The Business Times, Saturday 7th Feb, 2009

MONEY MATTERS

The Paradox of Thrift, and other thoughts

Logjams in the river need to be cleared but, despite the prevailing gloom, there are clear signs that things are improving

By JOSEPH CHONG

CEO, New Independent

MONEY for nothing.
• Almost every country and industry has been affected by the aftermath of the credit and banking crisis emanating from the US. The unnecessary bankruptcy of Lehman Brothers was the tipping point. Unbelievably, a relatively small US$700 billion sub-prime problem was incompetently allowed to morph into a global economic disaster wiping out several trillion dollars of wealth globally and causing unnecessary hardship.

• After much dithering initially, much of which was ideological, policymakers in finance ministries and central banks have finally come out of denial. The world has fallen into what John Maynard Keynes called the 'Paradox of Thrift'. Business and consumers are all cutting back spending at the same time; thus sending economies into a reinforcing contractionary spiral. This is what happened in the Great Depression in the 1930s. The free market has failed and only governments can break this spiral.

• Now, almost every country has introduced fiscal stimulus packages and central banks have dropped rates to zero or close to zero per cent with quantitative easing thrown in. Most of the fiscal and monetary stimuli are being funded by a combination of government bond issuance; and printing of money - money for nothing. Nonetheless, we hear news of job losses in the newspapers every day.

• So, are things worsening? The current situation is analogous to a river that we depend on almost running dry. However, in the distant mountains, the source of our dry river, we see torrential rains falling. In normal circumstances, we could reliably estimate how soon the rains would translate into plentiful water in the river. But these are not normal circumstances, because of logjams in the river.

• The US Federal Reserve has opened the money supply spigot to a maximum after the Lehman debacle. Broad money supply M2 is growing at a frenetic 15 per cent-plus rate - which is equivalent to about US$400 billion (around 3 per cent of GDP) being pumped into the economy. These are the torrential rains in the distant mountains. This is before counting the US$350 billion stimulus from lower oil prices and the US$880 billion fiscal package being debated in Congress.

• In normal circumstances, such a boom in money supply would translate into strong economic growth numbers in 9-12 months. Unfortunately, there is uncertainty this time as one of the main transmission channels, the banking system, has malfunctioned. This is the logjam in the river which is being pried loose. Logjams notwithstanding, there are clear signs that despite the job losses (which are a lagging indicator and poor market indicator), things are improving.

• Credit spreads on corporate bonds have been falling and corporate bond issuance has recovered. From an average of about 8.5 per cent four months ago, yields have fallen to about 5.5 per cent for investment-grade paper. As a result of this, an ETF (exchange-traded fund) which tracks the performance of investment-grade corporate bonds, iShares Invest Grade Corp Bond ETF, is already up 25 per cent in four months!

• Another economic indicator closely watched by investors currently is the ISM Purchasing Managers Indices for the US and Europe, especially the sub-index which measures the level of new orders. Purchasing Managers Indices for both the service and manufacturing sectors in the US and Europe for January have stabilised. Encouragingly, we see improvement in new orders - which signal a stronger first quarter.

• The price of gold has also recovered smartly by about 30 per cent from its October 2008 lows. Gold is signalling future inflation and not deflation.

• How then does one benefit from reflation? Government bonds around the world have rallied as the recession struck, pushing yields down to unsustainably low levels. Shorting government bonds could be profitable over the next few months. For risk-averse investors who need to have government bonds in their portfolios, inflation-protected securities or ETFs which track these make sense. Investing in these has the effect of being quasi-short conventional government bonds.

• Normally, investment-grade corporate bonds would recover first as companies will always pay debt holders before dividends. The big move on this has occurred. Thereafter, equities and hard assets such as precious metals and property (in markets which are not swamped with structural oversupply) are expected to move as the recovery gains traction.

• Gold is especially interesting among precious metals. It is both a store of value, an alternative to paper currency, and an industrial and commercial metal. As an alternative, it is expected to grow in attractiveness as major central banks crank up the printing presses. The eventual recovery in industrial production and economic activity will continue to support its value - as an industrial metal.

• Meanwhile, for businesses and employees, the key is to survive until the distant rains translate into a downstream torrent.

The writer is CEO of financial adviser New Independent. He welcomes feedback at : josephchong@ni.com.sg

This article is for information only. Readers should seek independent advice before making any investment decisions