Going ‘cold turkey’ – long battle ahead to wean financial system off its debt addiction

As we survey the wreckage of the global financial system in the January chill, we can be sure about one thing regarding the new year ahead: investment thinking has changed utterly. Any business model based on availability of cheap and abundant debt, such as private equity or hedge funds, is now questionable. Anybody with major amounts of debt to refinance in the immediate future or any other financial cash calls (such as margin calls) is carefully scrutinised.

Investors are belatedly focusing on cash flows (income or dividends). Capital gains have joined the list of endangered species. Prices must equate to the cash flows discounted back at higher costs of capital. Valuation fundamentals are once again fashionable.

A new order is being created in global finance.

The new investment mantras may well be:
(1) Flat is the new up.
(2) Debt is the new equity.
(3) Interest or dividends are the only return.
(4) If you're looking for the bottom of the market there's a special offer — buy one you get the next one free.

Banks continue to be in the intensive care unit and on life support. Availability of funding continues to fall. "Loan" and "debt" have become four-letter words.

The sharp decrease in debt levels is driving reduction in growth. Companies are cutting production, reducing staff and costs, suspending investment plans, raising equity and trying to sell assets to reduce debt. Consumer spending is falling sharply as individuals increase saving and reduce debt.

Falling investment earnings and lower interest rates also adversely affect the income of savers, reducing consumption. Rising unemployment (as companies retrench) and lower investment (as global demand collapses) mean the chance of a quick recovery is receding.

The central banks have flooded the markets with liquidity. The money unsurprisingly is not flowing through into the economy — banks are stockpiling the cash for their own needs. They are reluctant to lend as the real economy slows, with rising unemployment and lower corporate earnings. Banks also lack the risk capital to make loans.

Governments are resorting to lower interest rates and massive spending initiatives to stimulate growth. But such measures did not restore the health of the Japanese economy, which remains mired in a form of suspended animation. The rest of the world is struggling to avoid "turning Japanese".

The financial-sector bailouts (carmakers are apparently now banks) and government spending have converted a private-sector problem into a public-sector financing problem.

High levels of public debt and the poor fiscal position of some countries mean that the spending may be difficult to finance.

The continued reliance on savers in Asia, Europe and the Middle East is increasingly problematic given emerging problems in these countries.