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Looking back at previous financial crises can give us an indication of what might happen now but there are no easy answers
The lessons of history
Now that 2010 and the new decade is well and truly upon us, it is time to make real assessments as to what investors should be doing rather than simply pontificate on the likely outturn of events. And this is where it starts to get seriously tricky.
Notwithstanding the tendency of most industry commentators to talk up their market, little I have read makes me over-optimistic for the year ahead.
Two issues cause me concern. First, shares are no longer cheap on an historic basis unless, which is the $64,000 question, a massive economic turn-round is already under way.
Second, governments are necessarily going to have to rein in spending and somehow repay the massive borrowings incurred in keeping the good ship Capitalist Enterprise afloat.
While this second worry may seem a little too obvious not to be priced into markets, let me remind you of past experiences when the authorities have withdrawn big chunks of money made available to oil the wheels of the system.
In 2000, Alan Greenspan, the then chairman of the Federal Reserve Bank, took back all the multitudinous dollars he had created to neutralise the millennium bug. Technology shares collapsed as he did so.
Coincidence? I fear not. The way in which government or central bank largesse feeds into the financial system is well documented. Who can blame bankers for recycling cash when it is on offer to turn a buck or two? Well, we all probably can these days but I fear memories are far shorter than they should be when it comes to avoiding repeating mistakes.
So there is a risk that, once conditions become tighter, shares will suffer as credit lines are withdrawn. This is aside from the knock-on effect that lower government expenditure will have on economic activity.
This is more of a concern to us in Britain, even than in the US, where central government occupies a smaller relative space. The economic cost of reducing the ballooning debt being built up to head off recession will be significant.
As for the valuation argument, so much depends on the strength and sustainability of the recovery that it is hard to ignore the risks that are present now that shares have rebounded by more than 50 per cent. If all we are seeing is a pre-VAT buying boom coupled with a restocking bounce, then heaven help us when activity settles down to a more sluggish pattern - all too probable, given the continuing disarray in the banking sector.
But life is never as simple as reaching the conclusion that the recovery has gone too far (which they always do) and taking a few profits. This might indeed be the appropriate action but we still cannot be sure what the final outcome of such a major financial upset will be. A thoughtful friend in this industry drew my attention to a recent book on financial crises. It paints an interesting picture of what we might expect.
This Time is Different: A Panoramic View of Eight Centuries of Financial Folly by Reinhart and Rogoff, demonstrates how there are lessons to be learned from history.
In particular, it seems that those crises in the past with which current parallels might be drawn ushered in periods of inflation.
Inflation should be good for financial assets, yet Roger Bootle, esteemed economist who wrote The Death of Inflation in 1996, recently opined that interest rates will remain below 1 per cent for five years or more - hardly a high-inflation scenario. As I suggested earlier, there are no simple solutions as to what to do.
Brian Tora (brian.tora@ centaur.co.uk) is principal of the Tora Partnership
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Readers' comments (9)
John Whipple | 18 Jan 2010 3:24 pm
I tend to agree with your thoughts on this it could be that under 1% interest rates will be hung on to for as long as possible (possibly to long?) as the debt burden is so huge. but that does not mean that inflation will not follow this time in fact holding on to low interest rates might well exacerbate that inflation. Index Linked Gilts anyone?
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Blair Cann | 18 Jan 2010 4:20 pm
I get a little bored with prophets of doom who always seem to get media space irrespective of the merits of their argument.
Brian's comment "shares are no longer cheap on a historic basis.." - yes the Ftse 100 is probably ahead of the recovery-what else is new?
Technology shares collapsed as Mr Greenspan removed his mega bucks? Is the suggestion there is some connection, because many of us felt that technology shares collapsing was inevitable; largely due to the fact that certain companies that had no assets and in some cases were not even trading were valued at millions of pounds by greedy and cerebrally challenged dealers
I do agree with the warning concerning inflation and would go so far as to say a rise in inflation of probably significant proportions is inevitable. But five years of below 1% base rate? Surely not.
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Trevor Goulding | 18 Jan 2010 5:23 pm
I agree with all Brians thoughts including the effects on our UK market by the withdrawal of Q E (Quantitative Easing) so why dont we just concentrate on the F E, Bric and Emerging Economies for 2010.
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Trevor Goulding | 18 Jan 2010 5:23 pm
I agree with all Brians thoughts including the effects on our UK market by the withdrawal of Q E (Quantitative Easing) so why dont we just concentrate on the F E, Bric and Emerging Economies for 2010.
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Trevor Goulding | 18 Jan 2010 5:23 pm
I agree with all Brians thoughts including the effects on our UK market by the withdrawal of Q E (Quantitative Easing) so why dont we just concentrate on the F E, Bric and Emerging Economies for 2010.
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Nigel Bradley | 18 Jan 2010 9:48 pm
Inflation can easily turn quite quickly. This is to be expected once the anticipated recovery is in full flow and the rate of unemployment eases. I can see 3% BOE base rate quite easily within 5 years.
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Blair Cann | 19 Jan 2010 10:56 am
Something we are all agreed on. On this morning's (Tues 19th) news, inflation up from 1.9% to 2.9%
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Julian Stevens | 19 Jan 2010 3:58 pm
Inflation rises (so everything's getting more expensive), deflation threatens (which threatens to bring the economy to a standstill), unemployment's up, unemployment's falling (so there's a shortage of skilled labour), corporate profits are up, corporate profits are down, the stock market's up (so shares aren't as attractive a buy as they were a while back), the stock market's down (so everyone's wringing their hands and fleeing to Bonds and Gold). It's all part of the ceaseless ebb and flow of any capitalist economy. Take the medium to long term view and don't lose sleep over short term fluctuations one way or the other. It all comes out in the wash eventually. I really can't be bothered anymore with predictions for the year or two ahead.
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paul holmes | 19 Jan 2010 10:50 pm
I would prepare for inflation regardless of what anyone in authority suggests - it is hugely convenient for anyone or any government in huge debt - what a great way to erode the burden - it happened in the 70s and it could easily happen now - great for property and shares- let Dampier Property Bear put that in his pipe.....
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