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28 February 2024

Death of capitalism exaggerated

By Paul Murphy

Consider the so-called "fear index". This is the 'spread' or difference between three month dollar Libor (interbank lending rates in the US) and OIS, the overnight index swap rate. But without dwelling on the technicalities, it is fair to say that this measure largely captures perceptions of risk in the credit markets. Indeed, it is said to be one of the Federal Reserve's favourite metrics.

Historically measured in just fractional amounts – a few basis points or hundredths of one per cent – it first blew out in August 2007 as the credit crisis struck. Swinging wildly over the coming months, it then blew out even further last September as Lehman Brothers collapsed on Wall Street.

The fear index said, quite simply, that banks were not lending to each other.

But look at the index now. It is still higher than before the Lehman debacle. It's also higher than last April, when Bear Stearns collapsed. And, compared with long run historical measures the Libor OIS spread is still outlandishly high.

Yet the improvement has been dramatic and progressive. Fear has not been extinguished from the system, but bank confidence has vastly improved.

Now consider the intriguingly-named Barclays Capital US Economic Activity Surprise index, presented as a one month rolling average. It comes from Tim Bond, the bank's closely followed strategist, who explains that it "captures the relationship between actual economic data releases and prior expectations thereof."

It measures whether economists are shocked by economic statistics when they are published.

You will be able to see the swings lower as unexpected events have slammed into the market over the past 12 months – a solvency panic last January, the Bear collapse in April and then, of course, the Lehman turmoil in September and October.

But again – even more than the fear index – there are signs here of a return to normality. Or at least a better understanding in the markets of what is in store, economically.

With the BarCap Surprise index having returned to zero after the latest set of data releases in the US, the message would seem to be that fresh economic information has been in line with expectations. For the moment at least, investors are not suffering further negative shocks.

This is rather important. Financial markets have important predictive qualities, typically discounting events 12-18 months out. But if market participants are receiving repeated shocks to their economic assumptions, the markets' pricing system has a tendency to fall down. It becomes increasingly difficult to reach a consensus. So, with a reduction in the fear index and BarCap's rolling surprise index, it should not be surprising that we have seen a broad-based recovery in asset prices.

Sure enough, major stock markets have staged a typical rebound of 20 per cent or so from their November and December lows, while in the credit markets we have seen corporate bond yields tighten substantially – narrowing the yawning gap with government debt.

Commodities have also snapped back from their low points – oil having rallied 40 per cent – while shipping, as measured by the Baltic Dry and Freight indices, has also recovered.

But hold it there for a moment. This rebound in sentiment is relative. Remember that there was a global collapse in economic activity just three or four months ago – and the data and anecdotal evidence we are now getting only hints at a return towards normality.

Tim Bond at BarCap uses the Baltic Freight indicator as an example – up 66 per cent from its lows, but still down a shocking 93 per cent from its highs. As he points out in his latest Global Speculations note to BarCap clients:

"Similar points can be made of all the other asset markets, where the strong rallies of the past few weeks have still left valuations at levels that can only really be accurately described as distressed. Equally, for all that economic expectations may have adjusted to the new reality, that reality is bleak indeed.

"The general thrust of most data releases is that the global economy is at the weakest point seen for the past half century. Thus, our global manufacturing confidence index, whose history starts in 1960, registered the weakest-ever reading in December."

That said, Bond does believe that the general picture is one where the trauma engendered by the financial shocks of last September is starting to ease – and we do have to take account of the aggressive policy action taken by the authorities in the wake of those shocks.

"Commercial banks have received fresh capital and government guaranteed refinancing, money markets have been smothered with central bank liquidity, the US government has reversed from the disastrous decision not to actively purchase credit market assets and the Fed has cut rates effectively to zero, while engaging in substantial quantitative easing. The combination of the Federal Reserve's balance sheet expansion and the zero rate policy is a very powerful tonic."

He sees what he calls the "illiquidity premium" – the excessive price being demanded by the market in the face of forced deleveraging, a banking system collapse and the near-complete unavailability of corporate credit – starting to be smoothed away.

Bond, like the rest of us, is not quite sure what happens next. There are obvious medium-term threats arising from the Fed's policy action – most notably the danger of runaway inflation and/or a collapse of the dollar. But right now all we can really see is that the economic patient has survived the trauma.

Says Bond: "We would characterise such a revival as recognition that the capitalist market system, whose immediate demise was a legitimate worry in Q4 of last year, has in fact survived. However, while fears of the death of capitalism turn out to have been exaggerated, the actual prognosis is not exactly encouraging."

So most of us are still standing. Unfortunately, the twin problems of Western consumers and Western banks having spent too many years gorging on too much debt, remain with us. Unwinding that will take years, not just a few months.

- The writer is associate editor of the Financial Times