Why hopes of a fast recovery have been much exaggerated

By Eric Uhlfelder
Published: June 28 2009 (Financial Times)

When he was made chief economist at the International Monetary Fund in March 2007, Simon Johnson was deeply concerned about the state of finance across the world’s major developed markets.

But under secretaries of Treasuries, deputy ministers and deputy central bank governors of G7 nations reassured the IMF that in spite of some rumblings all was well.

While he was amazed by how unprepared these leaders were for dealing with the worst economic meltdown seen since the depression, Mr Johnson acknowledges that everyone, including himself, “bought too much into the idea that the financial industry, particularly big banks, had a complete grip on what we thought was risk and how it was being managed”.

But a year after the initial market hit in August 2007, Mr Johnson felt much of the developed world was still in denial about what needed to be done to address the crisis. So he left the IMF and became an academic at Massachusetts Institute of Technology. He is now professor of entrepreneurship, global economics and management at the MIT Sloan School of Management.

“I was trying to speak out while I was at the IMF,” he recalls, “but certain constraints come with position, and I found it was time to speak more bluntly than I could as an official.”

And blunt he was in a recent article in The Atlantic entitled, The Quiet Coup, in which he noted a disturbing similarity between emerging market failures and the US. “Elite business interests – financiers in the case of the US – have played a central role in creating the crisis,” wrote Mr Johnson, “making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse.”

What he finds even more unnerving is that these special interests “are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.”

This is not to say Mr Johnson thinks administration policy is way off mark. He likes the mixed-bag approach. “It makes sense that if you’re not sure what will work, you try a bit of everything: fiscal stimulus, housing support, and recapitalising the banks.”

While he thinks Barack Obama has been a little overweight on the fiscal stimulus, he says the president “bent over backwards not to really annoy the banks or to do anything harmful to their interests”. And to Mr Johnson, this could be Mr Obama’s Achilles heel. He thinks the so-called bank stress tests underestimated the worst-case scenarios by as much as a factor of two.

So, then, is the market rally for real?

Mr Johnson thinks it is mostly a response to the end of the panic phase of the crisis and calm returning to financial markets.

But he does not think those two features alone can carry stocks very far. “We’ll need to see a turnaround in the real economy before investors believe the current rally is sustainable.”

He fears that hopes of an immediate recovery have been greatly exaggerated, and thinks there is still a lot of nastiness that has to work its way through the system.

Asked about a model portfolio, Mr Johnson thinks in terms of US securities as he believes America has the greatest capacity to regenerate through the creation of new technologies and innovation.

Seeing a lack of creative policy response across the eurozone, he is sceptical about western European prospects. He anticipates anaemic growth for some time to come due to the European Central Bank’s refusal to sufficiently lower interest rates and embrace quantitative easing [where Treasuries purchase securities to pump capital into markets].

He is much more keen about certain emerging markets that have already weathered their own crises over the past 10 to 15 years. “I like Brazil, Mexico, India, and South Korea,” says Mr Johnson, “countries that have made systemic changes, which have helped them to hold up much better than most people anticipated.” With an eye on good management, he would have between 20 to 30 per cent of a model portfolio in such places.

However, he would be underweight equities in general. “I can’t imagine a return to the kind of equity growth we had seen over the past two decades, but I can imagine a 10-15 year period where stocks go nowhere.”

He admits his own retirement account is too equity heavy and should include more bonds. He also feels this crisis has taught many investors they have been holding too much stock, and that lots more volatility comes with such exposure. He thinks the recent market collapse proves the need for investment horizons of at least 20 years when investing in stock.

Since he believes quantitative tightening will be no easy feat to ensure impending inflation is contained, Mr Johnson agrees with many financial advisers that commodities will likely prove an effective hedge to future rising prices. But he cautions investors about the likely reinflating of commodity bubbles.

For the same reason, he also likes inflation-linked government bonds.

Overall, he thinks we are still in very uncertain times and believes the average investor would be well served by sticking with safe investments, such as US government debt. But he cautions “that even ostensibly safe sovereigns may not be for the faint of heart”.