Against the tide: Brunettes not Goldilocks

David Roche
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There is just about enough global growth activity to sustain growth-dependent assets. But stagnating Europe remains the weak link that could disrupt peaceful progress.

The latest manufacturing activity indicators around the world were dire. They fell close to recession levels. Even China is struggling. Globally, according to JPMorgan’s global purchasing managers index, we are at 50.2, just above stagnation. Worse, the PMIs for inventories were way up. That is probably more forced stock building. That will be a tax on future production, as stocks will have to be worked off before output is boosted.

Nevertheless, I remain moderately optimistic. Behind the veil of pessimism trailing across the landscape are key bits of information that support the thesis of economic recovery later this year. First, global final demand continues to grow at 3% to 4%. As long as this is the case, output will eventually catch up with final demand at a growth rate (low but positive) that is consistent with a deleveraging, structurally afflicted, world.

This is a long way from recession.

Second, capital goods shipments are nudging up 8% globally on a three-month to three-month annualized basis and orders are up by 14%. Third, real disposable income growth is positive globally: up in emerging markets and in the US, neutral in Japan and down in Europe. There is enough of it to sustain moderate growth in world consumption. The US consumer sailed through the fiscal cliff and kept shopping. My guess is that the same goes for the impact of the US Congress sequester on government spending. The decline in energy and commodity prices, being driven more by supply than demand, will boost real household purchasing power too. Finally, wealth is on the rise everywhere, except in Europe. US household net worth is up 9% year on year and 29% from the bottom of the crisis. Stock markets are partly the cause, but a recovery in home prices plays a part too.

But this is no dumb-blonde Goldilocks scenario. That was when everywhere you looked at was the same – not too hot, not too cold – nothing to worry a pretty head about. No volatility. No risk. No economic cycles. Disinflation baked in the cake. Rising margins. And so on. Now the scenario is much more of a fiery brunette with jagged hair and some streaks from a doubtful bottle.

Take Asia. If the structural reform part of Abenomics works, Japan might become a hub of growth in Asia. This is because Japan’s natural rate of return on capital would rise, while the cost of capital would stay low. Then productive investment would take off. But if structural reform fails, the Bank of Japan’s added monetary stimulus will just flow offshore as capital flight and drive the yen down. That will hit the export share of other Asian economies and generally reduce Japanese demand for their goods. In effect, Japan merely sucks growth from elsewhere.

G3 New Capital Goods Orders Three-month to three-month, annualized

Europe is sliding down a seemingly endless glide path. The US is up and down but generally on the dance floor. China, Brazil, Russia and India all have highly visible structural flaws and reduced secular growth rates. They are no longer the untainted miracle economies of yore.

The point is that this all adds up to just enough global activity to keep growth-dependent assets rising, but not so much as to force central banks to abandon their policies of profligacy in a way that would meaningfully tighten liquidity, causing asset prices to tumble and currency carry trades to reverse. It is a sweet spot.

The brunette

But no scenario is for ever. This brunette scenario will end too. My guess is that Europe, for all the crisis-inoculation it has given investors, will be the cause. Debt sustainability is getting worse in France and Italy, not better. The timing depends on when Italy’s slide into ungovernability becomes evident. Or on when Germany blows the whistle on France’s economic model and the European vision (post Angela Merkel’s re-election as the head of a grand coalition).

During Japan’s lost decades, society stayed calm. The Japanese want a ripple-less social surface as the cultural norm. This is not so in Europe. Five years of pain have been accepted relatively quietly. But what if economic stasis is the European condition for a decade? Europe remains a political project without a single national identity. Policy making is forged around local self-interest and is divisive. Elections can be disrupted or won by nontraditional forces using social media – as Italy has shown. I doubt that another five years will pass as peacefully if undiminished economic pain is our lot.

David Roche is president of Independent Strategy Ltd, a London-based research