The current rally in financial markets is being driven, and might well be driven further, by a sharp easing in monetary conditions after the May sell-off. Long-term rates fell in the US and Europe, and monetary tightening in Japan was more than offset by exchange-rate weakness.
So where do we go from here? One of the factors that could cause liquidity to contract is inflation. In the US, wages and salaries in the private sector grew at an annualized rate of more than 15% in the first quarter of 2006 and 8.5% in the second. The increases were fairly broad-based, including those sectors where bonuses do not distort the figures.
This might be a sign that liquidity-generated inflation is spreading from financial bubbles into the output economy. As US productivity growth is trending down, unit labour costs jumped 5% year on year in the second quarter of 2006. And unit labour costs are a reliable predictor of traditionally measured inflation.
| Inflationary pressures hit output |
| Capacity utilization in Germany, Japan and the US |
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| Source: Datastream |
Globally, policy interest rates are still lagging capacity utilization and labour markets, which are tightening fast. OECD industrial production is already accelerating. And household incomes will head up again, boosted by lower petrol prices and buoyant work income. In 2007, the OECD is likely to grow by 3% despite a slower US. Thus world capacity and labour markets will continue to tighten and push up inflation.
The rise in prices of US imported manufactured goods is symptomatic of the waning of the impact of China’s great deflationary export-led expansion. It will boost measured inflation worldwide.
So it will not be long before both margins and output prices are pressured by rising costs. Indeed, the US Federal Reserve’s flow-of-funds accounts for the second quarter of 2006 show that the US corporate financing gap (net cashflow less investment) is once more in the red after being in surplus last year. Non-financial corporate debt is now rising at a 7% annual clip and is catching up to the rate of growth in household debt. We might have reached a peak in corporate surplus savings.
Armageddon postponed
From here, the outlook depends on the shape of the economic cycle. To be bullish on financial assets, you have to be bearish on the economy. The contrary also applies. In other words, if the collapse of housing were to push the US into recession, interest rates would fall and the next liquidity cycle would start from there. Armageddon would be put off for another few years while the world happily built up even more extremes of leverage.
On the other hand, if the US economy booms because the consumer is still taking a lot more income from work this year than last and it gets spent, inflation will pick up and so will the cost of capital. That will hit the equity and bond rally.
Slowing, not stalling
What will it be? Weighing it all up, I come out on the side of a US economy that slows (mainly in the manufacturing and construction sectors) but does not slip into recession. It continues to grow thanks to a less resilient, but still expansionary, consumer. It is a scenario where cost pressures (which have already spread way beyond commodities and into the service sector that makes up 80% of the US economy) will start to have an impact on profits and will inflate output prices.
The mechanism is simple: once growth slows, productivity growth will tank and unit costs will accelerate. Everyone who runs a company knows how easy it is to pay more for inputs and keep output prices flat when sales are booming, and how hard it is to do so when sales are flat or falling. There’s no reason to think that an economy is different.
Inflationary cost-push will be made worse globally because both Japan and Europe are going to be growing too, helping to close the global output gap and tighten world labour markets. The fear that Japan and Europe will weaken will prove unfounded because the domestic consumer and investment will kick in to offset any slowdown in exports.
This will leave the Fed hooked on a dilemma: chase growth or conquer inflation? I suspect that the Fed will be back to tightening in a few quarters. So the continuing stock market rally is probably just a momentary pause in the tightening of global liquidity. It will end soon.
Against the Tide