posterous kontent

That the seemingly prudent face almost as much pain as the reckless. There are a few reasons for this:

First, the post-Lehman breakdown in funding markets, notably for trade finance, hit everyone. Global trade has fallen at a rate not seen since at least the Great Depression (it may be that the decline over the past half-year is faster than that seen in the Depression). Net-saving nations typically run trade surpluses - and hence suffered more as trade volumes collapsed.

Second, growth was set to slow on a broad front, even before the Lehman breakpoint, for a simple reason: Policy-makers were tightening in most economies due to inflation concerns. For example, monetary policy was being tightened in the major emerging markets (EM) economies right up until Lehman's failure. Synchronized tightening led to synchronized slowdown.

Third, financial stress has been spread by the financial sector. Finance is the most globalised industry in the world. It also has become clear that while not all borrowers were reckless, most lenders were - at least Western lenders. (Lenders in non-Japan Asia broadly avoided the mess, perhaps inoculated by the regional crisis a decade earlier. Japanese banks, likewise, have avoided problems, perhaps having learnt the 'lesson from Japan'.)

Europe is the best example of borrower prudence versus lender excess. Consumers in core Europe (Germany, France, Benelux) broadly did not join the Anglo-debt binge (unlike the periphery of Europe), but European lenders did. So while consumers are not faced with the self-inflicted financial stresses of, say, their British or American (or Spanish) counterparts, their lenders are under severe stress - which, in turn, is affecting domestic economies.

Exhibits 1 and 2 show leverage in a sample of big US and European banks (7 US, 15 European; leverage is total assets/tangible equity). Although accounting differences mean that the ratios are not precisely comparable, it seems that European banks are more leveraged, and have made less progress in reducing leverage.

Moreover, European banks now face two additional problems. First, on our estimates, they have been less aggressive on their mark-to-market losses. Second, European lenders face the prospect of further substantial losses on their exposure to Eastern Europe. Exhibit 3 shows a BIS/World Bank estimate of banks exposed to Eastern Europe.

Fourth, gross flows matter, not net flows. 'Prudent' countries may not have been net borrowers, but when credit is restricted, it's gross borrowing that matters.

Take the US and Asia as examples. America is the world's largest single net importer of capital (the flip side of its current account deficit). But that net flow is the balance of two larger gross flows: very large inflows to the US, partly offset by capital flows out of the US. So as the financial crisis unfolded, and capital retreated, even 'net savers' were affected as gross flows were repatriated. Asia may be a very large net lender to the US, but when Americans repatriated their capital, Asian markets were affected (in fact, last year they fell further than US markets did).

Colleague Stephen Jen makes the point that the reduction in cross-border flows is likely to be a two-stage affair. Last year saw the repatriation of portfolio flows. This year is likely to see a reduction in longer-term foreign direct investment flows. FDI is a good example of how the net flows mask much larger gross flows. As Exhibit 4 shows, the US exported almost as much FDI as it received. These flows were, up until the September 2008 quarter (latest data point in Exhibit 4), relatively resilient. Stephen expects (and I agree) that these flows will fall this year. Indeed, FDI in China remained positive through last year, but in January fell to 33% below year-earlier levels. The likely contraction in FDI fits with my view that the key drag on growth this year will be private investment spending.

Finally, it's becoming clear that the apparent strength in many 'prudent' economies was due in large part to the more obvious excesses elsewhere. This is a point colleague Stephen Roach has often made: China, for example, suffers important imbalances due to its reliance on the unbalanced US. Two sides of the one coin. (For Stephen's latest views, see A Wake-up Call for the US and China: Stress Testing a Symbiotic Relationship, 18 February.) Beyond China, it's become clear that the high saving of regions such as the Middle East or Latin America was the by-product of the global boom underwritten by dis-saving and leverage elsewhere. Gray Newman, our chief Latin American economist, saw the 'era of abundance' as a by-product of the boom elsewhere. As the spendthrifts cut back, the prudent suddenly found their apparent sound fundamentals quickly eroding.

If this economic adjustment boils down to spendthrifts lifting their saving, then global recovery will depend on the savers saving less. But this faces two hurdles. First, the 'era of abundance' for the prudent has disappeared due to the global downturn. Second, it seems unlikely that consumers who saved through the period of full employment, strong global growth, and buoyant asset prices will now spontaneously and voluntarily reduce their saving to offset the economic drag of spendthrifts who have now suddenly turned cautious. The one and only sector that seems willing and able to reduce saving to counter-balance this is the public sector. In short, there are almost no areas of private-sector resilience.

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END OF RESEARCH ABSTRACT

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Turn is just one quarter old. Yes, the financial crisis is several quarters old, and investors have been fretting about global growth for some time, and worried about US growth for even longer. But the global recession has just started. Whether there would be a recession was a live debate just 3-4 months ago. It was only in the December quarter that growth, sentiment and earning indicators fell sharply (Exhibit 1). It may feel like the recession is well advanced, but it's not.

This matters. A key issue for investors is when the cycle will trough and growth and profit indicators pass an inflection point. The consensus seems to be that the cycle will bottom in the June quarter - that is, in the third quarter of the global downturn. That would be plausible if this were a vanilla cycle. However, there are many signs that this will be a deeper, longer cycle than average. Moreover, the fact that the downturn started just a handful of months ago has a number of important implications.

First, it means that the global policy response is not very progressed. The Anglo-economies - notably, the US - are an exception, arguably because the Anglo-economies are at the epicenter of this crisis. Even so, Anglo-policy rates peaked as recently as September, and the aggressive rate cuts only commenced in October. Outside the G7, my simple average of policy rates peaked in mid-November (Exhibit 2).

Monetary policy, famously, works with long and variable lags. Even if this were a normal cycle - and, clearly, it's not - then it would be far too early to expect a response to easier policy in the current quarter, or even next quarter. Monetary policy typically takes 3-4 quarters to have a notable impact. Fiscal policy is likewise affected by lags. Colleague David Greenlaw highlights Congressional Budget Office estimates that less than 20% of the planned US fiscal stimulus will be spent this year, including only 7% of the infrastructure spending.

Second, the second-round effects of the global slowdown are yet to become clear. Richard Berner, our chief US economist, emphasizes how the global slowdown will feed back to dampen US growth. This is just starting. The ISM export indicator, for example, is signaling a precipitous fall in US export growth (Exhibit 3). These second- and third-round effects take time to occur. Most of them are yet to come.

Third, with the downturn still young, the decline in operating earnings is likewise in its early stages. This is where it's important to distinguish the finance-focused asset write-down story from the prospective decline in operating profits from non-financial firms. While US-sourced profits have been declining relative to GDP for two years, and are now around their long-term average, total profits remain well above long-term average levels (Exhibit 4). The gap is explained by the still-high level of foreign-sourced profits. The sharp decline in foreign-sourced profits will come, but has barely started.

If it is still early days for the downturn, how long is it likely to last? Standard downturns last 3-4 quarters. On that basis, passing an inflection point around mid-year (that is, 2-3 quarters after the downturn starts) would be a reasonable expectation. Downturns associated with financial crises historically last much longer. Research from Reinhart and Rogoff suggests that downturns associated with banking crises average 3frac12 years (Exhibit 5). To be fair, this is the length for which growth is running below trend, and on that basis this current crisis is now just over one year old. But the point remains that if this is a 'typical' banking crisis then it may be wrong to expect a bottom in the cycle in the current half year.

It remains a moot point what is priced into equity markets. Of course, investors are braced for the cycle and earnings to worsen in the current half year. However, as I noted last week, my sense is that the resilience of equities in the face of the horrible macro data of the past quarter is due to the view that the cycle will pass an inflection point around mid-year. A mid-year trough would justify the assumption that profits will be materially higher next year than this year. That, in turn, is permitting markets to look through the near-term tumble in earnings. If, however, that view of a near-term bottom and 12-month profit recovery is questioned, then equities will probably make substantial new lows.