Monday, August 04, 2008
Let Business Cycles Cycle
The headline must have sounded like bad English. Business cycles and commodity cycles are there for very good reasons. Cycles are basically expansion and contraction periods. However, the contraction periods are usually much shorter than periods of expansion, or else we would all be in deep trouble if it was 50-50 all the time.
Riding out of troughs is essential for business longevity and income preservation. The last two contraction periods was relatively mild in the US, lasting just 8 months. The first one began in mid 1990 and the second in 2Q 2001. The expansion phases for the last 2 cycles were very much prolonged. From 2Q 1991 till 1Q 2001 was 92 months. From end-2001 till 1Q2008 was about 84 months. These two were among the top business expansion phases in history. It was only surpassed by the prolonged business expansion upcycle from 1961 till 1969. Most of the rest of the expansion periods were less than 50 months.
The best explanation may be central bankers and financial authorities are better at using fiscal and monetary measures to massage the longevity of the expansion phase nowadays. The second explanation could be the growth in globalisation, the breaking down of trade barriers, which creates more trade and demand.
I like to use the last period of contraction to make another point, started by the Internet bubble imploding. We saw companies falling like flies, venture capital firms running around aimlessly. Over-optimistic future valuations and projections being destroyed literally overnight. Despite all that, the contraction period was only 8 months, mainly because companies were allowed to fail, forced to fail, if you cannot survive and did not get new funding you die. It was brutal but cleansing. That's why those internet companies that can survive that period deserve to stand high now.The major point being, there was no Federal bailouts of any kind then. Mainly because none of these are linked to the government.
Cycles need to go through boom and bust periods, and when they bust there must be pain in order for a cleaner and more prolonged upcycle next.
The other example was the massive trough in the Japanese financial markets back in the early 1990s - the whole financial system went into tai-chi, nobody called on the bad loans, so there were not classified as bad loans. Cross holding of shares was critical in order to secure long term business dealings, so nobody sold shares a lot for fearing of upsetting clients (fellow listed firms), business contracted massively. Until they cannot take it anymore, balance sheet was so bad, they had to sell the shares, they had to put most loans as bad loans. Only then can the government face up to the massive need for recapitalisation and closure of many finance companies and banks. It has to be the longest recession ever in any country, from 1990 till even now, though conditions have improved slowly over the last 3 years. Imagine have a 15 year recession. You have to let companies fail, you have to address bad loans, you have to write off, and you have to recapitalise. Japan could have come out a lot faster and be an even bigger force if they did that as they would have recovered from the recession within 2-3 years, not the 15 which they had.
So how is the US dealing with its current "recession"? The rest of the world basically is nowhere near a recession though. Financials in the US have been busy with write downs and recapitalisation - that's good. Bailouts and capital injections into government linked companies are basically OK. However, owing to the size of the bailouts, it weighs heavily on its currency and would also prolong the over-zealous money supply cycle again. The bad thing is that this is basically a credit implosion cycle, due to over-enthusiastic money supply growth policies by the developed world for the past 7 years, and the medicine prescribed by the Treasury and the fed are not addressing the cause but in fact are feeding it (again). Technically speaking we needed to see a lot more contraction in the US economy from this credit implosion. The US Treasury and the Fed are not going to let that happen as the repercussions might be too catastrophic if they did nothing. There is nothing you cannot save if you throw enough money at it.
Hence I believe that the US may be able to avert a recession judging from their government strategy. These are demand stimulation policies. Global governments are still not doing enough to encourage supply stimulation policies. We are all a bit short sighted in addressing immediate painful areas. Supply stimulation policies could include tax breaks to encourage production of alternative fuel sources (nuclear, solar) or incentives to go for deeper wells and more difficult prospecting areas. It could also include policies to jazz up research into better crop and land management, better fertilisers and more land being zoned for agriculture and farming.
This short sightedness may bring the global economy chugging along as demand would have been saved and restimulated. However, we are still faced with the prolonged problem of inflation in prices of goods and services. If the US can avert a recession, it means global demand will be on a firmer footing. Hence demand resuscitated will continue to drive up the commodity and soft commodity upcycle.
When prices continue to rise, it will be the same battle between company profit growth and higher cost of operations. We have seen that to a large extent in late 2006 and much of 2007 where company profits surged, but also cost of logistics, materials, livestock and salaries. We will see good periods for stocks as profits are good, but it will always be countered with higher prices. Hence going forward, we will see shorter boom periods for stocks, followed by big dips. It means everyone will have to live with higher volatility when investing in stocks. Investors will have to move in and out of stocks more often.
p/s photos: Monica Chan Fatt Yung