Painful Deleveraging Will Drag On

12/11/2008 1:00 pm EST


Joe Battipaglia

Market Strategist-Private Client Group, Stifel Nicolaus

Joe Battipaglia, market strategist—private client group of Stifel Nicolaus, says the US economy’s deleveraging will prolong the bear market and delay the recovery.

We believe we are witnessing a rare event in our financial history. Policymakers have little ability to change the behavior of actors in the economy who are attempting to save rather than spend and pare down debts rather than take on more credit. As economic conditions worsen, and as asset values decline, it is even more difficult to reverse these trends, which makes for a vicious cycle. 

The assumption of enormous levels of debt by virtually every sector of the economy has triggered a period of debt liquidation. Once joined by falling collateral values in the form of home prices, both borrowers and lenders pulled back from the issuance of new debt, which caused a historic decline in new credit and money creation as evidenced by net US household borrowing falling from a peak $1.4 trillion annualized level to under $200 billion.

We believe that household credit demand will not recover quickly as it has in past cycles because both borrowers and creditors look to de-lever balance sheets, hoard cash, and lessen risk.  This is due not only to the absolute levels of debt in the system, but also demographic changes as the Baby Boom generation moves closer to retirement.  In this environment, we expect savings rates to rise at the expense of consumption.

Historic measures have been taken to force interbank lending. This has resulted in a doubling of the size of the central bank's balance sheet, from roughly $1 trillion to $2 trillion virtually overnight as the bank became the central repository for troubled assets. [But] while the Federal Reserve would like to see a resumption of a vibrant level of lending, they cannot force it on a public that is not interested. 

To date, the ongoing liquidation of assets to pay off debts appears, in many ways, to reflect a debt-deflation rather than a traditional inventory-driven recession. We have seen all major asset classes, excluding Treasuries, come under pressure, and equities have been notably roiled as evidenced by a historic 68% downward revaluation of the Standard & Poor’s 500 index relative to long-term Treasury bonds. 

While this is a painful process, the resetting of risk [in time] will be seen as an important prerequisite for an eventual recovery in financial markets. In the here and now, however, we remain unconvinced that the environment is supportive of a sustained bull market—especially as the deleveraging process continues.

At present, credit conditions remain poor despite some modest improvement in response to a variety of government-sponsored programs enacted to stimulate lending at the institutional level. 

We await some sign of improvement in financial market conditions before committing risk capital.  Our current portfolio emphasizes high-grade and liquid assets, including government bonds and bills. 

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