A market correction is coming, this time for real

"A Market Correction is Coming....."

This comment, "A market correction is coming, this time for real," comes from William Rhodes, senior vice-chairman of Citigroup, and chairman, president and chief executive of Citibank. Consistent with the headline, Rhodes takes a bearish view (in fact, he says he has been concerned about leverage and indiscriminate pricing of risk for some time, and said he expected a market correction a year ago. Now not only does he say he expects a "market correction" in the next 12 months, but a "real correction," which presumably means a correction in the real economy (does that mean a recession, or merely a marked fall in growth?).

It's noteworthy that someone in a senior position in a major financial institution is forecasting a pessimistic (actually, quite pessimistic by the standards of this sort of thing) outlook for growth. And he was downbeat late last spring, and admits to having been premature. Now some financial services firms have bearish spokesmen they keep around (think Stephen Roach at Morgan Stanley, who is always worth listening too, even when he is wrong), so perhaps that is one of Rhodes' roles. But the pernabear function is generally occupied by an economist doing market or economic forecasts, not a member of management. So it's pretty certain Rhodes believes what he is saying (it's not a house view) and it's also pretty certain that it's at least in part based on information that is not widely reported (someone like Rhodes either talks directly to or is one step removed from top corporate executives, very wealthy individuals, central bankers, regulators, other senior bank executives, and major investors).

So while this is one man's view, he is likely to have better access to information than many of the pros....

The recent market turmoil should not have been un­expected. We are living in an increasingly interdependent world. Times have been good, even with the volatility of the past few weeks sparked by the Shanghai market and then fuelled by the subprime sector in the US. We have been living in extraordinary times in a global “Goldilocks” economy – not too hot, not too cold. The macro-economy still looks pretty good but the shaking of the trees over the past few weeks has, it is to be hoped, awakened investors and lenders to the risks in the marketplace.

High growth in emerging markets continues, as exemplified by the tremendous growth in China and India. Western and eastern Europe are growing. The Russian economy, driven by energy, has been strengthened well beyond what was expected a few years ago. The Middle Eastern oil-exporting countries are going through a boom fuelled by oil and gas: it is different from earlier periods of high oil prices because this time a substantial amount of the money is staying in the region, rather than being invested elsewhere as in the 1970s.

Africa is in many ways going through something of an economic renaissance. The Japanese economy also has improved and the US locomotive has continued, maintaining good growth of more than 3 per cent in 2006 notwithstanding the downward revision of fourth-quarter growth from 3.5 to 2.2 per cent.

However, much of the good news has come as a result of extraordinary levels of liquidity pouring into opportunities around the globe. To a large extent this is due to the Federal Reserve’s expansionary monetary policies early in the decade and the US administration’s fiscal stimulus. The yen carry trade has also facilitated the buoyant expansion of investments and leverage evident everywhere today. The low spreads, the tremendous build-up of liquidity, the reach for yield and the lack of differentiation among borrowers have stimulated both dynamic growth and some real concerns.

Pockets of excess are becoming harder to ignore. Problems in the housing and mortgage area such as the subprime sector in the US are one such example of excess that should come as no surprise. As lenders and investors inevitably become more discriminating, liquidity will recede and a number of problems will surface. Too many countries and companies with vastly different risk profiles are still commanding similar pricing.

It has been my experience that periods of economic expansion tend to last between five and seven years. We are entering the sixth year of expansion in the US. Against that background, I believe that over the next 12 months a market correction will occur and this time it will be a real correction. I said as much last spring during the Inter-American Development Bank meetings in Belo Horizonte, Brazil. Soon afterwards, in May 2006, the markets did experience a correction but it was so mild and short-lived that it was in a way less effective than no correction at all. I say that because it left the inexperienced with the impression that it would be smooth sailing from there on.

Market developments in the past few weeks should be seen as a warning. What has been evident for a number of months is that, in the US, we are seeing lagging inflation and slower growth. Whether this means that we are going to have to fend off recessionary tendencies is not yet clear. However, what is clear to me is that in the next year a material correction in the markets will occur.

During the last big adjustment that started in July 1997 in Thailand and spread to a number of Asian economies including South Korea, followed by Russia in 1998 – and led ultimately to the bail-out of Long Term Capital Management, the US hedge fund – a number of today’s large market operat­ors were not yet in the mix.

Today, hedge funds, private equity and those involved in credit derivatives play important, and as yet largely untested, roles. The primary worry of many who make or regulate the market is not inflation or growth or interest rates, but instead the coming adjustment and the possible destabilising effect these new players could have on the functioning of international markets as liquidity recedes. It is also possible that they could provide relief for markets that face shortages of liquidity.

Either way, this clearly is the time to exercise greater prudence in lending and in investing and to resist any temptation to relax standards.

US central bank sounds inflation warning

The World Today - Thursday, 29 March , 2007 12:34:00
Reporter: Peter Ryan

ELEANOR HALL: The world's most powerful central banker has sounded a new warning about inflation in the United States and sparked concerns about interest rates.

The chairman of the US Federal Reserve, Ben Bernanke, said that while he's worried about the high-risk end of the US mortgage sector and that it could contribute to an economic slowdown, he regarded inflation as the greater threat to the global economy.

Economists say Mr Bernanke's comments on inflation suggest a cut in interest rates is now off the agenda.

And that has sent some investors on Wall Street running for the door.

More from our Business Editor Peter Ryan.

PETER RYAN: For Ben Bernanke, today's world is hardly one of economic stability, with rising oil prices, growing tensions with Iran, and almost daily volatile data usually sets hearts racing on Wall Street.

It's not much comfort, but there is one constant for central bankers - the ever-present "i" word or inflation.

BEN BERNANKE: Although core inflation seems likely to moderate gradually over time, the risks to this forecast are to the upside.

In particular, upward pressure on inflation could materialise if final demand were to exceed the underlying productive capacity of the economy for sustained period.

PETER RYAN: Ben Bernanke was addressing a joint economic committee on Capitol Hill.

And he used the opportunity to reign in expectations stemming from last week's decision on interest rates that a rates cut was back on the agenda because of the softer language he was using on inflation.

But Mr Bernanke reinforced today's message on inflation with tougher words such as "risk" and "uncertainty".

And he added another touch of reality, confirming that the US economy, while not heading towards recession, is continuing to lose steam.

BEN BERNANKE: Economic growth in the United States has slowed in recent quarters, reflecting in part, the economy's transition from rapid rate of expansion experienced over the proceeding years to a more sustainable pace of growth.

PETER RYAN: Another factor, according to Ben Bernanke, is the continuing downturn in the US housing market, which has sent shockwaves through the overall economy, from building companies to the makers of building materials.

But at the moment, he says it's steady as she goes for the traditional mortgage market.

BEN BERNANKE: Mortgages to prime borrowers and fixed rate mortgages to all classes of borrowers continues to perform well with low rates of delinquency.

PETER RYAN: But it's the crisis in the sub prime mortgage sector - risky loans to borrowers with little or no credit history - that appears to be keeping Ben Bernanke awake at night.

BEN BERNANKE: To the downside, the correction in the housing market could turn out to be more severe than we currently expect.

Perhaps exacerbated by problems in the sub prime sector. Moreover we could see yet greater spill over from the weakness in housing to employment and consumer spending than has occurred thus far.

PETER RYAN: The mixed messages of a slowing economy, higher inflation, and little chance of a cut in interest rates despite the housing correction encouraged some investors to take their profits and run.

Wall Street closed in a gloomy mood, with the Dow Jones Industrial Average and the tech heavy Nasdaq both down 0.8 of 1 per cent.

And data earlier in the day showing that orders for durable goods rose less than expected last month, only underpinned the pessimism.

KEN MAYLAND: There really is a slow down going on in the industrial side of the economy and this is probably not the end, we're not at the end of it yet.

PETER RYAN: Ken Mayland is an economist and president of Clearview Economics in New York. He's also predicting tough times ahead for the US economy.

KEN MAYLAND: That's a bad signal, that's a sign that more production adjustments are necessary, so I think the next three, four months are going to be pretty tough slugging for the manufacturing side of the economy.

PETER RYAN: But it's the spiralling price of oil that continues to overshadow the global economic picture.

It's now up for the seventh day in a row - well above $US 64 a barrel - and the escalating concerns about Iran, particularly from Britain and the United States, could see the oil price remain volatile in the months to come.

ELEANOR HALL: Business Editor Peter Ryan.

Crash and Bernanke

Financial Times

Published: 20/3/2007 | Last Updated: 20/3/2007 20:45 London Time

"Alan, you're it. Goddammit, it's up to you." On Black Monday 1987, the president of the New York Federal Reserve joined the ranks of those relying on Alan Greenspan during a meltdown. He was not the last. By the time the Fed chairman retired, many believed in the so-called "Greenspan put" – that if markets got really bad the Fed would cut rates and bail investors out.

Today, with nervy markets, is there a Bernanke put? Central banks react to shocks in the real world: the co-ordinated global cut after September 11 is one example. But moral hazard makes underwriting markets a dubious activity. Even so, monetary officials know that unduly tight policy after crashes in the US in the 1930s and Japan in the 1990s may have contributed to economic slumps.

Investors should not be complacent, as the precedents are mixed. The Fed eased after the 7 per cent fall in the stock market on October 13 1989 and cut in 1998 after Russia's default and the Long-Term Capital Management crisis caused bond market jitters. But the liquidity boost in 1987 was aimed at forestalling a payments crisis on Wall Street rather than influencing asset prices. And in 2000, the Fed watched Nasdaq fall by 45 per cent, only signalling an easing in December, when it was more clear that the real economy had slowed.

Now the Fed does not have that much "ammunition". At 2.8 per cent, real rates, defined as the target rate less inflation, are about 50-150 basis points more lax than before the 1989, 1998 and 2000 responses. Whether the Fed now has the inclination to bail out markets is even more debatable. Like Mr Greenspan, Ben Bernanke thinks central banks should not try to burst asset bubbles. Unlike Mr Greenspan, Mr Bernanke also rejected a shoot-from-the-hip approach to market slumps during his academic career. His preferred philosophy of inflation-targeting, with a focus on the degree of spare capacity in the economy, suggests taking action only if market moves clearly signal or threaten a deterioration of the real economy. If the emergency phone from New York rings, Ben may be a little less sympathetic.

Copyright The Financial Times Ltd. All rights reserved.

Parallels with the 1970s are striking; real estate bust and stock market crash

Parallels with the 1970s are striking

The 1970s comparison with today is uncanny. This correspondent was a British schoolboy in the mid-1970s, and recalls a real estate boom that went bust almost bankrupting my father, and a stock market crash that hit the wealth of stockbrokers so much that they were still discussing it eight years later when I applied for a job in the City.

Sunday, March 18 - 2007 at 09:10

Older market watchers sense a return to the 1970s. We have had an oil price boom, excessive money supply growth, a real estate boom all round the world and a strong rally in global stock markets. This is like the early 1970s which then collapsed with first a slump in real estate in 1973 and then a major stock market crash in 1974.

If we look at valuation trends then again the early 1970s offer a clear parallel. The Dow's valuation trends of the past seven years are close to the late 1960s and early 1970s, with stocks delivering less than double-digit growth since 2000.

It is true that in early 2000 at the top of the Great Bull market the Dow 30 was trading at 45 times earnings and yielding only one per cent in dividends, while at its top a few weeks ago it approached 17 times and 2.4 per cent.

No plunge protection

But in early 1973, the US stock markets were also trading at moderate valuations, 19 times and 2.7 per cent. This did not prevent the market falling off the edge of a cliff. Indeed, any technical analyst will concur that stock markets swing from overvaluation to fair value to undervaluation, and do not stop at fair value.

It is surely towards the undervalued position that global stocks are headed next. If this 1970s parallel holds true where will be end up? Will we be wearing those awful flared trousers and kipper ties again?

Anything would be better than the investment returns of the later 1970s which were among the worst on record for post-war investors. Real estate recovered somewhat in nominal terms from the 1973 crash and that was when a lot of Arab investors took advantage of depressed London prices to buy up the central districts. But roaring inflation meant that nominal prices declined in real terms.

Stock market investors who bought after the 1974 crash eventually did well but the UK economy was nearly bankrupt in 1975 when the International Monetary Fund bailed it out. And in the US the economy went through a long and painful period of adjustment with a very low US dollar helping to stave off a real economic collapse.

Terrible decade

For investors who avoided the market crash, and a few jumped ship before the Titanic hit the iceberg, the mid-1970s provided the chance to buy bargains. But for the average investor in real estate or stocks it was a terrible time, and cash deposits actually outperformed the other major asset classes over the decade.

The exception was precious metals. Gold and silver suffered a major setback in 1975-6 but rebounded in the high inflation environment of the late 1970s, and oil prices headed higher again. Gold achieved an eight-fold surge between 1976 and 1980 and silver rocketed higher.

Will investment history repeat itself all over again? If so then avoiding investments now could pay big dividends later. But the late 1970s was a great time for in the Gulf States, and on that reckoning local stocks could be due for a rebound and any softening in local real estate markets should be short lived.