Tony Twine
According to the cautionary tale, Goldilocks may well have been the archetypal consumer who fell foul of a bear trend. In search of that elusive economic entity, a free lunch (or was it breakfast?), she unleashed a sequence of events which left her at the mercy of the bears – quite a depressing state of affairs.
Capital bears, market-makers who behave as if assets prices will drop, are nothing except yesterday’s bulls who buy up assets in the expectation of rising prices in the future. Bullish and bearish sentiment is, therefore, mainly a state of mind.
Bull markets occur when the preponderance of expectations for future asset prices are positive, while in bear markets they are negative. For long periods of time, bullish or bearish views can create extended self- sustaining runs. Something happens to trigger a change in sentiment, reversing the direction of price movements in the markets for capital assets.
Just like the bears’ porridge sampled by Goldilocks, capital markets can be overheated, too cool or just right. Investor sentiment, rather than cool economic judgment, leads to frequent loss of touch with what can really be sustained, resulting in a gap between the bull’s expectations and what can be delivered.
Financial markets are usually structured around interlocking investment arrangements glued together by investor confidence. In the recent East Asian example, the glue let go when foreign investors lost confidence that the ever-increasing flimsiness of the towering house of financial cards could deliver a return on their next investment injection. Investment flows into the Asian tiger nations reversed, exposing the excessive current account deficits that had been hidden by capital inflows.
Like an elevator that had been pulled up by a cable of capital, real economic activity began falling when negative sentiment cut through the cable.
Recession is simply two or more successive quarters of negative growth of real economic output – in the case of the wounded Asian tigers, the sequence of events was triggered by a loss of confidence and a cooling of investor sentiment.
This simultaneously lowered valuations of all classes of assets in the once-proud economies, sending property, equity, bond and currency (that is, exchange rate) prices spiraling down, and the price of credit (the interest rate) zooming up. By the second quarter of 1998, investors had broadly begun pulling funds out of emerging markets, fearing for the sustainability of returns from those countries.
Political instability in Russia, an apparent political appointment to the governership of the South African Reserve Bank, and reduced prospects for South American economic performance destroyed investor confidence, pitching all emerging nations together, irrespective of their underlying strengths and weaknesses.
The thought began to develop that the investor nations themselves may face a threat in that they now could not possibly expect to sustain export earnings if the emerging nations could no longer afford to import the West’s industrial output.
After losing some ground during July and August, the leading bourses in the United States staggered under a huge bout of selling, bringing the loss of market capitalisation to $2-trillion over the two- month period.
Remember how Goldilocks panicked. In investment markets, they say if you are going to panic, you should panic first. This is usually easier said than done, but it does bring up a vital difference between a recession and a depression.
Depression is a term used to describe the lower part of an economic downswing which follows periods of acute crisis and panic. Some of the symptoms are similar to those of a recession, for example low levels of business activity, declining productivity, unusually severe unemployment, stagnating or declining prices with deflation of bank credit, and falling wages. Depressions are triggered by panic, which is not necessary to set off a recession.
Global communication improvements have made it possible for us all to panic in a much more compressed time frame. If you feel like hitting the button to sell, remember that the only substantial asset during a depression is cash, rather than property, equities or bonds.
Wall Street’s 500-point drop on August 31 was not really a panic situation; a real panic could take another 4 000 points off the Dow Jones industrial index, halving its early September levels. In that case, use some of the cash to buy some Prozac – you may need it for the depression.
Tony Twine is a director of the independent consultancy, Econometrix