Going ‘cold turkey’ – long battle ahead to wean financial system off its debt addiction

Investors are belatedly focusing on cash flows (income or dividends). Capital gains have joined the list of endangered species. Prices must equate to the cash flows discounted back at higher costs of capital. Valuation fundamentals are once again fashionable.

A new order is being created in global finance.

The new investment mantras may well be:
(1) Flat is the new up.
(2) Debt is the new equity.
(3) Interest or dividends are the only return.
(4) If you're looking for the bottom of the market there's a special offer — buy one you get the next one free.

Banks continue to be in the intensive care unit and on life support. Availability of funding continues to fall. "Loan" and "debt" have become four-letter words.

The sharp decrease in debt levels is driving reduction in growth. Companies are cutting production, reducing staff and costs, suspending investment plans, raising equity and trying to sell assets to reduce debt. Consumer spending is falling sharply as individuals increase saving and reduce debt.

Falling investment earnings and lower interest rates also adversely affect the income of savers, reducing consumption. Rising unemployment (as companies retrench) and lower investment (as global demand collapses) mean the chance of a quick recovery is receding.

The central banks have flooded the markets with liquidity. The money unsurprisingly is not flowing through into the economy — banks are stockpiling the cash for their own needs. They are reluctant to lend as the real economy slows, with rising unemployment and lower corporate earnings. Banks also lack the risk capital to make loans.

Governments are resorting to lower interest rates and massive spending initiatives to stimulate growth. But such measures did not restore the health of the Japanese economy, which remains mired in a form of suspended animation. The rest of the world is struggling to avoid "turning Japanese".

The financial-sector bailouts (carmakers are apparently now banks) and government spending have converted a private-sector problem into a public-sector financing problem.

High levels of public debt and the poor fiscal position of some countries mean that the spending may be difficult to finance.

The continued reliance on savers in Asia, Europe and the Middle East is increasingly problematic given emerging problems in these countries.

The risk of deflation (falling prices) has created another massive asset price bubble in government bonds. Investors concerned about recession and deflation have purchased long-maturity bonds, driving long-term interest rates down to unprecedented levels.

The coming year may see a new phase in the financial crisis as the world continues to reduce debt aggressively. This will result in a sharp reduction in sustainable growth rates — $4 to $5 of debt is required to create $1 of growth. Approximately half the recorded growth in US over recent years was driven by debt primarily from mortgage equity withdrawals. As the level of debt in the global economy decreases, attainable growth levels also decline.

In effect, the world used debt to accelerate its consumption. Spending that would have taken place normally over a period of many years was squeezed into a relatively short period because of the availability of cheap financing.

Business over-invested, misreading the demand and assuming that the exaggerated growth would continue indefinitely, creating significant over-capacity in many sectors.

Last year was the year of "shock and awe". This year may well prove to be one of grim and brutal trench warfare as the world adjusts to a new economic order and reduced expectations.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall)