Nationalizing credit

The second quarter was great for equities and the third is shaping up to be even better. Optimism is back in fashion in a big way and commentators are moving past the 'green shoots' stage to talk about a rebound in house prices and a sharp 'V' shaped recovery. There are even those who are talking about 3% GDP growth in the US in the fourth quarter. On this side of the pond the newspapers are beginning to call and end to the recession and forecasting positive GDP growth by year end. What a turnaround from only a few months ago.

As a bull turned bear I feel as though I'm the one at the party drinking soda while everyone else is on the hard stuff. I recognize that markets move on more than fundamentals. This market has done well on a flow-of-funds basis and a growing belief that we shall see a strong upside recovery in H2. But to support current levels on the FTSE and Dow earnings need to rise beyond any short term boost that comes from restocking. With unemployment rising and deleveraging continuing this is going to be difficult.

What if instead of being a 'V' shaped turnaround this is a no-recovery recovery ? Why if things are going so well has the BoE issued a further £50 billion of Quantative Easing - taking almost all the analyst community by surprise?Stocks are surging and hitting stratospheric and possibly unsupportable valuations relative to earnings . I find it telling that in the US between April and June insider selling ran at a rate 22x greater than insider buying. Ryanairs chairman reporting his Q2 numbers says that he sees no improvement in any Euroland economy and that this winter will be particularly hard. Willie Walsh at British Airways is saying the same thing.

Another worry I have is consumption. US private consumption ran at a $10 trillion rate (16% of global output) in 2008 with EU levels at $9 trillion and Asian consumption at around $5 trillion.With American and European savings rates increasing sharply there is a real chance that we will see a significant reduction in global GDP in 2010. Japanese manufacturing fell 37% from peak to trough and looks as though it will settle down 20% or so from the peak - admittedly a pretty healthy upswing from the lows. In the short term the comparisons can look pretty good but what happens to profits once companies have cut costs by laying off workers?

I still can't get it out of my head that this is a bear market rally, that my trader friends are making hay while the sun shines, and that more trouble lies ahead.

Weekend reading.

All my old colleagues on Wall Street are in an upbeat mood having been awarded great mid-year bonuses. With a recession underway demand for loans has fallen and banks are having to park their money somewhere .The Q2 returns on trading equities has clearly been the right place to put their TARP funds and the stellar returns since April have been a big help in repairing some of the balance sheet damage incurred in 2008. Institutions that have been sitting long of cash have recently started to pile into the markets afraid of missing out on further strength at the end of Q3. Amid all this wild optimism I thought it might be useful to jot down a few comments from the Sunday papers to put current market valuations in perspective:

The total number of vacant properties in the US has reached 18.7 million as of June 2009. Assuming four people in a family this is enough surplus housing to resettle the entire population of the UK and Israel in America.

In the UK home ownership levels have fallen back to rates last seen in Q2 2000 erasing most of the much touted gains in homeownership over the last decade.

The number of households in America is decreasing as extended families move in together and new graduates opt to live at home in the poor economic climate.

Operating income for companies on the S&P 500 that have reported their Q2 numbers have been 29% lower than last year and 80% lower than 2007.

The 'funding gap' of the big UK banks - the difference between customer loans and deposits was estimated at £800 billion last year. This gap has been largely filled by government support but the Bank of England cautions that UK banks may need to downsize their balance sheets by £500 billion between now and 2013.

The latest survey by accounting firm Deloiites shows that companies are not looking to banks for finance.Equity is currently the most popular form of finance and bank borrowing the least popular. This is the exact opposite to the survey conducted in June 2007.

The UK economy fell again in Q2 and has now shrunk 5.7% from its peak in Q1 2008. The downturn in the early eighties saw output shrinking by 4.6% over five quarters so this is now officially the worst downturn since WWII.

The National Institute for Economic and Social Research expects growth in the UK to be 1% next year and expects it to be the autumn of 2012 before the economy reaches the output levels recorded at this time last year. Living standards are not expected to recover to 2008 levels until 2014.

British Airways Chairman thinks it will be at least five years before demand for business class travel recovers to the rate seen in 2008 .

Repression - what does it mean?

Read this morning that another 500 US banks could fail as a result of unemployment rising ,defaults on consumer loans increasing and commercial real-estate losses starting to soar. Hardly surprising when you think of the amount of deleveraging that's going on. Commerzbank and West LB in Germany have effectively seen their blalnce sheets halved.

Against this backdrop of tighter credit access what is the economy going to be like once we emerge from this downturn? Analysts talk about V, U, or W shaped recovery from the recession but in the absence of the consumer isn't this overly optimistic? What if it's none of the above and the economy is instead on a ' -- ' shaped track ? What would it mean if the 10% or so reduction in global output caused by this downturn doesn't ever come back? Sure, there will be inventory restocking from a very low level and sure families will eventually replace their ageing vehicles . Together this will stop the decline in output but replacements as a motor for growth are going to make the recovery very shallow. Compared with where we were two years ago there is bound to be a lot of surplus capacity in the system and a lot of capital expansion plans that will be scaled back permanently.

In a 'repression' governments will have to scale back services to balance the books and avoid bankruptcy, indirect taxation will have to rise ( VAT at 20% ) to pay for higher structural unemployment, and bank lending will have to be more tightly regulated to avoid a repertition of the crisis.Taken together this points to continued weak demand, softness in exports and continued weakness in corporate earnings.

Where will the demand come from?

Things have been pretty quiet of late and so my blogging on the economy has become somewhat dilatory. This afternoons Phialdelphia Fed Index did however shake my complacency as it shows that manufacturing is still very weak. It seems that while the rate of economic contraction is slowing there is little to signify that an upturn is yet underway. World trade is now down some 18% since September - a shocking number when you think about it.

Why the S&P is trading on 17x when the historical average is 16x remains a mystery to me. Despite huge injections of stimulus economic growth in the US,Asia and the US remains decidedly lacklustre. What corporate bright spots there are seem to be related to short term re-stocking leaving the longer term question of where demand will come from unanswered.

Naturally, with equity markets discounting a sharp recovery in earnings ( something I think most unlikely ) the delayed new issue schedule is opening up again. Russia seems to be in the lead - although which institutions will be keen to add to positions in a country where corporate governance is so 'light touch' remains to be seen.

British Airways faces reality - a 'repression'.

The airline operating level results continue to signal that this economy isn't getting any better despite Wall Streets enthusiasm. It looks as if things are getting worse but thankfully not as quickly as they were. BA's latest pronouncement said " market conditions continue to be very challenging with trading at all levels well below last year". The airline is cutting capacity for the peak summer months, defering aircraft deliveries, and reducing the capex spend . Not much there to show that green shoots are sprouting. Banks are repairing their severely impaired balance sheets rather than lend to the economy, unemployment is rising,corporate bankruptcies are growing, and finance directors are slashing travel budgets.

Elsewhere in the bellweather airline sector Swiss is cutting winter capacity by 9%, Austrian is laying off 1,000 staff while Czech is reducing its fleet by 10%.

Although we've stopped plumetting economies continue to drift downwards. If not a depression then it's certainly a more than standard recession - perhaps we should start calling it a repression. At the end of this global demand is likely to be severely repressed by perhaps as much as 7-10%. At some stage governments in the UK and the US are going to have to toy with inflation financing to get out of this mess - that's why in the long term I think the Euro will continue to appreciate. There is talk of 20% cuts in government spending in the UK but I'm not sure the electorate is ready for reductions of this projected scale. Anyway, the opposition would need to have a huge swing to unseat the incumbents huge arithmetic lead - Labour isn't dead yet. Currency and bond markets may well have got Sterling wrong.

Other unconnected pieces of recent data that surprised me:

• Phoenix house prices have fallen by 53.7% from their peak. By contrast Charlotte is down 11% and Dallas 8%.
• State level personal income tax collection is down 26% from prior year levels in the January - April timeframe.
• June autosales are set to rise above 10m units annualised in June - still down from last years 13.7m level.
• For the first 4 months of the year Central California bankruptcy levels are up 75% from 2008 levels.

Protectionism here we come?

The stockmarket seems to have woken up to the continuing weakness in the economy. After dreadful US June unemployment figures the indices have started to retrench from their recent enthusiasm. I spoke last night to an old freind who is now running a Wall Street firms London outpost. He came up with a frightening July 4th holiday statistic. In December 1999 official employment in the US was 130.53m.The comparable for June 2009 was 131.69m. If the American economy loses a further 1.16m jobs over the next 6 months ( not impossible after Junes loss of 467,000 ) then there will have been no new jobs created in the entire first decade of the 21st century. How long is it before someone in Congress starts blaming that on globalization? Protectionsim here we come?