Stating the Obvious

Cheap credit has inflated the markets, and we could be in for a crash landing

Trying to solve a debt problem with more debt has created a bigger bubble, and it's hard to see what the central banks can do

the Guardian,

9 June, 2013

During the past four centuries, there have been five occasions when major credit bubbles have led to stonking crashes. Tulip mania in 17th-century Holland was the first; the South Sea bubble in the 18th century was the second; the US real estate crash of the 1830s was the third; the 1929 Wall Street Crash and the Great Depression was the fourth. The sub-prime crisis that began in 2007 was the fifth.

As the world approaches the sixth anniversary of the freezing up of credit markets, a terrible idea has occurred to investors: we might only be part-way through the crisis. This has come as something of a shock. For the best part of the year markets have been pushing asset prices higher in the belief that the worst of the crisis is over. They have given a big round of thanks to Ben Bernanke, Sir Mervyn King et al for keeping monetary policy ultra-loose and avoiding a repeat of the 1930s.

Doubts are now starting to set in, and rightly so. Cheap credit has done wonders for equity and bond markets but precious little to revive real activity. This has been the weakest recovery from a slump in living memory. And financial markets have become dependent on central banks keeping the money taps wide open, even though the evidence is that each additional dose of easing is less effective than the last. Markets are currently skittish not because there is a risk that the Federal Reserve will start to reverse its quantitative easing programme but because of fears that it might start to reduce the amount of assets it purchases monthly. An extremely aggressive and highly dangerous dependency culture has developed and it is not easy to see how central banks get out of the problem that they have created for themselves.

There is clearly a risk that if the Fed, the Bank of England, the ECB and the Bank of Japan started to nudge up interest rates towards pre-crisis levels and gradually reversed QE, over-leveraged households and banks would not be able to cope. Yet, there is also a risk that seeking to solve a debt problem with still more debt is creating the conditions for an even bigger bubble, which could go pop at any time. Support for this idea is growing. John Kay noted last week that the world was heading for a second crisis because the financial sector was inherently prone to instability. "Prices are driven to silly levels, but everyone makes a load of money in the meantime, and then you get a correction."

Two possible flashpoints for the next crisis have been identified: China and the eurozone. Charlene Chu at Fitch has noted that total lending by banks and other financial institutions in China was almost 200% of GDP in 2012, up from 125% four years earlier. Not only is credit twice as big as China's economy, it is growing twice as fast. The lesson from the US in the years between the dotcom crash and the financial crisis of 2007 is that debt-fuelled growth on this scale can work for a while but eventually proves unsustainable as debts become unpayable.

Leigh Skene and Melissa Kidd of Lombard Street Research think the eurozone will be the catalyst for the next crisis. In their new book, Surviving the Debt Storm, the pair argue that Europe's banks are pretty much insolvent and kept going only by unlimited liquidity provided by the ECB. What's more, they are far bigger in relation to the size of the eurozone economy (350% of GDP) than are the American big banks (80% of GDP). The eurozone banks are highly leveraged, continuing to expand their balance sheets, and making little attempt to recapitalise themselves.

Skene and Kidd agree with Kay and Chu: something very nasty is lurking out there. Investors would do well to take note.

Pie in the sky accord?

Airlines dispute whether they deserve to be villains in the climate change debate. But at their global summit this week they agreed a resolution that they hailed as a breakthrough. Sceptics, naturally, saw it as collective buck-passing: a motion asking governments worldwide to pass unified laws to cap their emissions. Airlines haven't so much gone green as slipped into the red: high oil prices mean burning less fuel is critical for their accounts, let alone the planet.

But there is also a recognition that minimising CO2 is aviation's "licence to grow", as a senior figure put it. In the short term, this will include carbon offsetting – a cheap solution that risks making research and investment in genuinely greener technology less attractive. But in a tough market with razor-thin margins, aviation demands a universal scheme, allowing European carriers to compete fairly with their Chinese counterparts. Whether politicians can deliver that global solution is the next question.

Stinging cut for Sorrell

A year ago this week Sir Martin Sorrell, the founder and frontman of advertising company WPP, got something of a shock. Almost 60% of the firm's shareholders voted down a plan to increase his pay by up to 60%. To a certain extent he had seen it coming. The year before, the company received the equivalent of a yellow card when 41% of shareholders voted against WPP's pay policies. It also became clear in the days before the AGM that a rebellion was on the cards.

So what did Sorrell do? He broke the unspoken rule in the corporate world by commenting on his own pay. "In 1985 I borrowed £250,000 to buy almost 15% of WPP. Today anybody who invested £1,000 in WPP at the beginning of 1985 would have more than £46,000 including dividends, or £31,000 excluding dividends," Sorrell wrote in the Financial Times.

Britain needed to pay its staff competitively to have successful companies, he said, and signed off: "WPP is not a failure, it is a success."

Success or not, it was not enough to stop the revolt, which did not sting badly enough for Sorrell to follow the advice of Ivan Glasenbergcorrect, the chief executive of commodity trader Glencore Xstrata, to quit if he lost the vote.

It was painful enough, though, for the advertising company to come back this April with a £150,000 cut in his salary – still a reasonably healthy £1.15m – and a 20% reduction in his potential payouts from a long-term incentive plan, which would give him a mere £19m if he hits all his marks.

It has been enough to convince ISS, an influential voting advisory group, to advise investors to back the pay report at this year's AGM on Wednesday in the Savoy. But behind the scenes there are still grumblings from some investors that Sorrell's pay is over the top. He received £17m in 2012. A full-scale rebellion may not be brewing, but the row is simmering. If there is another protest this year, Glasenberg's view from last year may be ringing in his ears.