IKGW – revisited
For 15 months, ever since the global financial crisis burst onto the scene the watchword of this column has been ‘It Keeps Getting Worse’ (IKGW). If the feedback I get is anything to go buy, this slogan raised either hackles or smiles of contempt – until people finally adjusted to a reality in which it, the crisis, simply kept getting worse and understood that all the pap pumped out by ‘the great and the good’ after every lurch down, about the worst being behind us, was either denial or drivel.
In the wake of the financial collapse of September-October 2008, which saw the largest and most rapid destruction of wealth in the history of the world, it is legitimate to ask whether IKGW retains its validity, or whether we have finally reached the point where it has, or will soon, stop getting worse. The starting-point for this question is the assumption that the market massacre is in its closing stages and will end in the next few days. Whether the main market indices make new lows, or merely ‘retests’ the lows of mid-October, is of importance to the technicians, but is secondary to the expectation that this leg of the crisis is ending.
In order to ascertain what happens next, it is essential to understand what drove the extraordinary rout of the last 6-8 weeks. The explanation, fortunately, seems fairly clear-cut. Two major negative forces came together and interacted, making each one far worse than it would have been on its own. The first of these is the process of deleveraging, ie the dismantling of the accumulated layers of debt that had financed the financial boom of recent years. This boom, it should be stressed, was not solely or even mainly to do with equities. Rather, it was mainly directed at real-estate, including everything from condos in Miami to shopping malls in Budapest – as well as equities, commodities, art and just about every other form of investing that modern society has been able to invent. Everything was paid for with borrowed money, backed by other assets paid for with borrowed money, supported by collateral that was itself paid for with borrowed money – and so on, in seemingly endless coils of debt-financed debt.
In 2006, the housing bubble in America peaked and the prices of residential real-estate started falling. From that point on, the process of deleveraging has been underway, relentlessly gathering pace as it rolls forward. Once the grand myth on which the housing boom was based – that house prices can only rise – was punctured, confidence crumbled and the huge edifice of mortgage debt began to implode. That dynamic has been repeated across market after market, extending across all sectors of the economy, all regions of the world, every kind of economic system. Of course, not everyone is impacted to the same extent: households, firms and, now, countries, that were not profligate and did not accumulate mountains of debt, are in better shape than those that did – but no-one, anywhere, is immune from direct damage, whilst collateral damage is mounting all the time. (Collateral damage is when hard-working and frugal employees lose their jobs because their employer took huge loans that drive him to bankruptcy – or when a well-managed company is crushed by customers or suppliers that go bust because… etc.)
This essentially financial process has climaxed over the past two months, apparently because the Lehman bankruptcy triggered a frenzied rush to cash – although if Lehman had been saved it would have occurred at some later point. But the intensification of the year-plus-old financial crisis catalysed the second force at work, namely the incipient economic crisis. Economies that had been slowing and gradually sliding into recession were abruptly plunged into a much more rapid and destructive dynamic. Seemingly overnight, demand plunged for a broad range of goods and services: companies that had been easing back on production to prevent inventory build-ups find themselves swamped with stocks, because the fall in demand has overtaken the decline in production.
The business sector’s response to this collapse in demand must be a sharp reduction in supply – triggering layoffs and ensuring that the economic multiplier amplifies the negative effect of one company and one sector’s response up and down the business ‘food chain’ and across sectors and countries. The world economy is now heading into a synchronized slump that is set to be the most severe in decades. If the leaders of the major economies make serious policy mistakes in their upcoming pow-wows, comparisons with the 1930s will be valid. But even in the best case, in which the markets now begin to convalesce and the focus of the crisis moves from the financial to the real economy, the overall outlook is decidedly IKGW.