Another day of big sell-offs. The Chinese stock exchange is now technically in bear market territory, meaning stocks are more than 20 per cent down from a recent peak. The infamous contrarian investor Marc Faber has forecast that the S&P 500 could fall between 20 and 30 per cent. Bond prices are crashing, meaning that the cost of repaying debt, including government debt) is set to rise. All in all then, it’s a pretty unhappy set of circumstances, but I just don’t buy it. This time and for some countries, I see reason for optimism.
The Dow peaked in 2007, hitting a record high which was not surpassed until last month. Even the FTSE 100 went within a whisker of passing its all-time high during that period. Yet it was all nonsense. The economy hit the buffers soon afterwards, markets crashed. In 2007, the markets got it very wrong. I am getting déjà vu, but this time for very different reasons.
One of the reasons put forward by economists in 2007 and early 2008 to show why they thought recession was unlikely boiled down to maths. They constructed their models of the economy, which were based on certain assumptions. And one of those assumptions related to savings rates. I can remember Martin Wolf saying he did not agree that recession was imminent because savings would have to rise for this to happen.
But savings rates both in the US and the UK did rise. And they rose for a very predictable reason. Households had run up too much debt. The optimists dismissed this argument. They argued that it was impossible for consumers to be in too much debt, because that would mean they were irrational. But economists underestimate the role of groupthink. The penny has dropped that group compliance can permeate markets. But it can also permeate society and I am not sure that is generally appreciated – even now. People ran up enormous debts, but argued it was sustainable because they knew other people with even more debt.
There was also a kind of moral hazard problem. Just as banks knew that if the worst came to the worst, they would be bailed out, I think a similar attitude was dominant amongst households. The government, they reasoned, would not allow house prices to crash. And in a way they were right. Interest rates fell to record lows, then they fell some more.
Despite this, debt was reduced. Between 2007 and the end of 2012, US household gross debt to gross disposable income fell from 131 to 108 per cent. This was a massive fall. You don’t need to look any further to see why the US fell into recession. It was a similar story in the UK, with the equivalent ratios falling from 174 to 146 per cent.
But just as the markets underestimated the significance of debt levels in 2007, I think they are doing so again.
This time, the US household is well poised to start spending again. The Fed is talking about increasing interest rates by 2015. By then, and judging by the rate at which US households are cutting debt, US household gross debt to gross disposable income will be back to the level it was at in the year 2000.
That, in part, is why I think the US is on the mend. That and evidence that manufacturing jobs are returning to the US, and beyond that the revolution in 3D printing, See: 3D printing and why the US economy really could be on the come-back trail
Don’t get me wrong. There are reasons for pessimism too, and tomorrow I will take a look at why there is some justification for current market fears, and draw my conclusions.
These views and comments are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees