A History Lesson

 

It is over a year since concerns first surfaced regarding the possibility of a major Bank failure.  Prior to this we had witnessed a major credit boom.  A speculative bubble had built up in many assets, including Shares but more particularly in the property market.  In addition, the ease with which credit was available led to increased consumer spending and resulted in a reduction in savings.  Inflation had increased and the currency became overvalued as rates had risen to counter inflationary concerns.

 

However, the boom reversed.  Asset prices started to fall and the economy started to slow.  Unemployment rose rapidly.  A wave of bankruptcies hit the banking sector which was  forced to make massive provisions for losses.

 

As a result, the Government had to intervene.  The whole banking system was in danger of collapse and it was important for the Central Bank to supply liquidity to the markets.  The fear was that if it did not act fast, falling asset prices may create serious problems for private sector balance sheets, which would affect both household and business expenditure.

 

Does this sound familiar?  It is, in fact, a description of the Swedish banking crisis as observed in September 1992 but it could have been our own markets over the last 18 months.

 

What happened?  The Swedish Central Bank provided liquidity to the markets allowing banks to re-build their capital at the cost of a massive increase in the Government's budget deficit.

 

Lower interest rates made it easier for the private sector to service debts and the financial crisis eased.  By the Summer of 1993 the economy had stabilised.  A year later conditions had rebounded, inflation was increasing.  Five of the seven largest Swedish banks had to be helped out at a cost of 12% of Sweden's Gross Domestic Product.  The Government dealt with banks harshly and those who held Shares in the banks most affected lost a lot of their money.

 

However, investors in the main Equity market saw their investments recover.  Having lost 40% of the Market's value between July 1990 and October 1992, the OMX, the Stockholm Stock Exchange bounced back even quicker, doubling in just over a year and rising a staggering 520% over the next seven years.

 

The point of this story is twofold.   Firstly it demonstrates that when things look really bad and have done so for some time, there should be little more to worry about as long as there has been some policy response aimed at solving the problem.  The situation will eventually improve as policy starts to work and the biggest worry should be missing out on the recovery when it does happen.  I am not saying it will be spectacular, like it was in Sweden, but there will be a recovery and as it becomes more obvious, then confidence will return.  The second point is that the World learnt its lesson from the wrong policy response to the economic set back in the 1930s.  Big mistakes were made and as a result we had the Great Depression.  The Swedish Central Bank recognised the mistakes made in the 1930s and successfully revived their economy and averted a financial crisis.  The officials Worldwide are today following a similar response to that made by Sweden.

 

Of course, no two situations are ever identical but the World will carry on.  This is just a temporary, albeit painful, retrenchment as policy is adjusted to re-build personal and corporate balance sheets. Growth will return as inventories are run down and personal savings build up.

 

It is impossible to predict when the Stock Market will turn positive or to guarantee that we will not drop to new lows. However the Market does normally react six to twelve months before the economy so you could see the Market start to rise whilst there is still a lot of bad news about. In the UK there are signs that we may already have seen the worst of Stock Market falls.  Since the New Year there has been a constant stream of bad news; falling growth, bankruptcies and job losses.  However, instead of collapsing on each gloomy news piece, Markets have consolidated and are now waiting for the first signs of improvement.  This is still likely to be bad news but it may not be as gloomy as forecast.  Once this happens, the Markets will start to recover but it is likely to be some time before the economy picks up.  As a result, interest rates are also expected to stay lower for longer which should give households and businesses the time it will take to reduce debts and build up savings.

 

Patience should reward those who stay invested in solid companies with good business models and are well capitalised.  There will, though, be losers and I would be very cautious about investing in businesses with large debts.  Furthermore, buying Bank Shares at the moment is just like gambling.  Despite the big falls in prices there are better bets elsewhere. Over the longer term though we still have a growing population in the world which will continue to aspire to the lifestyle of the western world. The Emerging markets are still growing albeit at a temporary slower pace. Growth and innovation will return as will profits.

 

The views expressed in this blog are David Stephenson’s personal opinion as at January 30th, and do not constitute financial advice.