The final analysis Developed nations are continuing to live in a credit fantasy.
Enjoy the ride, because the reckoning is coming
Reflation will be the keyword for 2010, and the positive trends that began last year will continue well into this year as more sceptics are convinced to buy into the global economic turnaround after extraordinary amounts of stimulus measures initiated by developed economies. Our bullishness is not based on the long-term sustainability of the cash that has been thrown at the industrialised nations, but rather on the fact that it is likely to appear to work well into 2010, leading investors on the sidelines to believe that the recovery is real. But make no mistake, the current improvement in financial markets, GDP figures and consumer sentiment is no more real than the speculative boom fostered by easy money from 2003 through 2006.
In our view, we have entered the third of three major credit-induced expansions since the mid-1990s. The first one lasted seven years, from 1994 to 2000, and was based on deregulation and the "Greenspan put". The second expansion, from 2003 to 2007, was driven primarily by record low interest rates and an unprecedented consumption binge. We entered the third one during the second half of 2009. This current expansion is not only the work of super-low interest rates, but also quantitative easing and a legion of government bailout programmes.
Thus, the developed world has been dominated by credit bubbles since at least the mid-1990s - if not for several decades - and every problem has been met with lower rates and more debt. We expect this cyclical recovery, with its lack of risk aversion, to continue during the first half of 2010. However, there are some major challenges ahead that we believe could materialise later in the year. One potential trigger for a dampening of the current recovery could be a sharp decline in economic activity in China, after the so-called investment-driven export model runs into a brick wall of fading Western demand and domestic investment opportunities. Further, we believe that the market will begin to feel the effects of the vast number of adjustable-rate and Alt-A mortgages when they reset, combined with more writedowns related to commercial property, both of which will reach their peaks in the third quarter.
Finally, the private sector - both individuals and businesses - is deleveraging for the first time in many decades. This is an important step toward re-establishing long-term sustainability, where demand is compatible with the costs of servicing debt. The problem is that governments continue to spend money to stand in the path of this process. Moreover, the problem with the bubbles since the beginning is that it takes an exponentially growing amount of stimulus to keep the party going.
Labour in most of the developed world is also under severe stress due to arbitrage. The economic crisis serves as an excuse to reduce costs by slashing expensive labour in the West and outsource production to lower-cost countries in Eastern Europe or South East Asia. We expect the private sector deleveraging to continue in the next decade because of higher unemployment, excess capacity in most industries and continued difficult access to credit. This will result in deflationary pressures, especially in the coming three years.
David Karsbol is head of research at Saxo Bank, the Danish online broker