The rally in risky assets is proving hard to stop. Low interest rates have been the main driver, though having limited alternative markets or currencies to invest in must share the blame. But we must not mistake the stock market for the economy. As stock and commodity prices continue strong, there is a tendency to believe that the economy has bottomed out with them. This far from the truth.
With interest rates near zero, investors- individuals and institutions- feel compelled to put their unusually high cash balances to work. The stock, and the commodities markets offer a return, though variable, higher than can be garnered in the bond market.
Company profit margins have held up well because industry has been able to shed jobs without lowering end prices markedly. Companies are saving cash and cutting back on capital spending. Banks are not lending, period!
Consumers are repaying debt, and are loath to take on any new debt. Consumer confidence is fragile at best. Retail sales have been good but are due mainly to government sponsored incentives- cash for clunkers. Lower mortgage rates and the perception that interest rates will remain low for a long time, buoy confidence, but the hand outs will end, as will the enthusiasm. There are just too many imponderables to make man light of foot, mind, and spirit.
Commercial loans outstanding, are over $3 trillion and over 50% of that number is held on the books of the banks. The entire profile of the commercial loan market is in peril.
Unquestionably, the loosening of rules of the credit markets and innovations and securitization created the illusion that risk could be eliminated. These monsters must be dismantled. Recently Ex Fed Chairman Paul Volcker made a Wake up Call to the financial community. He called for taking proprietary trading completely out of the banks and putting it totally on the hedge funds dealers’ books. “If you fail, fail. The stock of the hedge fund is lost, but no one else is affected. “
Then here comes Dubai. Dubai, unilaterally rescheduling its more than $8 billion debt, while their entire debt is over ten times that amount, sent shivers up and down the spines of the entire banking world. The fact that Abu Dhabi did not step into the breech signals, at best, that wealthy Abu Dhabi is becoming choosier in bailing out its energy poor neighbor. Greece, Latvia, Ireland and several other strung out Euro economies are eyeing Dubai longingly, if not imitatively. Tick, Tick, Tick.