Brother, can you spare a dime?

SERIOUS MONEY:Corporate profits are set to slump in the year ahead and a global recession is now a distinct reality, writes Charlie Fell

A TSUNAMI struck the world's financial markets last autumn but investors mistakenly believed that it was one giant wave, when in fact it was a series of waves with each impacting with greater intensity.

September lived up to its record as the year's most difficult month with crisis after crisis culminating in the rejection of the US Treasury's $700 billion bailout plan in its final days. Stock prices predictably dropped sharply but, more disturbingly, the financial system or the lubricant that greases the wheels of the real economy ceased to function. Talk of a severe recession accompanied by double-digit rates of unemployment no longer seems ludicrous. Brother, can you spare a dime?

The flight to quality and a surge in the demand for liquidity was more than evident in the money markets as the overnight rate at which banks borrow reserves from each other soared to almost 7 per cent or five percentage points above the target rate, while the spread between three-month US dollar Libor and overnight index swaps, a measure of interbank funding pressures, jumped to a record high of almost 250 basis points. Meanwhile, the spread between three-month Libor and Treasury bills of equivalent maturity leapt to an all-time high of more than 350 basis points as the yield on short Treasuries dropped to their lowest levels since the Great Depression. Needless to say the world's financial markets are in full-fledged panic.

An amended bailout bill has been passed by the Senate and may well succeed in Congress, but the plan, though it addresses liquidity issues through the removal of toxic mortgage assets from banks' balance sheets, does nothing to alleviate the shortage of capital and is, therefore, not sufficient to bring the crisis to an end. The list of problem institutions continues to grow and roughly 800 to 1,000 banks could disappear in the next two years. Thus, lending conditions are likely to remain tight for some time.

Furthermore, the damage to the economy has already been done and recent consumer spending and manufacturing data have disappointed. Almost $3 trillion has been erased from household balance sheets since last summer - an amount equivalent to more than 20 per cent of GDP, and combined with rising unemployment the outlook for consumer spending is grim.

Meanwhile, the non-financial corporate sector's fundamentals are rapidly deteriorating. The debt-to-equity ratio at market prices is higher than in 2002 and the proportion of short-term debt in capital structures has also reached the levels of six years ago. This is worrying, given that the bulk of an earnings recession lies in front of the corporate sector and not behind, such that default rates on high-yield debt could reach double-digit levels within the next 18 months. This is hardly an environment conducive to robust business investment.

The export sector has been the one ray of hope given a weak and increasingly fragile domestic economy. However, growth has plunged in the developed world and an economic downturn is set to grip the UK and is increasingly probable in the euro-zone. Meanwhile, the developing world is slowing from the remarkable rates of growth enjoyed in recent years. The bottom line is that corporate profits excluding financials are set to slump in the year ahead.

A global recession in 2009 is now a distinct reality, although this outcome has become increasingly reflected in stocks prices with valuations on trend earnings back to the levels that prevailed before the great bull market take-off of the mid-90s. Unfortunately, investment managers by and large maintained overweight equity allocations through the gathering storm and the damage is now plain for all to see. Some managers have overseen a more than one-third decline in pension fund values over the past 15 months, which requires a 50 per cent gain just to reverse these losses. That is highly unlikely in the short-term without excessive risk-taking.

Investment managers often justified their high equity weightings by highlighting the risk of missing the turn in stock prices. Of course, any competent finance student would be aware that this is not risk but opportunity cost. In any case, it simply isn't supported by historical fact. Investors had ample time to adjust their portfolios for a bull market in 1987, 1990 and 2002, though stock prices in 1982 did explode to the upside, but then again the protracted bear market had seen market averages drop in real terms to levels first registered in 1954.

The financial tsunami has broken the Wall Street investment banking model but it has called into question the value-creating abilities of pension fund managers. They would do well to heed the words of Sun Tzu, "Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat."

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