| The top of the Matterhorn may look flat to an ant. So may this cycle to most commodity investors |
There are three possible outcomes of the present environment for the global economy and financial asset prices. The world economy might be in a temporary soft patch that will soon give way to stronger growth and rising equity and commodity markets. Or it could be heading into a deflationary spiral of recession, where only the safest government bonds and gold will perform. But most likely, the world is in a lengthy, post-stimulus grind of deleveraging. That means slow growth and volatility in financial asset prices.
Soft patch, deflation or the slow grind of deleveraging: one of these outcomes will be the fate of the global economy – and the determinant of asset prices.
Three models
The soft patch view attributes the slowdown to a peaking of commodity and energy prices; the Japanese disaster, for which there will be a normal S-curve bounce-back (and there is evidence that’s coming through); and an inventory cycle that will cause global manufacturing output to run below final-demand growth. In this prospect, all these factors are temporary; in the second half of 2011 the global economy will bounce back to ruddy health.
Deflation is the other extreme – a return to an ice age: too much capacity remains idle; debts are excessive; inflation is absent – except for commodities; and bond markets are telling us of an imminent downturn, as are the aggregates for credit and broad money – at least in the big economies. In a word, the world is retracing the path of post-bubble Japan.
The third option – the slow grind of deleveraging – sits in between. It sees another five years of balance-sheet restructuring in the private sector and 10 years for the public sector. There are insufficient household income gains and spending to drive real demand at anything but fairly low rates. Government won’t and can’t help growth.
| US real employment and personal disposable income |
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| Source: Datastream, Independent Strategy |
The rolling sovereign credit crisis will be exported from the eurozone periphery to the global core of the US and Japan. That will limit growth, but the world will not experience the great depression predicted by the deflation scenario – just the slow grind of growth being curtailed by putting right previous excesses.
This deleveraging model is not a stable world, but one that bounces around the jar of possible outcomes like a trapped bluebottle. At times, deflation and depression will seem quite likely. At others, the global economy will seem healthy and dynamic. Inflation will stay around 4% to 6% a year depending on the country – enough to erode debt slowly, but enabling central banks to keep interest rates low in real terms.
The pattern of the US Federal Reserve’s QE2 programme of quantitative easing is not that clear-cut under this scenario. QE2 has two components: printing money and underpricing it. The Fed will stop the former, but not the latter. Less money growth means less asset price inflation. But cheap money continues to make the dollar attractive as a funding currency for all sorts of speculative trades. The two variables will tussle for influence and asset prices will reflect this. Market volatility will remain high.
False euphoria
Under the deleveraging scenario, the current weak path heralds the return to a low-growth path consistent with balance-sheet restructuring. The euphoric burst of growth we saw for a short while was little more than a bounce-back from depressed levels, through massive, but unsustainable, policy stimulus.
We are probably at the top of the commodities cycle, because growth is past the peak and monetary stimulus will be less. Yet the top of the Matterhorn may still look flat to an ant living there. So may this cycle to most commodity investors.
As deleveraging is a scenario whose warp and woof is like the slow progress of a sailing boat tacking across a watery landscape under a leaden sky, no single asset allocation provides a fast investment anchor. As the sovereign debt crisis ricochets around, US and core European bond markets look way overvalued. Currencies and other asset classes will wax and wane.
David Roche is president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com