapse. The Fed cut interest rates three times in successive months in response to the Russian financial crisis and near-collapse of LTCM.