Published October 9, 2008

A long, hard road to recovery

ONCE the dust settles on the present carnage in financial markets, attention will turn to the issue of how long the resultant economic contraction might last and where a bottom might lie for stocks. As always, the key lies with the US and, as is becoming increasingly obvious, whether or not European governments can fashion a cohesive and coordinated rescue package to calm markets that are suffering an unprecedented crisis of confidence.

For the US, analysts who had consistently underestimated the enormity of the risks posed by the sub-prime collapse over the past year - and were until last week still in denial - are only now coming round to the realisation that this is not your normal, run-of-the-mill cyclical downturn that can be expected to pass in a few quarters. The prognosis? At least 18 months but possibly longer.

This was the conclusion of both Morgan Stanley (MS) and Merrill Lynch (ML) earlier this week. In a report titled Stress Fracture in which it examined the IMF's latest World Economic Outlook, MS said that a typical recession that is preceded by a banking crisis can be expected to last 7.6 quarters (about 30 months) and is associated with a cumulative output loss of 19.8 per cent, both figures being much higher than during a normal, non-banking-related recession.

Worse, interest rate cuts - and both the Federal Reserve and the European Central Bank cut by 50 basis points yesterday - may have limited effect: as MS pointed out, monetary policy gets transmitted through banks, and if banks are under stress, the monetary policy response is weakened.

Similarly, ML pointed out that the negative credit dynamics of a recession have yet to start in the US, and that the country's consumer recession is just starting this quarter. Perhaps more worrying is that the American consumer accounts for more than 70 per cent of the country's GDP and 18 per cent of global GDP - bigger than the entire economies of Japan, China, Russia and India combined. If ML is correct, then Wall Street can only be expected to bottom around the end of 2009, based on an analysis of previous recessions that shows the market tends to bottom about four months before the recession ends.

As for Europe, the UK government's move yesterday to partially nationalise the country's banks is a welcome move to try and shore up confidence, but it remains unclear if other countries will follow suit, or even if it has come too late. Despite the news, the UK market fell 5 per cent in the first two hours of trading, with the rest of Europe also suffering losses of 3-5 per cent. Even if Europe's governments can agree on a coordinated response, it is clear that the road to recovery will be a long and hard one.

As it stands now, the best estimates are that it will take 18-30 months and this is probably what the tumbling equity markets are now pricing in.