The 2001-2002 Recession

This time it is…different

The most important factor underpinning the boom in asset prices over the past 5 years has been the high level of liquidity that has been maintained within the financial system. Debt levels have been excessive for some time, but as long as new debt could be created and 'monetised' in ever-increasing amounts there was no real threat to the boom. There was no reason to be bearish on the stock market, beyond the short-term, because a flood of new money would always elevate valuations to new highs following each correction.

During the final few months of both 1998 and 1999 the level of liquidity within the financial system was high. Liquidity is not directly controlled by the Fed since almost all new money comes into existence as a result of private financial institutions (banks, government-sponsored mortgage agencies, money-market funds) expanding their balance sheets via the creation of new loans or the repackaging/reselling of existing loans. However, the Fed effectively 'sets the tone' courtesy of its interest rate policy and its control over bank reserves.

Coming into this year we were expecting the Fed to do its utmost to rein-in liquidity growth during the first half of the year using both interest rate hikes and a contraction in the monetary base (thus hampering the ability of banks to make new loans). We thought the Fed would then facilitate an increase in liquidity, beginning around the middle of the year, in deference to the elections. This pattern unfolded according to plan up to and including September as liquidity-growth contracted going into May and then began to recover. However, the situation then changed. Rather than accelerating higher during the final few months of the year as per 1998 and 1999, we are seeing signs that the rate of liquidity growth has stalled and is probably even falling. In other words, this year is shaping up quite differently.

Liquidity and economic growth

An excellent analysis of liquidity and its effect on the economy was provided by Joseph Carson (chief economist for the Americas at UBS Warburg) in the November 6 edition of Barrons. Mr Carson maintains a "liquidity index" which is calculated based on the trend in real M2, changes in business and consumer credit, and the growth in long-term liquid assets. The following chart, which was taken from the Barrons article, shows how changes in liquidity (as measured by the liquidity index) have accurately telegraphed changes in the GDP growth rate over the past 40 years.

As the above chart shows, liquidity growth has recently dropped to its lowest level since 1994. Mr Carson points out that if the current trend continues to year-end then the liquidity index would show no growth over a 12-month span for the first time since 1991.

Why is liquidity falling?

The following factors have all contributed to the reduction in liquidity growth:

a) Fed policy - the Fed has hiked short-term interest rates over the past 16 months and, during the course of this year, has not actively promoted money supply growth (a marked change from 1998 and 1999).

b) Debt may be reaching saturation levels. The ability of consumers and businesses to take-on more debt has most likely been impaired by the repayment burden associated with the existing debt. This is certainly the case for the major telecommunications companies, many of which have taken on massive amounts of debt to finance spectrum purchases and the build-out of infra-structure.

c) As always happens when credit is allowed to expand at an excessive rate for a prolonged period, money is used less-productively. Investments are made that otherwise would not be made and could not be justified in the absence of the excess money, meaning that each new dollar provides less 'bang for the buck'. This is demonstrated by the ratio of credit-growth to GDP-growth, which rose from an already high 2.8:1 during the 1995-1998 period (total credit increased by $2.80 for every $1 increase in economic output) to 3.8:1 during the 1998-2000 period. This equates to a 26% decrease in the productivity of money and credit during the 1998-2000 period versus the 1995-1998 period.

d) The stock market is down since the beginning of this year, thus reducing the ability and/or the willingness of investors and the holders of company stock options (some of which are now worthless) to participate in the on-going credit expansion. The relationship between asset prices and liquidity is circular (during both the expansion and the contraction phases) in that reduced liquidity leads to lower asset prices which, in turn, lead to a further reduction in liquidity.

e) An increase in the level of 'loan losses' at banks. This is also a circular relationship in that escalating loan losses force banks to cut-back on their lending, thus reducing liquidity and putting their more highly-geared customers at risk of default.

e) The need to pay substantially higher prices for energy.

Where are we headed?

If the liquidity growth rate continues to fall, and there is no reason to think that it won't, then the US economy is in for a very tough time over the next 2 years. Over the next few months the signals are likely to remain mixed, with some evidence of strong growth continuing to filter through as the economy transits from boom to recession. This will be especially true if some political certainty is soon re-established and the stock market can mount a year-end rally.

The stock market exerts a substantial influence on the economy and thus a sizable counter-trend rally over the next few months (something we think is likely) would probably postpone any serious economic weakness until around mid-2001. However, the trend towards lower levels of liquidity should persist until the Fed moves aggressively to re-liquefy the system (via rate cuts, additions to bank reserves and, if necessary, the 'monetisation' of bad debts within the private banking sector). Based on past experience the Fed will not be pre-emptive (it tends to rely predominantly on backward-looking indicators). It is therefore unlikely to act until it sees blood in the streets (or, at least, blood in the boardrooms of major banks).

The present monetary system's natural tendency towards higher and higher inflation will eventually 'kick in' and today's contraction will be superceded by the next round of credit expansion. However, based on the level of excesses that have been built-up over the past few years the corrective process is likely to extend well into the year 2002. During this time there will no doubt be a number of stock market rallies (within an overall down-trend or, at best, a trendless market) that can be traded profitably from the 'long-side'. Those who are not active traders will probably be best-served by maintaining a high level of cash that will only be put to work after the liquidity trend has turned positive, although some funds should be directed towards the gold sector. Gold and gold stocks are likely to perform very well in absolute terms over the next 12 months as the Dollar's exchange value declines due to a slowdown in the rate at which capital flows into the US.