Managing director Thierry Apoteker and his team at French company T-A-C (Thierry Apoteker Consulting) have correctly predicted many of the economic shocks that the world has seen in the past three months. To varying extents, their group predicted the slowing US economic growth, the fall in the US stock market, the strengthening of the US dollar and the need for central bank intervention in many countries.

TAC also foresaw some of the details such as the need to reduce risk and potential panic among bank depositors. Deposit guarantees of 100% have reduced that risk to zero in many countries.  

While expecting an economic downturn, TAC perhaps underestimated the extent of it. Their economic models predicted no recession in the US or Europe, which has turned out to be wrong as a recession is underway in both places. As often happens in economic forecasting, the model got the direction correct but not the size of the move.

In a recent presentation hosted by the International Trading Institute at the Singapore Management University, Apoteker made a convincing case for worldwide inflation and recession, known as stagflation. His remarks seem to have anticipated many of the events which unfolded in subsequent weeks, resulting in crashing stock markets and downward revisions of nearly all economic forecasts.

Apoteker noted that, “US GDP growth slowed from almost 4% in 2004 to 1.5-2.0% in 2008. During that time, inflation picked up from 2.7% to over 4%”. The trend continues although inflationary expectations may have abated.

Financial Crisis 

He also points out that the financial industry was riding high in 2004, with more than 40% of all US corporate profits. This, of course, has seen a drastic change and the finance industry today is probably the most vulnerable sector. 

“The problem”, said Thierry Apoteker, “is that an endogenous financial crisis was triggered by subprime home loans, primarily in the US but also extending in a less extreme form to Europe. It resulted from a very large pool of liquidity that went in search of assets in which to invest. This amplified volatility, making monetary policy less successful.” Apoteker added, “Many central banks have found it especially difficult to do their job lately.” 

The models used by his consulting firm, TAC, showed the problem did not originate in the real economy. It certainly did not start with companies or households. Dr Apoteker explained, “It was endogenous in that it began within the financial system, especially on Wall Street. The main cause was a financial casino of ever growing leverage. It was built upon excessive liquidity and securitisation, which placed excessive amounts of trust in the invisible hand of private markets.”

Apoteker cited the example of US$450 billion of credit default swaps issued by insurance company AIG and used to insure collateralised debt obligations (CDOs).   It is a part of the high leverage which contributed to the near-collapse of financial institutions. Using CDOs, hedge funds were able to leverage up to 35 times. He pointed out that, “The CDOs appeared safe because of the high ratings they received from rating agencies. Of course, those ratings were wrong and the CDOs were more risky than indicated by Moody’s, Standard and Poor’s and other ratings agencies.”

Apoteker produced useful statistics to support his contention that excessive leverage under-stated risks. It contributed to the financial meltdown that later infected the real sector, including business and consumer spending. A key piece of data revealed that, “In 2004, in addition to accounting for US$35 billion of Wall Street bonuses, the US financial industry represented 40% of all US corporate profits.”

Apoteker pointed out that voices of caution were shouted down in the euphoria. No one wanted to spoil the party. Some, like Warren Buffett and Jean-Claude Trichet, warned that “we no longer know where are the risks in the system”. 

Central Banks to the Rescue

Observed Apoteker, “It explains mis-steps by central banks since it is difficult to offer the correct policy prescriptions when the risks are uncertain. Of course, it is difficult to prescribe the correct medicine if one does not correctly diagnose the illness.”

He stressed that throughout the crisis, keeping the banks liquid has been a necessary but not sufficient condition for economic revival. “Central banks have so far been successful at injecting large amounts of liquidity into the financial system,” said Apoteker. “The problem is it just sits there. Banks have not been lending the money to consumers or businesses. Until recently, they were not even lending to one another. The inter-bank lending market had dried up due, primarily, to a concern among banks that they may be lending to a bank that could fail.” 

He once again correctly predicted that the problem could be solved by countries guaranteeing private bank debt. While it has mitigated the problem of inter-bank lending, Apoteker points out this is the first step needed to revive world economies. 

It still leaves a sufficient condition unresolved, which is convincing banks to resume their lending to the private sector. Of course, private sector loans are not guaranteed and banks remain skittish as a result of their recent experience with unprecedented loan losses. This is an important part of the equation for which a solution is still needed.

“The spread between AA commercial paper and Fed Funds is usually close to zero,” said Apoteker. It had moved much higher -- from zero up to 80 basis points -- at the time of Singapore talk, and subsequently rose even more. He concluded, also correctly, that this not only reflected a crisis of confidence, it also produced one. The crisis could feed on itself and spill into the real sector, producing the inflation and economic downturn which he foresaw.

Apoteker pointed out that a lack of consistency in dealing with the crisis was perhaps aggravating it. “One example has been the decision to save the seventh largest US investment banking firms, Bear Stearns, while allowing the fourth largest investment banker, Lehmann Brothers, to go bankrupt,” he said. 

He predicted that the Lehmann bankruptcy -- which had occurred just 3 days prior to his talk -- would have far-reaching consequences. It has, including the negative effects on over US$500 million of structured products linked to Lehmann Brothers that were sold in Singapore. Elsewhere, such as Hong Kong and Taiwan, sales of Lehman-linked structured products have been in the billions of dollars. 

Hard Times Ahead

According to Apoteker, “The priority of government policies has been to avoid panic within the general public, and a run on deposits in commercial banks and mutual funds.” The TAC model has predicted, since August 2007, that there would not be a “free fall” as occurred in the 1929 depression. However, Apoteker has predicted that “…a period of sub-potential growth will set in, possibly for as long as 3 to 5 years.”

One possible area of underestimation of the effects of the crisis is Apoteker’s forecast of no recession. “The US would see slow growth in real GDP, ranging from 1.5% to 2,” he stated. However, most recent data suggests otherwise. Third quarter GDP was minus 0.3%. Most fourth quarter estimates range from minus 2% to minus 4%. It appears almost certain, therefore, that the US is already in a recession.

Apoteker also expected no recession in Europe and looked for growth of around 1% to 2.5% inflation. Again, it may underestimate the severity of the crisis. Comparing Europe to the US, TAC differs from other forecasts in its expectation that Europe’s growth will be the weaker of the two. It also believes European banks are even more exposed to bad loans and investments than US banks.

Apoteker expects the US is close to a bottom in the housing market. One reason is the large 30 to 40 year-old population. It is the age at which one buys a house in the US and differs from Europe and Japan, where the population is older. It means the key segment of young home-buyers is smaller.

At the end of 2007, Apoteker and his TAC team accurately predicted the rebound of the US dollar. In his Singapore talk, he expected the US dollar to move up against the Euro to 1.35 by the end of 2009. The dollar’s appreciation proved to be even stronger and, by November 1 2008, it had risen to 1.28. 

Apoteker correctly predicted financial difficulties requiring emergency loans in Pakistan and, particularly, Kazakhstan.

Three long-run problems which Apoteker believes will limit growth and also contribute to inflation (and will combine to cause stagflation) are: (i) high demand for commodities (despite higher efficiencies of use); (ii) aging populations (triggering upward pressure on wages of younger workers); and (iii) de-leveraging (resulting in slower loan growth and reduced spending). He also expects that “A slower US growth engine will contribute less to driving the demand in world economies, which will be a problem.” 

Regarding the stock market, Apoteker sees more uncertainty, resulting in higher risk premiums. It will increase yields (E/P) and therefore reduce P/E ratios, making stock appreciation less likely. This has turned out to be an accurate prediction of the stock market’s collapse, which occurred three weeks after the talk.

Regarding currencies, Apoteker expects exchange risk to grow. We have seen that in the appreciation of the US dollar and the concurrent decline in other currencies. Among the most dramatic has been the 50% drop of the Australian dollar relative to the US dollar in the four months from July 1 to November 1 2008.