Risk Management: Making Sense of the Surging Markets

In the book The Great Depression: A Diary, the late American lawyer Benjamin Roth recorded his observations during the 1930s, when the U.S. and much of the world were in the grip of a paralysing economic downturn. One of the most striking passages concerned the period between 1935 and 1937, when businesses turned profitable and the U.S. stock market came back to life.

“It seems to me,” Roth wrote in 1937, “that the time has come where we can formally and officially announce that the depression of 1929 has ended.” He was wrong. In September that year, the stock market crashed and the U.S. returned to recession.
David Cohen, director of Asian economic forecasting for Action Economics, hopes history will not repeat itself, but he fears that a double-dip recession is still possible. The lesson of the 1930s is that the early withdrawal of fiscal stimulus can lead to another downturn. “Also the Federal Reserve [at the time] was not sufficiently expansionary in its policies,” he adds.
Cohen spoke to CFO Innovation’s Cesar Bacani about the risks the world still faces, the expected quantitative easing by the U.S. Federal Reserve, the G-20 summit in Seoul in November and other events that may tip the global economy back into a downturn. 
What do you make of the recent bullish tone of global stock markets? Does this indicate that the prospect of a double-dip recession has receded?
This mood can swing from week to week. The stock markets globally had foundered back in mid-August amid the talk of double dip and disappointing data from the United States. But then we saw the global equity markets rebound quite nicely in September, and it seems suddenly people weren’t so concerned about the possibility of a double dip.
In reality the data hasn’t really changed all that much. There’s been deceleration in the pace of global recovery since the middle of the year. This has not been entirely unexpected. Some of the strong bounce we did see in the four quarters through the middle of this year, from the lowest point of the first half of 2009, has been exaggerated by inventory correction.
Remember, the downturn during the height of the crisis in global manufacturing had been [marked] by inventory reductions around the world. Amidst the panic, businesses sharply cut their inventories, so production actually fell even more sharply than the fall in final demand. We enjoyed the flip side of that over the four quarters through the middle of this year, where production rebounded more strongly than the turnaround in final demand around the world because of the boost from the inventory side.
That whole part of the recovery is behind us now. That’s one reason why the growth has decelerated.
And yet the Dow recently passed 11,000 points and the Hong Kong, Shanghai and Shenzhen indexes are remarkably buoyant.
There’s a sense that, although [we face] lingering drags in the United States and Europe from the legacy of the financial crisis, there are factors that tend to re-stream the pace of recovery, and we’re seeing that apparently in the United States. The growth is fairly sluggish, leaving a disappointingly high rate of unemployment, but the consensus is still that growth would continue positive in the United States.  
There had been all that nervousness that maybe the restraint measures [on credit growth] by Beijing were dampening economic growth in China, but the most recent purchasing managers indexes, in fact the PMI in the last two months, have shown an encouraging pick-up. That helped contribute to the pick-up in global equities.

Some of the equity bounces have also been supported by the expectations that the Federal Reserve would implement quantitative easing at their next meeting [in November]. But that’s really a big unknown. No one knows how effectively that will boost growth in the United States. As I said, the data, overall, have not changed all that much, so maybe we’ll be due for another correction.

And there’s still risk out there. You could argue that measures by the Federal Reserve are, in part, looking back to the experience in the 1930s. There is criticism of the pattern of government policy in the 1930s, that perhaps the government had removed some of the fiscal stimulus and started moving back to balance the budget [too early] and then also the Federal Reserve [at the time] was not sufficiently expansionary in its policies. So I think [today’s Fed] is trying to avoid that mistake.
Another concern has been about the stimulus from the fiscal expansion that many governments around the world had implemented two years ago to combat the global recession. [Governments are] now facing fiscal constraints. There’s going to be a lessening in the fiscal stimulus to the world economy.
Now that the replenishment of inventories, which I take it helped fuel the recovery in exports from China, Malaysia, Philippines and other parts of Asia, is over, what’s the driver that will help the world economy continue to recover, albeit slowly?
It is going to be more dependent on final demand now.
As well as government stimulus?
There’s not much room for that. Most of the governments are facing fiscal constraints now. But at least the central banks are going to try to continue to provide more stimulus right now [including quantitative easing in the U.S.].
How exactly will quantitative easing help the U.S. economy?
They [Federal Reserve] are going to buy different types of assets, mostly government bonds and maybe some mortgage-backed securities. By buying a large amount of long-term bonds, that should push down long-term interest rates a little bit.
But interest rates are already low.
That’s why some people say it’s not going to do anything. There’s definitely a split of opinion. Some say inflation is low right now, so what’s the harm? Other people say it can lead to an explosion in inflation.
What you need is really consumption, isn’t it? Sure, interest rates are low and may go lower with quantitative easing. But what’s the use of having cheap money if companies aren’t going to invest and create jobs and so encourage household consumption? 
Exactly. There’s a lot of uncertainty whether [quantitative easing] is going to have any effect at all.
The hope is that the United States can remain on the gradual recovery track. It will be frustratingly slow because of the high unemployment rate that continues in the wake of the recession. As long as they can escape a serious double dip in the United States, there should be enough consumption demand and investment spending in Asia and elsewhere [to keep world recovery on track].
The idea is that China and the rest of Asia can help sustain the growth in final demand around the world, even if the U.S. is still weak. But nobody pretends that if the U.S. were to suffer a serious relapse, everybody would feel it.


So what may cause a serious relapse in the United States?
It would take a financial shock of some sort. Remember, in the first half of the year one factor that weighed on sentiments in financial markets around the world was a concern about a fiscal crisis in Europe, in particular, the exposure of the European banking system to the sovereign debt of Greece, Spain, Ireland and Portugal. There was a risk that that could cause another banking crisis, Lehman revisited.
What about U.S. politics? If the Republicans win in the mid-term elections in November, will that cause a serious relapse?
I think it would just be a stalemate in policy. Not much is going to get done over there. That’s why the Federal Reserve is the only policy maker that has any room to do anything in the United States.
There’s a lot of uncertainty, for sure. No one knows what this quantitative easing is going to do. But the mainstream outlook is for continued slow growth in the United States. It would be vulnerable to some new shock of some kind, that’s always possible. But typically, once a recovery process is under way, there is enough self-sustaining momentum to it that it would require a shock to derail the recovery.
It’s been two years since Lehman Brothers. Isn’t the global financial system stronger now, balance sheets cleaned up, bailouts done and so on, and able to absorb a Lehman-like shock?
It has been strengthened. We did avoid a meltdown. But if Greece or Portugal were to default on their debt, then that could cause a whole new crisis. It’s not just the Greek and Portuguese banks; the French and German banks are also exposed to these debt. The only reason that the euro zone came up with their coordinated support for the package for Greece was because of the exposure of the German and French banks to the Greek debt. The German taxpayers weren’t about to support the Greek government, except they were afraid that their own banks were going to get picked by a default.
The European banks are important in the world. If the European banks were hit hard by some problem with some default by a sovereign, that could cause another repeat of the whole disruption of the credit channels around the world. Remember, after Lehman Brothers, the normal credit channels around the world [froze up]. That could happen again.
Basically the European banks would not be able to get funding overnight and they have a lot of short-term debt they have to roll over every day. That’s what happened after Lehman. Central banks in the US and Europe took aggressive action to provide credit to their big banks so they could do their necessary daily funding or else there could have been a collapse in the whole banking system.
So we could end up back in square one.
It’s possible, but I think the most likely scenario is that the Greeks will muddle through. They did take some austerity measures. But there’s still a lot of uncertainty out there. When things improve it feeds on itself; it’s sort of a virtuous circle. Companies hire more people, consumers have more money to spend and government finances get better. But if [the recovery] weakens, it all goes in the reverse direction. Government finances get even worse again.
What’s the role of China, India and the rest of Asia to ensure it’s the virtuous circle that comes to pass? The Chinese keep saying they want to re-balance the economy towards domestic consumption and not just exports. Is Chinese consumption in fact rising?
It’s growing. The whole economy is expanding at 10% this year on a combination of things. Retail sales in China have been very strong. The criticism is that consumer spending is still not big enough portion of the economy. But it’s definitely growing.
But there’s the issue of asset bubbles in China. A big part of domestic consumption would be related to property buying as people furnish and decorate their homes and so on.
Like other policy makers, the Chinese have to balance the different risks facing their economy, but they seem more or less comfortable as they see growth is continuing. As long as we don’t get another collapse in export demand, the Chinese should enjoy continued strong growth even if they try to take some steps to avoid a property bubble.
And India is in the same boat perhaps, retail there can help?
I think India is also showing momentum in domestic demand. They’re probably a little less dependent on exports than China. But like China they are enjoying momentum in their domestic demand growth.
In terms of the economic growth prospects in India, China, Asia in general, do you see that continuing on the condition that the caveats we mentioned...
That’s the hope, that the Asian economies can help support the continued recovery in the global economy. Nobody talks about decoupling anymore. It’s “two-tier growth” – the Asians as well as the emerging economies in Latin America are growing faster than the weakness in the U.S. and Europe and [the stasis] in Japan.

I think that it’s the likely scenario, that over the next couple of years the drag from the legacy of the financial crisis will limit growth in the United States and Europe. But they’ll avoid a serious double dip, so in that environment, the Asian economies will continue to show respectable growth, though maybe not as strongly as we saw this year, because it was inflated by the whole inventory cycle.

In addition to a financial shock of some kind, is protectionism another risk that can tip the world back into recession?
That’s another risk. When [economists] talk about the 1930s, they always say one of the factors that aggravated the Great Depression was countries resorting to protectionism. There’s always the fear that if that happens again, it could disrupt world trade and cause a double dip, perhaps.  But it seems a lot of the noise we’re hearing from governments right now is just bargaining and brinksmanship.
One difference between now and the 1930s is that today we have the World Trade Organisation, the G20 and all these global structures in place.
Supposedly that was one of the lessons the world learned from the 1930s, that there’s a better way to do things. That was one of the reasons why the WTO was established. We’ll see.
What about currencies? Can the spat between China and the U.S. over the renminbi result in some sort of financial shock?
It’s not just the Chinese currency; most regional Asian currencies are seeing upward pressure right now. There’s concern out there that they’re getting pressure from the U.S. and the Europeans to allow their currencies to appreciate more. The point is, no one wants to act alone to see their currency get that much stronger against everybody else. Nobody wants to lose [export] competitiveness.
When individual countries make suggestions to the others, everybody’s always suspicious of what the motivation is. The IMF [International Monetary Fund] is supposed to be an objective third party that can come up with a credible suggestion. What the IMF is saying is that all the Asian economies [should] appreciate together against the dollar. But so far it doesn’t seem to be working.
That’s going to be a lively discussion as we move to the G-20 meeting in Seoul next month. We’re going to hear an awful lot about [currencies] during the build-up to that meeting, because the FX market has been very volatile, and we also have U.S. Federal Reserve meeting on November 2 – we’re not going to see the quantitative easing until then. Exactly what they’re going to propose and [what the impact on the] currency markets are going to be remain pretty volatile for the next month and there’s going to be a lot of headlines.
If the G-20 officials can at least tone it down [the rhetoric] a little bit in that [Seoul] meeting and you don’t hear them talking about a currency war, then businesses can take that as an encouraging sign that it’s not going to break down to protectionism, which would be one of the possible events that could derail the recovery.

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