Interesting things seem to happen in March. It was on March 16, 2008, that Bear Sterns went down. This was the first major United States financial institution to be taken down by the sub prime financial crisis.
It was also in March 2009 that the S&P 500, a major US stock market benchmark index, began to rally off the lows of 667 to its present level of 1,404. For those afraid to invest in the stock market this equates to a return of more than 100 per cent in three years. The 2009 rally was fuelled by the results of a US Federal Reserve stress test on financial institutions. The stress test coming at a time when a number of other major financial institutions were on the verge of going under provided a framework for financial institutions to raise capital and secure their balance sheets.
In short, it provided a level of investor confidence that had the knock-on effect of boosting bank stocks, which created a catalyst for a market rally that, despite huge volatility, continues to today. In fact, for the 12-month period to March 16, 2012, the US stock market is up around 31 per cent. Last week the US Federal Reserve released the results of the most recent stress test and, in the three days following the announcement, the market is up almost 3 per cent. More importantly is the fact that this event has pushed the market through the 1,375 region, a key technical level. Over the past 12 months, the market has gotten to 1,350 and failed to go past 1,375 on numerous occasions. Now it has been able to zip right through and get into the 1,400 zone, a level not seen since May 2008.
Confidence
Here in T&T, we often lament the lack of confidence in the local economy and many have argued that it is the absence of confidence that has stymied economic growth over the past couple years. There have been many calls for private sector capital to augment state capital with the expectation that the combined effort will propel the economy to new highs. If we try to sift out the lessons from the US experience highlighted above, we should as a nation recognise that there are a few elements to building confidence and it all revolves around a key word called credibility. If we accept the view that confidence means an expectation that the future will be better than the past, then the necessary ingredients are a clear and transparent account of where things stand now, a credible outline of what must be done to address the issues going forward and an audience that is sufficiently engaged to understand the issues that are being presented, believe in the solution and then act in their self-interest, which, by design, should be aligned to the solution. I leave it up to the reader to decide if this scenario represents the status quo in T&T.
Problems for T&T
Back to the performance of the US stock market, which provides a good example of how self-interest can be channelled to engineer a desired outcome. The stress test by the US Federal Reserve allowed those entities that passed to be able to recommence the return of capital to shareholders either in the form of a dividend or share buyback or both. This meant that cumulatively, billions of dollars would be returned to shareholders and this was sufficient to push the market to multi-year highs. Any stock market that is appreciating continues to create a wealth effect, which translates into higher levels of economic activity, which creates more jobs; the end result being a positive feedback loop as increased job availability leads to additional spending, which all add up to economic growth.
If this "happily ever after" scenario turns out to be true, then it could actually be of concern for us here in T&T. We may not have realised it, but T&T has to come out of its economic slump before the US, otherwise we may find ourselves in a sticky situation. Let me explain. The spread between ten-year interest rates in the US and ten-year interest rates in T&T average around 300 basis points (3.0 per cent), all other things being equal. Over the recent past, ten-year interest rates in the US have hovered around the 2.0 per cent mark and the equivalent rate in TT dollars has been around 5.0 per cent. US rates have moved from 1.90 per cent to 2.32 per cent over the period February 27 to March 16. That is a 22 per cent increase in a matter of weeks. If rates in the US continue to rise, it is because there is the view that the economy is on sounder footing and would be the result of money moving from the bond market (selling of longer-dated US treasuries) into the stock market. If you were able to get 4.0 per cent for ten years in US dollars versus 5.0 per cent for ten years in TT dollars, where would you put your money? The answer, of course, would be in US dollars as the return for the level of risk is better than in TT dollars.
In such a scenario, either the TT exchange rate has to fall against the US dollar to reflect the demand for US dollars or TT interest rates must rise to make TT dollar investments more attractive. If TT interest rates were to rise, there are likely to be losses to bondholders as the price of a bond falls when interest rates rise and, so the carrying value of those bonds on the balance sheet will be lower and the movement reflected as a loss in the income statement. To date, there has been little discussion as to how we intend to "drain" the excess liquidity from our financial system, if the need arises, nor is there much discussion as to how we intend to manage the economy in the face of higher long-term interest rates in the US.
There has, however, been much discussion about the personal assistant of the prime minister, which probably sums up where our misguided priorities lie.
Still time
My base case view is that we are unlikely to see higher longer term interest rates in the US being sustained. Given our lack of concern on the issue, we should hope that my view turns out to be correct. Recognise that the stress test was simply a model and we have seen from 2008 how models can get things very wrong. In fact, human behaviour is almost impossible to model and panics are caused by human behaviour. If an event causes banks to stop lending to each other, as was the case in 2008, that constitutes a liquidity crisis, which is near impossible to predict whereas most tests are designed to assess the adequacy of capital, a problem that tends to show up after the liquidity problems.
Once again it is important to appreciate this point in a local context. Confidence is not engineered by providing the perfect solution or staking out the optimal equation, but rather is based on credibility and a plausible rationale. If confidence is lacking, then these are the issues that need to be addressed.
The current US stock market optimism is based on improving economic indicators and these improvements are real. Unemployment is falling and the year-on-year comparisons are better. There should, however, be some measure of caution with the data. Last year's numbers were skewed to the downside because of a cold winter, this year the numbers are skewed to the upside because of a mild winter. This creates a significant divergence this could create a level of optimism that outstrips reality.
Recognise that job growth is a lagging indicator and this was explained above as it takes consumption to increase before job growth takes place and, if the rate of consumption growth is decreasing, then it means be on the lookout for challenges up ahead. It is my view that globally the business cycle has moved from a period where there were ten-year periods of growth and months of recession to shorter periods of growth and longer periods of recession. The business cycle has shrunk. Investors in stocks need to recognise the need to stay in the market and ride the waves because by the time the data confirms growth, the markets have already peaked and vice versa. Bottom line: stay the course and don't panic.
Ian Narine is a broker registered with the Securities and Exchange Commission.
