The story goes that markets are very good at predicting recessions and recoveries. They have predicted seven of the last three recessions… But the point is that markets anticipate and economies react. We are at a phase of the global credit crisis that will appear worse than it is. We have had the news on how bad it is in economies on the front line: those with direct financial exposures to the credit crunch and those heavily dependent on previously overheated property, commodity or capital goods markets. Unemployment has risen swiftly in the US, UK, Spain, Russia and elsewhere. We are also now beginning to see signs of significant economic weakness in those countries on the second front: those dependent on exports of goods and services to those on the front line: China, Brazil and India too. Remember ?decoupling?? Well forget it.
We are in the middle of a cascade of global economic woe. But much of this is already in the price of global financial assets. This is not to say we are on the cusp of a sustainable rally in global equities and credits. There is room for disappointment with regards to how long the recession lasts. The global equity markets will probably enter a period of false dawns that will shake the ?bulls? out, just in time for the sustainable rally to take off later in the year. The god of markets enjoys irony. Consequently, investors should do a ?Winthorpe?. In the classic film ?Trading Places? Dan Akroyd, playing Louis Winthorpe III, tells his accomplice, Billy Ray Valentine, played by Eddie Murphy, that he must ?buy low, sell high?. This is not the time to go falling in love with cheap assets that are showing signs of life. I know unemployment is a lagging indicator, but when the biggest economy is shedding half a million jobs a month, you cannot signal the all clear. Economic risks could yet beget hitherto unforseen political risks.
While global equity rallies will be dragged back by the economic news, we are probably not too far from the bottom either. The less fearful will say that this adds up to selling volatility: not much upside, but not much downside too. Volatility is currently expensive to buy and so this may well be the right trade if, like Louis Winthorpe, you think: ?Fear? That?s the other guy?s problem?.
We are close to the bottom because policy makers are finally fumbling towards a ?bad bank? solution to the crisis. The ?bad bank? is the tried and tested solution to previous crashes. Bad assets are put into a government funded pool without an accounting or funding requirement to sell assets early, removing distress from the markets and giving private investors confidence to return to cleaned up banks. The Resolution Trust Corporation of the US was set up in 1989 to buy the assets of the Savings and Loans industry. A year later the German government established the Treuhand to hold East German assets that were unsellable at the unification exchange rate of 1 deutschemark to 1 ostmark. A decade later Japan had its own Resolution Collection Corporation. With ample time on their side, bad banks often end up selling assets for more than they paid for them, giving something back to the tax payer. Bad banks work.
There are good reasons why the bad bank solution was not tried earlier. In the past it was relatively easy to identify the bad assets that nobody wants. The beauty and horror of securitisation is that the bad stuff is sprinkled across everything. It is no longer easy to separate the good from the bad or merely ugly. Moreover, these toxic sprinkles are not just potentially worth zero, they could be worth a lot less than zero because the income stream represents an insurance premium for a piece of credit insurance that the owner has sold. If there is a default the positive income stream turns into a liability many times larger. Default rates are up sharply. Leaving the banks with the simple stuff would require setting up a bad bank that holds assets previously valued in the trillions. People are getting number fatigue with all these jumbo-sized rescue packages, but to put this into perspective, the RTC in 1989 was considered a big deal but ?only? required a backing of $125bn. However, while $1.25trn would have been considered too large at the beginning of the crisis, it is now seen as a figure we would be happy to settle for if it would draw a line in the sand and restore the credit markets. Amid the crash, bang, whollops of this crisis, quiet moves towards the establishment of a bad bank will sow the seed for a sustainable market recovery later in the year. In the mean time, brush up on your trading skills by watching Winthorpe and Valentine again.
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