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At the beginning of the year, my conviction was that higher global growth and interest rates would eventually damage your financial wealth. I've not changed that view. But remember, we deal in a world of dreams. What the market dreams, not what happens, is what sets prices (at least until reality wakes the market up). And currently the consensus is dreaming of low growth.
What would be the consequences of a low-growth scenario?
First, it spells big doubts about European monetary union (Emu), as unemployment and government deficits soar in Europe. That means a strong Deutschmark and good Bund performance. The bond and equity markets of countries with poor public finances, such as Italy, Spain and Sweden, will suffer, while European core equity markets will be affected by Deutschmark strength against the dollar and peripheral countries' currencies.
Second, slower us growth, but continued Japanese recovery after a summer plateau, would suggest a further slight weakening of the yen against the dollar, as us-Japanese trade moved towards equilibrium, and capital outflows continued from Japan. But the drama of last year's big yen/dollar devaluation would still be over; there's little room for further improvement in the us trade account.
In south-east Asia chronic trade deficits would be made worse by lower us growth. That would keep south-east Asian currencies under pressure against the us dollar. Domestic interest rates would be higher, growth lower, than markets expect. Profits would also suffer.
Can the market dream of lower growth become reality? That hinges on two factors. In the us, rising (market-determined) interest rates could "self-regulate" the us consumer to save more and spend less. The 100 basis point rise in us bond yields since the beginning of the year could already have ensured a slower economy. Housing demand has shown signs of weakness, and consumer credit is high. The higher savings rate recorded in June may be the first indication that higher interest rates are hitting us consumers.
Growth could also disappoint in core Europe. That would scuttle Emu or at least prevent it happening on time. Unemployment would continue to rise. Budget deficits would worsen. Maastricht criteria could never be met. And Germany would never give up the Deutschmark until its financial house was in order (let alone those of future Emu partners).
Growth failing to pick up in core Europe is a not unlikely scenario. The latest German figures on foreign and domestic demand are at best ambiguous: industrial orders and output are creeping up, but export orders, retail and wholesale sales, employment and automotive output are weak. France is mired in a recession which even French national statistical institute insee can't convincingly call growth. In peripheral Europe, export gains from competitive devaluations have run their course and fiscal deflation is depressing domestic demand as well.
But here's the conundrum: if global growth were to slow, why wouldn't central banks cut interest rates and so expand liquidity? The answer is: it's already happened. Central banks cannot cut by as much again, because they haven't raised rates since. And the global productivity miracle is on the wane come high growth or low. That will hit profit margins sooner or later.
So if global growth does slow, us equities will eventually correct, as interest rates will stay stable and corporate earnings will disappoint but not straightaway. Expectation of stable us short-term interest rates and lower long-bond yields will provide equities with short-term support. Also, Japanese equities are likely to be weak, as the yen won't weaken much more to help, and rising interest rates will hinder valuations.
Strong growth most likely
European core equity markets would be the fall guys in the case of lower growth, a stronger Deutschmark and a weaker dollar. Corporate earnings growth would disappoint and lower short rates wouldn't help much. The uk, with its sound but sustainable low growth, would be a defensive equity investment.
South-east Asian equity markets would become a backwater for a while. Latin America might like stable us interest rates but a slowdown in the us economy is bad news for Mexico and Brazil. All in all, a slow-growth world is no dream ticket for emerging markets or their currencies.
But this low-growth scenario is only a dream. I still think continued strong global growth is more likely. German growth will accelerate over the next 18 months. More growth in Europe would initially make politicians and investors more sanguine about Emu. So European yield spreads would be dominated by "convergence" and narrow towards German Bund yields, even if the Bundesbank were to reverse its current rate-cutting strategy and begin to raise short-term rates, as I expect.
But, as I have argued in this column before, this growth pick-up will not spread efficiently enough from Germany to France to enable France to bridge the growing gap in quality of fiscal management between the two countries. So France will fail to meet the Maastricht criteria.
This means that, come high or low German growth, European monetary union is for postponement (with a short-fuse timing on that happening if growth doesn't return by the autumn). The current climate of convergence will turn into divergence; bonds and currencies of high public-deficit economies will be pressurised. Europe will become a centre of cosmic volatility over the next year, and cracks will appear in the current smooth surface of the Franco-German axis as soon as this autumn.
David Roche is president of Independent Strategy, a London-based research firm
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