As we close in on four weeks since the Lehman Brothers bankruptcy bombshell, it appears that the pieces are now in place for financial markets stability. Broadly speaking we have seen four sets of extraordinary measures taken in recent weeks on the part of public and private actors: enormous liquidity made available to financial institutions under various programs from the world's central banks; the passing of the $700 Billion Troubled Asset Relief Program to purchase illiquid mortgage-backed securities; billions of dollars of direct capital injections into U.S. and European banks; and coordinated interest rate cuts across the world (including the European Central Bank, whose recalcitrant leader Jean-Claude Trichet was last seen rearranging the deck chairs on the Titanic as it took on water). These actions seem to be having diminishing positive impacts on the global capital markets however, as credit markets are still far from functioning normally and equity markets have been in freefall. Investors are understandably nervous and this is reflected in the VIX index, which measures expected future volatility, which has surged to two-decade highs... higher than in the days after 9/11, higher than the Long-term Capital Management debacle, higher than the Asian Currency Crisis... you get the picture (see "It will fluctuate" - JP Morgan, when asked what the stock market would do - August 1st for more on the rise of volatility). Nonetheless, financial markets will survive and eventually will get back to doing what they're supposed to be doing, distributing capital to investment opportunities. The economy on the other hand, is another matter.

When evaluating the current mess in the capital markets, it is tempting to look to past episodes of turmoil to understand what the future course of events will look like. The difference between the events of 1987 or 1998 and today is that during those past events, the economy, and more specifically the consumer, were in good shape. That is not the case today. Today the U.S. consumer (we will refer to U.S. consumer spending as it accounts for more than 70% of U.S. GDP and 18% of Global GDP, but most of our observations are applicable to consumers throughout the world's developed economies) is facing several important headwinds that will keep spending weak, including:

• Employment: The U.S. economy has shed 760,000 jobs so far this year and the job losses show no signs of abating yet.
• Declining Asset Values: House prices have declined 19.5% since their peak in July 2006, which in tandem with weak investment portfolios have negatively impacted household balance sheets.
• Credit: This is the big one. The U.S. market has been in a secular credit boom since late 1992 (i.e. the end of the last full-scale recession) and now with consumer leverage somewhere around the eyeball level, that boom appears to be coming to an end. This negative credit cycle will amplify the decline in consumer spending (not to mention commercial and industrial spending) as consumers reduce their borrowing, liquidate assets, and pay down debt. To boot, financial institutions are in the midst of sharply tightening their lending practices, reducing credit availability (see Smells like tough markets - August 29th for more details). The chart below shows the monthly changes in consumer credit outstanding going back to WWII. In August, credit declined by $7.3B, the first outright monthly decline in over ten years and the largest monthly decline on record... and that was August. This is a bad situation and it's going to get worse.

Brother, can you spare a dime?

All right, so where does this leave us? We've descended into the first full-blown consumer-led recession since the early 1990s. The deleveraging process will magnify the negative impact of the slowdown in economic activity. The impacts will be global.

But,

The sun will continue to rise and set. The financial system will eventually resume functioning. The major investment themes we have been discussing over the past few years, namely the industrialization of major emerging economies and the constrained global food and energy environment, will continue to exist. In fact, given their massive capital reserves and comparatively conservative banking industries, the emerging economies appear to be on reasonably sound footing.

However,

Investors will not care about any of this in the short-term. Newspaper headlines will continue to be negative (or horrendous) for some time yet, and fear and pessimism will be entrenched. The long-term opportunities are fantastic; the short-term situation is frightful.

In other news...

It would appear that times are tough for everybody, including the buyers of premium race horses. Although the market is far from collapsing, it seems that the oil barons and real estate tycoons are not as enthusiastic as they were a year ago when prices were on average 10% higher. Tough times indeed.