So which is it? Is indiscriminate selling by panic-stricken hedge funds undermining the global economy; or will bold measures by governments around the world heal the wounds?
It’s both. The immediate outlook calls for a period of uneven healing amidst volatility on Wall Street and uncertainty on Main Streets around the world.
Make no mistake; we are in the midst of a vicious global de-leveraging. The phenomenon took a turn for the worse in mid-September following the failure of Lehman Brothers. Lacking credit and having incurred large losses, a growing number of hedge funds are now being forced to liquidate.
The bottom line boils down a simple hypothesis: the healing has started, but it will be gradual and irregular…Get ready for a further weakening of the economy as the damage engulfs both Wall Street and Main Street.
Left to its own devices, the de-leveraging process would continue to feed on itself like a snowball coming down a mountain. The result would be further market devastation, including sharply lower valuations, disorderly trading, and a cascading paralysis of markets.
Contagion would take several forms. A further freezing of financial markets would reduce to a trickle whatever credit is still flowing to consumers and corporations. Savers would experience an even greater sticker shock as their 401K statements detail the extent to which retirement nest eggs have evaporated. And some may even look to sell mutual funds to safeguard whatever is left of their savings, thereby aggravating the de-leveraging dynamics.
The damage would not be limited to the U.S as we are already seeing. Other countries would feel pain as the U.S. is more than just the largest economy in the world. It is the provider of “public goods” used by virtually all countries, such as the deepest and most liquid financial markets and the reserve currency of the international monetary system.
Given these prospects, it should come as no surprise that we have witnessed a massive government response over the last 10 days. Let me share with you a partial perspective on this gained from having spent last weekend in Washington DC for the Annual Meetings of the IMF and World Bank.
This year's meetings brought together officials from over 180 countries. As usual, the gathering provided a great opportunity for consultations. Yet the mood and proceedings were highly unusual, as was the outcome.
From the start, it was abundantly clear to all that a powerful financial crisis initially centered on the US markets had morphed to global proportions. A multi-country response was urgently needed, preferably a coordinated one. But very few countries had arrived in Washington fully prepared for the enormity of this task.
What then transpired will be remembered for years to come.
The G-7, a rapidly outmoding consortium of the seven major industrial countries, scrambled in its Friday meeting to come up with a general action plan. Fortunately, it could draw heavily on the historic bailout announced by the UK earlier in the week. The plan was endorsed on Saturday by the larger gathering of countries under the auspices of the International Monetary and Financial Committee.
This provided the global framework for country officials to consult with their political masters in their home capitals.
The result was a series of policy announcements that were - and you can pick your mix of terms — unprecedented, unthinkable, unimaginable, improbable, extraordinary, remarkable, etc... It started with Australia and European countries—on Sunday a week ago—followed by major and remarkable US statements on Monday with the strongly pro-market Bush administration announcing that the government would intervene in virtually every aspect of the financial system: through injections of capital, massive guarantees of deposits, explicit backing of bank bond issuance, and so on.
The impact on the markets was immediate, but not lasting. Stock around the world soared on Monday but, by Wednesday, had erased much of the gains. This is fueling concerns that governments may have run out of policy ammunition to counter the accelerating de-leveraging dynamics.
It is too early to reach this conclusion. There is usually a lag between policy announcement and implementation. In addition, execution does not lead to immediate effect. It takes time for measures to impact the most vulnerable areas.
All this suggests that markets will remain volatile. Moreover, even with this global policy full-court press, the actions will be too late for some institutions. At a minimum, we should expect a major consolidation among hedge funds.
Finally, let us not forget the real economy. US consumers face massive headwinds on account of employment losses and housing weakness. Large investment losses will also dampen spending enthusiasm, especially on the part of those worried about their retirement.
The bottom line boils down a simple hypothesis: the healing has started, but it will be gradual and irregular. We must thus keep two issues front and center in the days ahead notwithstanding the truly remarkable policy response by the US and other countries. First, it is not yet time for most investors to loosen their seat belts. Keep them tightly buckled, as further market swings are likely. Second, get ready for a further weakening of the economy as the damage engulfs both Wall Street and Main Street.
And to think the situation would have been even worse without the recent policy reactions.