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Economy and Equities still vulnerable : It's just a matter of credit.

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cash “only money matters” (Milton Friedman?)

Some clients have kindly told me in recent months that I accord too much importance to monetary figures, such as M2, M3, the Commercial Paper market or bank loan volumes, and that while these data were fundamental to understanding the macroeconomic outlook, they could not predict the near-term behaviour of financial asset prices, which fluctuate under the more decisive influence of cash flows and, thus, waves of optimism or pessimism.

Their point is perfectly valid, but I pointed out that if I had found the right mix between macroeconomic analysis and short-term trading strategy, I might today be happily practicing another line of work.

If I insist on closely studying the mechanism of loan circulation in the economy , it is because, to paraphrase Milton Friedman’s often bantered about statement in recent times, “only money matters”.

This quote has indeed been used by certain paranoids, who draw a strange parallel between the doubling of the Fed’s balance sheet and its supposedly logical consequence: (hyper) inflation.

I would just like to point out that Mr Friedman , who was awarded the Nobel Prize in Economics in 1976, claimed in his debate in 1968 with Walter Heller, the leading economic advisor to the Kennedy and, later, Johnson administrations, that it is an “absurd position, of course, and one that I have never held ”!

This same Milton Friedman in 1997 criticised the Bank of Japan’s monetary policies as “inept ”, and stressed that Japan needed to “accelerate its money supply ”.

So why this obsession with credit?


The ease of obtaining credit and its cost are the sine qua non condition for economic growth

Most business projects require borrowing to finance the capital investments needed to produce theirfuture revenue flows .

If credit is unavailable, oligopolistic situations are reinforced, because under such conditions only companies with sufficiently large cash reserves can continue to invest. Such a situation spells the death of innovation and productivity growth.

This hard truth is not limited to manufacturing firms, but to all businesses, be they in services or manufacturing.

A healthy credit system is also needed on the consumption side of the economic equation, because buyers of homes or costly durable goods (cars) also need to spread their cash expenditures over time in line with their anticipated future income.

On the basis of these principles, we took a very pessimistic view on the economic situation during the death of securitisation with the implosion of the Bear Stearns hedge funds, and we believe that today’s stock market rally will be hard to sustain, given the evolution of macroeconomic parameters.

As an illustration, check out the graph, below, tracing the curves in Europe of the Eurostoxx 50, the unemployment rate and the growth of M3, as well as bank loans to households in the eurozone.

In the first place, M3 in the eurozone has not been so weak since the post-reunification period of 1993-94, while the ECB is using all the “unorthodox” methods at its disposal to counter creeping deflation.

Moreover, the volume growth of loans to households has collapsed to 0% from an average of 6% to 8% (+5.2% at the lowest point in 2001).

We see the same phenomenon in loans to non-financial businesses, which fell to 1.5% in July from 15% in 2008 (low point of 2.7% in November 2001, not included in graph for readability reasons).

The eurozone unemployment rate, out this morning, now stands at 9.50%, the highest in a decade …

These elements are obviously correlated, because this decline in loan circulation is not simply the result of banks’ reticence to lend as they struggle to bolster their balance sheets.

It is also a consequence of the now familiar Debt Deflation process.

On the one hand, households with the means to do so are doing everything they can to pay off their existing debt, as they struggle under the weight of, what have become prohibitive real interest rates , instead preferring to place their available cash in money market funds which offer almost no yield.

On the other, lending terms have hardened for the weaker loan applications.

When officials explain that unemployment will continue to rise, households react by putting off purchases. It is hard to justify agreeing to future monthly payments when your income visibility has disappeared.

These same officials like to talk up the positive aspect of lower prices on real household income, but who wants to rush out and borrow under such conditions, particularly, if we believe that prices will decline in the future?

The $1 trillion question is thus: how can we determine if the stock market rally since March 2009 is simply a reaction to the preceding very steep fall in a very short lapse of time, or if it is simply anticipating the success of fiscal and monetary stimulus plans and the rebound of the other curves a few quarters down the line?

Europe: Eurostoxx 50 and fundamentals

Are stock markets anticipating an economic turnaround?ec

  • Access to credit is not improving

We will need to keep a close eye on these different credit indicators, and I must admit that the latest available data does not leave me all that optimistic .

In the US , the Atlanta Federal Reserve has iust confirmed that banks continued to tighten lending terms in the second quarter, citing greater future uncertainty and less risk tolerance, but the Fed also says demand for new loans is down.

In the United Kingdom, the association of business executives, EEF, has just stated that the hardening of lending terms will undermine moves toward economic recovery.

Since we’re on the subject, let’s not forget China, the world’s main credit pump in the first half of the year.

Some tell me that just goes to show that it helps to have “directed” banks, but I would just like to point out that if Fannie Mae and Freddie Mac were not directed by the US Treasury, with their financing ensured by the Fed, it would be hard to imagine what the US home loan market, or the property market in general, would look like today.

In any case, it was confirmed this morning that Chinese banks granted only 300bn yuan in new loans during August, down from 1.53 trillion yuan in June, which goes in the direction we had anticipated.

However, I remain convinced that, should the Shanghai stock index fall too steeply or if the contagion hits the real estate market, the Chinese government will order banks to step on the lending accelerator once again.

That will change nothing in the downward spiral, as laid out in the Minsky ladder , but whether it occurs with a SHCOMP at 5 000 or 3 000, god only knows.

It is important to understand that the Chinese stock market is purely speculative . It is a momentum market, operating on credit.

Who really believes that the country’s individual investors, which make up the bulk of the market, are interested in macroeconomic analyses or company balance sheets?

That is not yet part of the domestic stock market culture, which also needs reliable data.

As an anecdote, I was solicited yesterday evening by the main Chinese equity research site,, which wants to published my reports dealing with China. As such, they put on their first page this morning, “The Chinese Minsky Ladder”. I am a little worried about how they will take …

We continue to believe that the stock market rally, understandable when short-term rates are at 0% (extension of capitalisation multiples), but difficult to reconcile with our macroeconomic scenario for the coming years, is not worth betting on, except for trend-follower investors, to the extent that they arevigilant enough to know when to pull out.

But we advise investors to avoid this bet.

AS for government fixed rate instruments, although we would prefer taking advantage of a slight correction to suggest new downward interest rate strategies, we remain positive on this asset class, which has come out of the last six months fairly unscathed on stock markets.

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