Don't Be Fooled by the Stock Market Rally, More Pain Ahead

By: MoneyWeek

The G20 protestors have got it all wrong. They shouldn't be on the streets of London , carping about bankers. They should be barricading the German embassy, demanding a stimulus package from German Chancellor Angela Merkel. You see, it's all the exporters' fault, this economic crisis we're in. Irresponsible countries like Germany , Japan and China have selfishly forced their top-notch cars and their cheap clothes on the innocent Americans and British.

Faced with such a vast array of quality products that we couldn't actually afford, it's little wonder that we borrowed ourselves silly – how could we resist? And now that the credit has dried up, the Germans refuse to goad their own consumers into spending more. Instead, they seem to expect us to come up with all the stimulus packages to get our consumers spending again. The cheek!

So it serves them right that we consumers of the world are going on strike...

People want to pay off debts rather than spend

Global trade has fallen off a cliff in recent months, mainly because of a slump in global demand, which hasn't been helped by problems in obtaining trade finance (this basically guarantees that the importer will get the goods and the exporter will get their money - for more on trade finance, click here: Is international trade grinding to a halt?).

This has hammered countries that depend on exports, such as Germany , Japan and China . Their customers in the US and the UK borrowed too much money, and now they're broke. And try as hard as they might to stimulate demand artificially, the consumer countries are finding it's not working too well so far.

For example, the Bank of England's moves to stimulate the British economy by slashing interest rates have certainly made life easier for those with big debts. The bad news for the Bank is that rather than spending that extra money – the stimulation part – they're using it to pay off their debts more rapidly.

In the last three months of 2008, homeowners repaid £8bn to their home loans. That's the biggest repayment seen since 1970, and is the third quarter in a row that homeowners have put more money into their houses than they've taken out.

It's not a huge surprise that this is happening. With house prices falling, people with big home loans feel vulnerable, so they're keen to repay their debt as quickly as they can. And because interest rates have been slashed, anyone on a variable rate shouldn't even have to increase their monthly payment to do so – as the interest on their bill falls, the amount of capital repaid rises. The flipside of all this, of course, is that savers lose out on interest payments, which effectively, are being diverted to repay someone else's debt.

Bad news for retailers

Now, the fact that people are paying off their debt is good news. The faster they can reduce it to a manageable level, the better the position they'll be in when interest rates have to start rising again. And once people feel comfortable again with their level of debt, they'll be happy to start spending again.

But if the extra money in debtors' pockets is being spent on repaying their debts, and savers are seeing their interest income stripped away, then that means there's no more money to be spent on the high street.

That's going to hurt retailers, and anyone else dependent on discretionary consumer spending. Since 2000, the BBC reports that about £300bn has been taken out in the form of housing equity withdrawal. At its peak in 2003, equity withdrawal accounted for about 8.5% of the average household's after-tax income.

But now the big housing cash machine has gone into reverse, sucking money out of the broader economy. The repayment in the last quarter of 2008 meant that 3.3% of after-tax income went on repaying debt.

Don't be fooled - there's much more pain to come for the economy

Meanwhile, as we mentioned earlier this week ( Why the G20 meeting could be bad news for investors ), the G20 is unlikely to lead to anything except mutual recrimination and more financial regulation. Exporters – unsurprisingly - won't see why they should be pushed into spending more money by profligate consumer countries. That'll leave the consumer countries like the UK , pressing on with printing money, which will continue to weaken their currencies and make imports more expensive.

As company profits are hit by falling sales and rising costs, that'll inevitably mean more lay-offs. So while there are signs of some green shoots just now – such as the rebound in the stock market, and the news that house prices actually rose in March (for the first time since October 2007) – don't be fooled. There's a lot more pain to come for the economy.

And the other major problem we face is that when a recovery starts to take hold, we'll need higher interest rates to stifle inflation, and higher taxes to pay for all the stimulus. And that combination could easily send us straight back into recession – but more on this in a future Money Morning.

By John Stepek for Money Morning , the free daily investment email from MoneyWeek magazine .

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