The bearishness is now universal. Analysts and policy makers are competing with each other to be more bearish than the other. With reason?scary stories are being replaced with scary numbers, such as a rise in joblessness in the US by half a million in November alone and a record drop in German industrial production. One measure of how extraordinary this crisis is that, who would have imagined in 2006 that in two years the British banking system would end up being more state owned than the Indian banking system? But what can we really forecast and is the bearishness overdone?
Whether it will be as deep and prolonged a crisis, I do not know, but this crisis will cast the same length of shadow over economic and financial landscape of the next 20 years as the Great Crash of 1929 did. The structure of public and private activity in 2018 will still be defined by this crisis. Expect three things for the next decade or so: governments in the industrialised world will be substantially indebted and significantly entangled in the economy. Under the weight of government deficits and debt, economic growth in the industrialised countries will disappoint and central bankers will keep interest rates down in an attempt to support it, potentially building up a future inflation headache. Banking will be repressed, whether by self-restraint or, more likely, an over-reaction by regulators.
Governments will direct credit to politically approved sectors and other sectors will be starved of capital. This will sound very familiar to those who live in India, but the average Brit and American has probably forgotten that this resembles their 1960s. Perhaps because it was also a time of social liberalism and experimentation, many have a warm fuzzy notion of the 1960s. It is important to remember that while they were not too bad in terms of domestic growth, employment, inflation and music, the 1960s were not great for global trade and they form a lost decade for equity markets. Worse still, they were followed by the 1970s.
Of course, once the market panic is behind us?perhaps because the banking system is nationalised? and we are mainly facing an economic recession, there will be winners as well as losers. We have discussed this before. The ?markets? have crushed the banking system and next they will crush the quasi-banking sector?those retailers, pharmaceuticals, car companies, airlines and other companies that were effectively behaving like banks ?borrowing short-term from the wholesale money markets to invest in illiquid assets whose prices have now collapsed. Of course within those sectors and elsewhere, the assets to buy are those that look least like a bank. Companies that are sitting on huge war chests of cash are looking to invest it: big pharma, big technology and defensive retailers. Cash is king. Dividends are back. You know that already.
But what could all this pessimism be missing? Oil. While all eyes have been on the equity markets, the Mumbai-tragedy, President-elect Obama?s new team, the oil price has slumped from around $145 per barrel to $40. I reckon it could overshoot to $25. The oil market follows what economists call ?the hog cycle? and it has a habit of overshooting in one direction or the other. High prices in 2006-07, led to the exploration and development of new oil supplies that will come on to the market in 2009-10. This will hit an oil market where falling economic activity is already creating a glut, pushing oil prices towards $25 or lower.
Ultimately low prices this year and next will postpone needed infrastructure investment and a shortage of supply will re-emerge in 2011-2012, but let?s take one step at a time.
The scale of the decline in oil prices to $25 from $145 is not inconsequential. It is comparing apples with oranges but to make context of the numbers, the gains to consumer welfare of a drop in oil prices of over $100 per barrel would more than match the $7trn of bank rescue packages we have seen recently. It would certainly provide a fillip to those energy-intensive sectors like tourism/airlines/supermarkets. Indeed, it may have such an effect as to burst the bubble building up in ?alternative energy technologies?. Beware. I am convinced that these technologies represent the future?especially solar, wind, ethanol-from-sugar and bio-fuels from waste?but today these technologies often rely on oil being over $75 per barrel to be economic and governments are not going to have much spare cash around to subsidise technologies that are generating energy at three times the equivalent price of oil.
The bottom line is the bulk of equity price declines are behind us, but the equity market is unlikely to recover quickly as a whole. Returns will come from stock picking not market timing or asset allocation decisions. But be aware that while in the past markets were overly optimistic, ignoring any bad news, we are currently in a position where markets are pessimistic and they appear to be ignoring an important bit of good news from the oil markets. So study your stocks now and creep back in, very, very slowly. Add to positions, no faster than 5% per week. The best traders are good averagers.
?The author is chairman of London-based Intelligence Capital, governor of the London School of Economics and emeritus professor of Gresham College in the UK