Is There a Correction in Our Future?

The New York Times and the Financial Times have both warned recently of a possible stock market (and economic?) correction in our future.

The NYT said on March 24, "Investors who fail to take a hard look at the vulnerability of the American economy are courting tremendous risk. The fact that after years of profligacy the federal government is fiscally ill prepared to respond to a destabilizing downturn only increases those risks."

William Rhodes, CEO of Citibank, wrote in the Financial Times on March 29:

The low spreads, the tremendous build-up of liquidity, the reach for yield and the lack of differentiation among borrowers have stimulated both dynamic growth and some real concerns....

As lenders and investors inevitably become more discriminating, liquidity will recede and a number of problems will surface....

I believe that over the next 12 months a market correction will occur and this time it will be a real correction....

Today, hedge funds, private equity and those involved in credit derivatives play important, and as yet largely untested, roles. The primary worry of many who make or regulate the market is not inflation or growth or interest rates, but instead the coming adjustment and the possible destabilising effect these new players could have on the functioning of international markets as liquidity recedes. It is also possible that they could provide relief for markets that face shortages of liquidity.

Either way, this clearly is the time to exercise greater prudence in lending and in investing and to resist any temptation to relax standards.

My own view of what's going on is that interest rates price both inflation and risk. When inflation was higher and interest rates were higher, they more or less incorporated the risk factor, i.e., it was relatively small in comparison to the inflation factor. As inflation fell and interest rates fell with it, the risk portion shrank in tandem. However, if anything the risk has been going up, not down, as hedge funds, private equity, and derivatives have played a more and more important role. In addition, the entry into the world economy of new major players such as China and India, who have kept inflation artificially low by depressing wage costs, has also kept the risk factor artificially low while actually increasing risk.

As Rhodes said, someday investors will begin to notice this underpricing of risk, maybe not until something happens to highlight the risk factor. The sub-prime mortgage sector is probably not big enough in itself to do this, but if some other bump comes along while sub-primes are still a problem, that might do it.

Politically, it should be noted that while interest rates have fallen for big investors, they have risen for small consumers. In addition to the sub-prime mortgage scandal, which came to light because the interest rates on these mortgages increased dramatically, credit card issuers are raising rates far above the prime rates they charge wealthy individuals, as well as adding all kinds of fees and penalties. This doesn't represent risk pricing so much as it does hucksterism and usury. Lenders are taking advantage of people who have gotten themselves in trouble by borrowing too much. This is illustrated by the fact that people in credit trouble often get more offers from lenders ("loan sharks," even if they are big, fancy banks) than people with good credit histories.