In the next 12 months, the asset and debt bubbles that underpin global imbalances and growth will be deflated. Today’s bubbles – from US consumer debt and much of the global housing market to the China story and umpteen bond markets – are all a result of underpriced capital. The cure, as always, will be a repricing and reduced supply of capital.
Financial markets will experience negative returns for bonds and equities, outperformance of gold and a weakening of the US dollar and the commodity currencies against the euro and the yen. Commodities will suffer from lower global growth and the hissing sound of hot air escaping from the China story. There will be shrinkage of risk appetite and a rise in volatility for most asset classes.
The US is the centre of all asset bubbles and excesses; it will pay the price for this. At the same time, the eurozone and Japanese economies are developing autonomous economic recoveries. Monetary policy in both Japan and the eurozone will tighten. The US will then be the sub-par performer in growth and inflation. The current gap between US and Japanese and European interest rates and growth will narrow. The dollar will be the fall guy as capital flows elsewhere.
| Corporate savings/investment balance |
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| Source: Datastream |
The investment-limiting effect of past excesses is now on the wane. Corporate investment is recovering everywhere. US, Japanese and even German investment is rising sharply. The output gaps in both Japan and the US have been eliminated, return on capital is high and corporations have enough cash and borrowing capacity to fund more investment.
However, as the growth in corporate profits peaks and begins to slow, the net effect of reviving investment will be that corporate cash levels are insufficient for investment in financial markets. This is the classic case of a reviving economy sucking liquidity out of the financial markets and into the ‘real’ economy. These are the factors that will cause the real cost of capital to rise. Asset prices will necessarily adjust to that development. Whether this happens suddenly or slowly will determine whether the outcome will be a long, slow grind or a violent financial market crisis.
The final chapter in this outlook is rising inflation. The feeders of this are excess money, profligate governments and tightening capacity utilization in the productive sector. The cost increases that will push forward along the production pipeline are far more widespread than just energy costs, while increasing inflationary expectations that will make rising prices acceptable are in place.
Inflation is a major risk for all long-term financial assets. It will affect volatility and real bond yields by increasing the risk that future income streams will be worthless. That will herald the return of the short economic cycle and upset profit projections for equities.
All bubbles begin and end in financial markets, with the real economy being affected in between. After the game is over, wealth destruction drags down consumption levels, and underinvestment sets in for a number of years. Society moves to a higher level of thrift and a lower level of risk tolerance. And so it will be for the present global set of bubbles and excesses.
Lesson to learn
But if there is one lesson to be learnt from the low level of volatility sustained in both financial markets and economies last year, despite a number of fairly major icebergs in their path (Refco, GM, deflating housing bubbles in UK and Australia, and so), it is that the markets are getting good at absorbing risk, which means risk is well distributed among those who can bear it.
This is pertinent to predicting financial asset performance and the path of the global economy. It does not change the final dénouement or the process of adjustment. But it does shift the speed from that of a sudden shock to a slow grind. That lessens the likelihood of a quick flip into deflation for the global economy, which is what asset price collapse would entail.
On the contrary, it increases the likelihood that the whole process, including uncomfortable levels of medium inflation, will drag on. That will weigh on asset prices for longer. Indeed, if the global economy continues to cruise along at 4% growth well into next year, it will only make a revival of inflation more likely and the repricing of capital inevitable.