The credit crunch is something of a myth beyond the narrow financial world where its effects have a real impact. Yet this last week we were able to peek into an ugly parallel world where the debt bubble that inflated in the years up to Summer 2007 splatted the globe; a world without Ben Bernanke.
First, the credit crunch myth. During the last week we rudely interrupted a number of fund managers who, frankly, had other things to worry about than hearing from us. Nonetheless, their responses were eye opening. Remember that if there is a credit crunch it would mean that creditworthy consumers and businesses could not get finance, and that if the “credit crunch” was the bogeyman that is supposed to have been overwhelming the economy in 2008, this inability to get credit would be being felt across the economy. In previous commentaries we highlighted that our external mortgage expert tells us that it is not a problem to get a mortgage for a creditworthy consumer – but what of individual companies?
One fund manager told us, in respect of the hundreds of businesses which they research, “I can’t think of any (investment grade) company that is struggling to get access to funds. Most of them have bank lines in place (but) as most companies have been very responsible in recent years, most of these facilities with banks are undrawn.”
One other manager, who tends to invest in businesses with lesser credit ratings, told us that “there is very little evidence (of a problem) in most sectors. Slightly surprising. So far the turmoil remains quite contained to financial markets…It reflects the fact that performance and risk of (non-financial) companies is quite transparent, (in contrast) banks are black boxes where people have lost confidence in their ability to assess them”.
What also surprised us was that there seems to be a similar tendency in the US. Last week the chief economist of the Credit Union National Association (they are the nearest equivalent in the US to building societies in the UK) said that the impact of Wall Street on Main Street is over-stated, that consumers are much more influenced by petrol and food prices than events in financial markets, and that a creditworthy consumer will not have a problem getting credit or a mortgage (which is important because 43% of the economically active in the US use credit unions).
Nevertheless a major recession on the scale of the six precedents in the UK over the last century would be a great concern. As we have set out in previous commentaries, these major recessions resulted from a large shock which almost overnight changed the behaviour of consumers and businesses. Previously confident consumers that bought items, reasonably freely, suddenly lacked confidence, and cut back their spending. Businesses that were confident about investing in new capital or projects or advertising, cancelled or deferred such spending, and began to make redundancies.
There has undoubtedly been a change in consumer and business behaviour following the inflation shock in the May/June period (though not following the birth of the credit crisis in 2007), and you can clearly see it in retail sales, activity in the housing market, and rising unemployment. But it is nothing like the scale you would expect if a major recession similar to the historic precedents was in the offing. After all, the elements at the heart of the inflation shock (sharply rising oil and food prices) have been self-correcting for some weeks, with oil off around 40% from its peak at one point, and inflation heading to just 1% by the end of 2009.
However, the economic downtrend now underway in the UK, currently destined to be shallow though possibly prolonged, is always at risk of being transformed in to something worse by a new shock. It was the possibility of such a shock that forced the hands of the US authorities last week, and obliged Gordon Brown to become directly involved in the Lloyds TSB takeover of HBoS. To understand what might have happened if they did nothing, it is necessary to reflect on two earlier occasions: a US recession in 1930 morphing into the Great Depression, and, more recently, the Northern Rock debacle.
The pictures of long queues outside Northern Rock branches were disconcerting even for those without NR accounts. When the UK authorities acted to nationalise NR, it was very late in the day, and we were probably within 24 hours of the panic spreading to Bradford & Bingley and Alliance & Leicester, and with such a shock it is easy to envisage how a widespread collapse in consumer confidence would have rapidly unfolded.
Now go back to 1929 (though we stress it is important to understand the differences as well as the similarities, so that the analogy isn’t taken too far). Up to 1929 there was a remarkable boom, widespread speculation, and an over-confidence which created an inherent fragility – this is not what we encountered up to Summer 2007, in fact, as the fund manager pointed out above, most non-financial companies have behaved very responsibly in recent years. From the end of 1929 an economic downturn began which by 1930 was already very serious – we are now also midst an economic downturn, but nothing like the scale of 1929/30. But from 1930 it got much, much, worse, and a nasty recession turned into the Great Depression. It is the trigger for this dramatic change in 1930 that was arguably in the mind of the Federal Reserve when they recommended the remarkable step late last week to, effectively, nationalise the bad debts of the US banks.
The trigger was US banks beginning to fail in November 1930 (we won’t go into why here, but rather concentrate on the consequences). Although only 3% of total deposits were lost, more than 7,000 banks were suspended over the subsequent three years and depositors were unable to access their money for some time. As the door of the local bank was slammed shut, individual depositors couldn’t have been sure they would get any money back. Imagine their shock when the bank door was bolted against them, imagine how their behaviour changed instantly, how they stopped buying all but basic necessities, and the overnight impact this had on businesses, and then unemployment, which rose to nearly 24% at a time when unemployment meant hunger and destitution. In a paper in 1983, reflecting on this period, it was noted that there was a coincidence of bank failures “with adverse developments in the macroeconomy”. It was a bit of an understatement, but, while others tended to over-intellectualise in their analysis, this was an important insight into how shocks immediately change the behaviour of consumers and businesses. The writer of this paper was Ben Shalom Bernanke.
As we have said previously, if you had to choose someone to be in charge of the US Federal Reserve right now it would be Ben Bernanke – thankfully he already is, because a collapse in the US banking system, which was threatened last week, would have had serious global repercussions. His historical insight, shared with key colleagues, and the dynamism and actions of recent weeks, culminating last Friday with the proposed nationalisation of US banks’ bad debts, stand between a one-dimensional economic slowdown in the UK, triggered by an inflation shock (though mis-labelled as “the credit crunch”), and something far more unpleasant.
Oh, and we mustn’t forget that Gordon Brown also did his bit this week when he forced through the Lloyds TSB takeover of HBoS, to prevent them having to be nationalised.
To end on a positive note, it was last Summer, as the credit crisis unfolded, that we said the perpetually gloomy headlines could only be justified on the assumption that the powers-that-be would sit on their hands. We thought that assumption silly, particularly with Bernanke in place, and so it has proved to be. Even so, this is not a time to be complacent, as the dynamism and ingenuity of the US authorities, providing world leadership, will be required for a while yet.
In the next commentary we plan to look in more detail at investment opportunities that have arisen out of last weeks events (historic opportunities are typically born of such periods of despair), and also those sectors and asset classes which should continue to be avoided.