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The unbearable tightness of money

Unemployment on both sides of the Atlantic is shooting towards record levels, stock markets are moribund and company profits are under threat. Sentiment has been wrecked by investors borrowing too much, banks lending too much and governments spending too freely.

I been laid off from work
My rent is due
My kids all need
Brand new shoes

So I went to the bank
To see what they could do
They said son - looks like bad luck
Got-a hold on you.

Money’s too tight to mention.

Recession inspired John and William Valentine to write this song – later covered by Simply Red – thirty years ago. And, as we lurch towards 2012, during a faintly festive season, the lyrics are too close to current sentiment for comfort.

Unemployment on both sides of the Atlantic is shooting towards record levels, stock markets are moribund and company profits are under threat. Sentiment has been wrecked by investors borrowing too much, banks lending too much and governments spending too freely.

Running costs have been cut right back. Orders are still being placed, but they are lumpy. When anyone does place an order, it takes months to be finalised. At which point, vendors will need to negotiate an increase in the price of their services, as a result of rising costs, or take a hit to margins.

In the early 1980s, Federal Reserve chairman Paul Volcker engineered the recession experienced by the Valentine brothers by hiking interest rates to control inflation. But his decision to cut rates, from August 1982, stimulated a recovery which lasted, on and off, for thirty years.

This time round, shell-shocked businesses and financiers are refusing to respond to successive stimulus packages from the Federal Reserve. Cash is piling up on the balance sheets of healthy businesses. Those which are less healthy are caught in a spiral of despair.

Governments spent freely to prevent a depression in 2008 and 2009. But this has wrecked their finances and their scope to repeat the trick is constrained.

Anyone who has the good fortune to come into some money saves it. Reduced investment in the public and private sectors is further reducing the velocity of money. This constrains inflation, but chokes off recovery.

These days, investors are only interested in jam today, rather than forecasts of jam tomorrow.

US bond manager Pimco has championed the idea that the global economy is entering a “new normal” where growth will be both lower, and more uncertain, than over the last thirty years.

This means investors are operating in an environment where the willingness to take risks is sometimes “on” and sometimes “off”. Instead of being able to rely on prices playing off the single distribution curve you get in stable economic conditions, Pimco argues you need to plan for two.

It says that in a standard model, where equity returns are steady, you can hope for a 10% annual return struck on 20% volatility. But after mathematically adjusting the model for a bearish alternative, where stocks fall sharply and get trapped in a lower holding pattern, you might end up with a 4% return based on 26% volatility.

On this kind of outturn, the optimal weight in equities would end up at 10%, against the standard 50% requiring a cut in equity weightings of nearly 80% to achieve a stable return.

This might look a potty to people brought up to believe in an equity culture nurtured since August 1982. But all bets are off, when money is too tight to mention. 

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