Thinking About Fear . . . . And Measuring Its Impact

‘Nothing to fear but fear itself’. Actually, that can be re-written for today’s media-wrapped world: ‘Yes, we have stuff to fear, but My God, brace yourself for the wave of confirmation bias CEO quotes coming our way.’

That’s perhaps a bit unfair.  But we should recognize that, among other things, we’re now in a period where there’s a ready market for business journalism based on the whining of CEOs ready to tell us how demand for their services/products is disappearing, and the government must do something.

Actually, if you’re prepared to ignore the ticking of the EuroDoomsday Machine, the impact of fear becomes more . . . measurable. Fear postpones purchases, postpones investments, postpones expansion. And it does it for one big reason: households and companies meet fear rationally – by working hard to limit their financial exposure.

Consider first the behaviour of the US corporate sector: in a way, the whining CEOs aren’t kidding – in real life they remain immensely cautious for years after the end of the last recession. We can track this behaviour through the US flow of fund accounts. When recession hits, the corporate sector finds ways to stop the growth of their net exposure to credit markets. That much is obvious: rather less obvious is the amount of time it takes them to get over this fear. Take a look at the chart:

• The 1990/91 mini-recession ended in 1Q91, but it wasn’t until 1Q95 that corporate’s net credit exposure dipped back to pre-recession levels, and started growing once again.
• The 2000-2001 semi-recession was ended in 3Q2001, but it wasn’t until 4Q2004 that companies were prepared to take on more net credit.
• The 2008-2009 recession  officially petered out in 2Q2009, and so far net credit exposures have not returned to pre-recession levels.

Nor, it currently seems safe to say, should we expect a corporate appetite for credit to revive any time soon – previously experience suggests we might wait until 2013 or 2014 for revived credit appetite. It could, of course, be worse this time.  That’s the impact of fear.

Households reacts to economic and financial fear in much the same way – they net-repay debt. I have shown previously (here) how US households have repaid more than half their net debts to banks and credit markets since the cUS$3 trillion nadir of mid-2007. At the current rate of net repayment, the US household sector can expect to be net creditors to credit markets again by around 2015. 

But notice that this net repayment has been made not principally by repaying debts, but rather by shifting the balance of their savings from risky instruments (equities and equity mutual funds) to less risky (deposits).  At the peak of US household financial risk appetite  - during the tech bubble of 2000 – equities etc accounted for 37.2% of all gross household financial assets, whilst deposits etc accounted for just 18.5% at their lowest point.

The subsequent market collapse eroded that share both directly (by prices falling) and indirectly (by people switching out of equities) to reach first 22.8% in 3Q02, and then 20.4% in 1Q09. Notice that the subsequent market recoveries never took that equity proportion back to glory days of the late 1990s. Rather, it seems likely that, post-disillusionment, the proportion meets a ceiling of 28-29%. More likely, the volatilities in these ratios are gradually trending back to pre-1990 norms (ie, deposits representing 30-35% of assets, equities etc representing 15-20% of assets).

We do not yet have the data for 2Q, but there is likely to be little change in equity holdings in 2Q, since the S&P ended June only about 50 points lower than it ended March. To get much of a change in the US$13.84 trillion  holdings of equities and equity mutual funds, you’d need to assume a general exodus of households from equity markets – ie, a change in risk preference. That doesn’t seem particularly likely.

But it does now, doesn’t it? Prior to today’s opening the S&P 500 was loitering around 1,136. Roughly speaking, every 50 points change in the S&P currently represents a change of just under US$500 billion in net household financial assets.  Even with no change in risk appetite, this implies a fall of just under US$2 trillion in the value of households’ equity holdings, and a fall of the same amount in household’s net and gross financial asset – which stood at US$34.97 trillion and US$48.85 trillion respectively at the end of March 11.

This sounds dramatic: but so far, in fact the impact in both dollar and proportionate terms, is rather lower than in previous market collapses – a reflection purely of the more risk-averse construction of household portfolios. Here’s how I think US household net financial assets’ position is likely to have changed since 1Q11: the last two data-points are my estimates – but shouldn’t be far out. 

Unless the S&P has much further to fall, at this point is seems unlikely that the current round of fear will have the impact on household balance sheets that the bear markets of 2000 and 2008 had – the sizes of the financial shock at this point simply are not comparable. Maybe we’ll get there. Or maybe at some point, we’ll remember that the US is still an economy that is creating loads of jobs, and loads of ideas no other society seems capable of producing, and is paying down its debts at a rapid clip.