It’s worse than we thought: Kohler

The S&P500 dropped more than 4% to below 800 this morning, breaking back to where it was three months ago in the depths of the post-Lehman funk, because it has now become clear that that event was worse than anyone thought, even then.

Specifically the evidence is now in, that the near collapse of the global financial system last year caused a sudden global recession.

Growth has turned negative in Germany, Britain and Japan, especially Japan, and has shrunk materially in China. The situation in the US is still unfolding but looks grim: California is virtually bankrupt; the motor industry is at a dead end; there is gloom about the effectiveness of both the fiscal stimulus and the bank bailout measures; and monetary policy is zero-bound – it can do no more, at least on interest rates.

Overnight, the president of the St Louis Federal Reserve Bank, James Bullard, said in a speech that there is now the risk of a “deflationary trap” in the US.

He said: “In some ways, our current environment parallels the Japanese experience after 1990. The Japanese banking system encountered difficulties with ‘troubled assets’ and the intermediation system broke down. Eventually, persistent year-on-year deflation was observed in core measures of inflation, and average economic growth stagnated.

“Ongoing deflation in the United States might be particularly pernicious. Household mortgages are long-term nominal contracts. Sustained deflation increases the real debt burden of leveraged homeowners and can erode their equity. With sustained deflation, the foreclosure experience that we have seen in the sub-prime market could generalise to a wider spectrum of home-ownership. This is a significant downside risk to macro-economic performance.”

This risk is what is weighing on the sharemarket now, as evidence of both the breadth and depth of the recession comes in.

It’s not only the credit crunch following the global bank run that followed the collapse of Lehman Brothers on 15 September (which was quickly followed by the Reserve Primary money market fund “breaking the buck”). It was also, and perhaps mainly, the spike in commodity prices in the middle of last year.

The huge increase in transport fuel, food and metal prices in the first half of 2008 had a devastating impact on business confidence and investment, as well as a slow-burn effect on consumer spending, that was reinforced by the sudden withdrawal of credit in October.

Governments and central banks have acted quickly and decisively, but for many it was beyond them.

The economies of Japan, Latvia, Iceland, Ireland and possibly Spain are in free fall – what might be called a technical depression (10% contraction of GDP). Britain appears headed for that too.

Continental Europe is about to face its own sub-prime crisis because of the massive and imprudent lending by its banks to Eastern Europe, mostly in euros and Swiss francs. The currencies of most of the eastern European countries have collapsed, massively increasing the value of their debt.

Meanwhile the US auto industry is approaching its day of reckoning. General Motors and Chrysler are now due to submit their restructuring plans to the Government.

It is beginning to look like the Government “bailout” of that industry and the alternative – bankruptcy – won’t actually look much different. The industry will be forced to shrink significantly, with massive layoffs and losses for investors. This realisation has been a big part of the gloom on Wall Street over the past few days.

In the circumstances, the optimism evident in yesterday’s Reserve Bank minutes for later in 2009 looks unrealistic.

Deflation in the US, Europe and Japan would leave China with significant over-capacity that it would be struggling to meet with domestic demand. Chinese output would have to shrink and along with it demand for raw materials, at least in the short term.

The twin engines of Australia’s long boom – bulk exports and business investment – will inevitably go into reverse. More likely, the Australian downturn will be just getting underway in the second half of 2009 – not ending.

If you are looking for good news, check out the US money supply and the Federal Reserve’s balance sheet.

According to St Louis Fed president James Buller, the US monetary base has increased from $US871 billion in August to $US1.73 trillion in January 2009, all of it directly from the Fed.

As a result, in the past month credit conditions have eased for the first time in 18 months. David Cho and Richard Berner of Morgan Stanley report that: “A clear majority of firms in every other sector reported that credit availability had either remained the same or become easier over the past three months. In fact, at least half of all companies in the energy, healthcare and telecommunication services spaces indicated that the current credit environment was relatively less restrictive than in recent periods.”

Moreover, the Morgan Stanley Business Expectations index rose 18 points to 36% this month – the highest reading since the summer of 2008. This result was collaborated by the Philadelphia Fed survey, which has showed a similar improvement.

So “quantitative” monetary policy – flooding the US economy with cash – is working.

President Obama’s fiscal package will hopefully give a turbo boost, and by the middle of the year there might be some momentum in the economy once more.

But on this morning’s performance, the sharemarket doesn’t think so.

This article first appeared on Business Spectator