Expect big dislocations in the global economy and financial system. Irresponsible central banks are force feeding free money to an inflated financial sector. The financial sector in turn feeds asset and debt bubbles at all levels of the economy, but particularly those involving the ignorant and super-indebted consumer.
This will bring higher inflation and lower growth and will halve returns from traditional long-term financial assets over the next few years. At least half of the wealth creation of the disinflationary decades was made possible by falling inflation and interest rates. That caused rises in the wealth multipliers (the price of an asset divided by the income stream it produces) of everything from equities to bonds and housing.
But the value of an asset cannot rise faster than the value of what it produces for ever, and the end of disinflation means the process is over. Returns from financial assets will in future be meagre.
Indeed, if politicized central banks (see The fourth generation of central banking) and anti-free market and fiscally irresponsible politicians tolerate this renascent inflation, the world will move back to the negative real asset returns of higher inflationary periods like the 1970s. Alternatively, if inflation is properly combated with tight money and fiscal prudence, many of the debt and asset bubbles will start to leak.
Then the world of moderate but rising inflation will be succeeded by the rebirth of deflation as the bubbles collapse. Helping deflation along will be ageing populations in Japan and Europe (whose spending patterns increase the cost of capital by decreasing savings) and geopolitical fragmentation.
But let’s look on the bright side, which means looking to the short term. Between now and the darkness of this long-term financial winter lies a spectacular autumn sunset. We are entering another economic sweet spot that can last at least until the end of this year. It will be that way because global growth will remain positive, even if it is slowing already from its recent dizzy pace. The US consumer will remain the driving force. As the Chinese economy starts to slow sharply, commodity and oil price inflation will moderate and US wage inflation will not be transformed into accelerating output prices thanks to new economy productivity and continued price competition in global markets.
On this view, expectations for inflation and interest rates become more favourable for markets during the autumn. In Europe unit labour costs are already rising less quickly than prices. Profit growth is still good in the US (15% to 18%), if rising less spectacularly than in the past. And it will accelerate elsewhere, particularly in Japan (30% to 40%) and in Europe (20% to 25%).
There is also cash piling up in institutions, ready to buy equities. There are good valuation arguments for them to do so. The S&P is selling on a prospective P/E ratio of 17, Japan is around 18 and the rest of the world on 14 or so. This is not dirt cheap, but a lot cheaper than when markets were a major bubble.
Even bond market returns will be mildly positive as short-term inflationary expectations fall. Some big underperformers, such as emerging-market equities, debt and commodities, could also have a short spell in the sun.
There are several critical factors that could invalidate my view. First, slowing labour productivity growth in the US could cause a big profit disappointment or a nasty inflation surprise. More jobs are not easy to reconcile with sustained high levels of productivity growth. Indeed, unit labour costs are now moving up.
Any profit margin erosion would kill equities, while faster inflation would hit both bonds and equities and possibly the dollar – now dependent on speculative portfolio inflows. Thus a nasty profit, inflation and interest-rate surprise is high on my risk list.
And then there is the possibility of a win for Democratic challenger John Kerry over George W Bush in the November presidential elections. If that looks likely, markets won’t like it.
My own cynical view is that as one dog goes, another comes along. So not much changes in the farmyard. Kerry will be much more subject to congressional scrutiny and control than Bush was post 9/11. That means that his silly ideas will be watered down until they become, well, water. But the fear of Kerry could nevertheless abort or delay the last great rally of this equity market.
The dollar is the other uncertainty. It is being held up by official and hot money inflows. The greenback will start to weaken again as the US becomes an increasingly inhospitable home for capital. But I think the dollar will benefit from rising equity prices for the duration of the economic sweet spot. Then the long-term decline against the euro (but not the yen) will resume.
Meanwhile, the rather dismal future will be held off for a while by an Indian summer.
