European Recovery?

There were some conflicting reports today. On the one hand CPI Inflation in Britain unexpectedly rose to 3.2%. RPI, which had been predicted to become negative fell to zero.

See: RPI

In itself this isn’t bad news. Falling prices mean workers wages go further. But, persistent falling prices are usually a sign of excess capacity in the economy, and tend to create a vicious circle. Consumers hold off buying in the expectation of continuing falls in prices, which causes prices to fall further, output is reduced cutting back income and potential demand and so on. But, the surprise increase shows that the huge amounts of liquidity being pumped into the economy to offset that and to deal with the Credit Crunch is already feeding through into higher prices. That could limit the potential for further such action for fear of creating a hyper inflation, but not doing so could lead to stagflation

See: Bloomberg UK Inflation

On the other hand data out of Europe gave some indication that those Green Shoots in the financial sector I have referred to previously – the significant falls in interbank lending rates, and some indication that liquidity was beginning to circulate again – might be just starting to trickle into the real economy. The composite European Purchasing Managers Index showed a stronger reading on pretty much every count, following stronger readings from both Germany and France the leading economies in the Eurozone. The Purchasing Managers Index is a better guide than GDP for how the economy is moving, because GDP figures are backward looking – they tell you what has happened not what is happening. The PMI data is made up of the actual decisions and intentions of the people in the companies who actually do the buying of inputs.

Its not a good idea to take one month’s figures as a basis for argument, and these are only the flash readings, and subject to revision, but it would not be surprising if the huge amounts of monetary and fiscal stimulus pumped into the economy of the world in recent months was already beginning to find its way into increased demand. After all, Germany which is one of the countries dragging the European figures up, is still the world’s largest exporter, and a large part of its exports goes to China which is still growing at between 6-8% per annum. And the fact that the Baltic Dr Index, which is a measure of the prices exporters pay for shipping their goods around the world, turned up last month, suggesting that the large contraction in world trade that presaged the slowdown in growth, might already be easing. Even so, the figures are still nothing to write home about. The highest PMI reading was still only 37 (compared though with a forecast of 33) whereas it requires a figure over 50 to indicate growth as opposed to things slowing not so fast. But, if the problems of the Credit Markets are resolved then the release of what could be large amounts of credit to finance pent up demand could see a rapid recovery in economic activity by the second half of the year, probably still not enough to give a positive reading for the year as a whole, but certainly not the catastrophic scenarios of a 1930’s Depression some have forecast, and a base for strong growth in 2010.

An indication of that was the response of the US Stock Markets on Monday to the Geithner Plan to deal with Banks Toxic Assets. He intends to spend $1 trillion buying up those assets, but that understates the degree of intervention.

Last Summer when I forecast that this financial crisis was about to break – See: Severe Financial Warning , I wrote,
“The fact is that the current package - unprecedented as it is - is unlikely to resolve the problem. The fact is that all the State has agreed to do is to take mortgage debt off the books of these institutions - including in its commoditised form as CD's and other derivatives. But, morgtage debt comprsis only one part of the problem. Many of the people who have prime mortgages also have huge amnounts of other debt; credit card debt, overdrafts, debt to sub-prime lenders and loan sharks. Just look in Britain. Even now you see on TV and hear on radion adverts from these sub-prime lenders offering to clear your debts, by some new debt-busting - in reality debt increasing - loan, fronted by people like Carol Vorderman. You see the prudnetial and other companies encouraging older people to give up the security they have in their home, and to take out some equity-release scam. All of this debt is provided on the back of money-market funds, funds now charging igh rates of interest, and to the very people who are unlikely to be able to pay it back. When this avalanche of debt begins to slide the present Credit Crunch will look like a temporary glitch.

Its likely that in order to deal with this problem the Capitalist State in the West will have to reort to methods of the past. For one thing a huge rise in inflation. But, already some signs of the future course of events can be seen. As I suggested some time ago there would be winners as well as losers. The winners would be those, such as the Sovereign Wealth Funds, which had huge amounts of Capital to invest, whereas the losers would be those that had built up a massive amount of leveraged debt. We have seen Barclays snap up Lehman Brothers, or at least the most profitable bits, Bank of America has taken over Merrill-Lynch, HBOS has been snapped up by Lloyds, whilst Middle eastern and Chinese SWF's have taken large stakes in US banks when their share prices were decimated. Only the latest package prevented Goldman-Sach, Washingtomn Mutual and other huge US institutions being swallowed up.”

See: Socialism For The Rich

That process did begin to unfold with the collapse of Lehman Brothers, as the issue of Third Party risk came front and centre. Such a cascade effect would have meant financial institutions foreclosing on loans good or bad, to shore up their cash positions, demanding payment on credit cards and other loans in a way that has not happened even with the Credit Crunch, and was avoided, precisely because the State was forced to intervene on the scale I suggested would be necessary to prevent that contagion.

But, we can now see in the Geithner Plan the second part of that beginning to come together too. Geithner has proposed that the State should buy up $1 trillion of this mortgage debt, but that $1 trillion is to match an equivalent amount of investment by private investors, but more than that. In addition to that $1 trillion Geithner proposes to provide a 6 to 1 leverage for those private investors in their investment. In other words for every dollar they invest they will get 6 dollar’s credit. In addition to that, the State will provide insurance against any losses that these private investors incur on the investments they make. Under such conditions its highly likely that there will be no shortage of those financial institutions referred to in my quote above, who are still sitting on huge cash piles of Surplus Value, who will take advantage of what amounts almost to free money. Already, the world’s largest Bond Fund – PIMCO, run by former poker player Bill Gross – has said it will take part. The plan has the advantage for the State that by involving these private investors in essentially an auction for the debt, prices will be created for what until now have been unpriceable assets – indeed that’s been part of the problem, they couldn’t be priced so no one was prepared to assign them any value, and as Financial Institutions have to value such assets in their books on the basis of “Mark to market” that is what they could get for them if they sold them today, these assets had to be shown as effectively having no Value!

But, as Mark Tinker of AXA Framlington said on CNBC today that is ridiculous. The Mortgage Backed Securities that included many sub-prime loans obviously had less value than the market was assigning to them as the Credit Crunch began, and the subsequent events with people walking away from their houses in the US, means they are even less valuable today than they were then. But, those houses DO have some value even in a forced sale. More importantly, those MBS’s also contained a large proportion of non-sub-prime mortgages – in fact the original idea of them first suggested back in the 1960’s by Michael Milkin, was to spread risk by such a means – and because since the Savings and Loans crisis of the early 1990’s – many people in the US took out fixed rate mortgages over a 27 year period, the costs of those mortgages for the vast majority of people have not gone up, and so unless there were some really catastrophic rise in unemployment which prevented them from repaying, all of those mortgages are sound, and the returns that were envisaged for them will be realised, by those who pick them up now on the cheap!!!

In fact, the resolution to the problem I suggested last year now seems to be playing out. I wrote,

“In order to avoid this problem, the better solution for Capital is to mobilise the trillions of dollars sitting in SWF’s around the globe, built up in economies with high savings rates, and which have prospered from a growing world economy as they have exported more than they have imported.”

That is what the Geithner plan effectively intends to do. It is bribing private Capital to take the risk in taking these assets off the banks books by effectively removing the risk for them of doing so. China has already lifted some of the restrictions on its domestic companies in relation to investing overseas, and trillions of dollars could on this basis be mobilised to pick up these “toxic” assets, which may appear far less toxic in a few years time, and will thereby cleanse the Banks Balance Sheets, thereby freeing up the monetary and credit system again. In fact, some signs of that may be showing through. A few weeks ago I wrote,

“The basis is being laid for an end to the crunch, and Bank shares will soar when it does. Its no wonder that some of the sharp players in the market want to short the stocks now to get out the small investors. That way they will make a killing by buying at the current ridiculously low, prices and selling when they have made a killing. They will not be looking at the kind of return that a small saver makes on their meagre savings. If RBS, which only a few weeks ago was trading at 65p, rises from its current 10p to £1 - which would still be only a sixth of its level a year ago - they will make 1,000%. And because of the interlinking nature of the financial system this increase in the price of Bank Shares will strengthen their own Balance Sheets, further loosening the crunch, and once again facilitating an increase in their lending activities.”
That might have seemed far fetched at the time, but within a couple of weeks of that statement RBS shares had already doubled, and today stand at 27p, or already a 270% return from that 10p price. In fact, taking up Mark Tinker’s point today, the reason is clear, as I said back in January.

“Yet, the reality is that there are signs that the Credit Crunch is easing. Despite the huge losses, and decimation of Bank Balance Sheets, banks remain probably the most cash generative businesses on the planet. Even allowing for bad debts on loans and mortgages that should never have been made - bad debts which are bound to rise as the recession reduces the ability of some individuals and companies to pay back those loans - the vast majority of people with mortgages, along with the vast majority of companies WILL pay back both the interest and the Capital sum they have borrowed. Day in day out those huge sums will continue to flow into the Banks coffers, and with the cost of borrowing for the banks reduced almost to zero, whilst the interest payments on loans remains at 5, 6 or more per cent - considerably more for all those people who have outstanding amounts on Credit Cards - those repayments will become increasingly profitable for the Banks.”

In fact, Deutsche Bank has already said, today that it expects to make a profit this year. The issue is still likely to be for workers not the potential for deflation, but trying to defend their living standards in the face of the inevitable high inflation that is bound to result from the massive amounts of liquidity pumped into the global economy, once that liquidity begins to circulate with an increasing demand for goods and services as confidence returns.

The Santelli Rant.