Against the tide: Autumn coda
Financial markets should benefit from recent policy moves in the eurozone and the US, but the underlying economic picture remains uncertain and potentially grim.
The start of autumn has already brought positives, in the form of measures to save the euro and revive global economic growth.
Global growth has been a source of justifiable pessimism. It will remain weak by historical standards. A deleveraging world leaves the US with 2% trend growth, Europe with 1.5% and Japan much the same. Economic data have been below trend for a while. And when growth falls below trend, pessimism abounds.
The uncertainty of the ultimate outcomes, which range from depression to hyperinflation caused by the unsustainable burden of debt in all the main economic blocs, means that expectations are more volatile than the economy itself. That will remain the case for as long as debt remains unsustainable. It’s not the stuff of great depressions but rather of grey tomorrows.
In this environment, the good news for investors is that the Federal Reserve has taken the plunge and opted for another bout of quantitative easing (QE3), and this time asset purchases are open-ended. The Fed will go on pumping in liquidity until the US labour market shows signs of life. In the meantime, financial asset prices will benefit.
And the European Central Bank has also acted, with its plans for outright monetary transactions (OMTs). It will use its limitless resources to bring Spanish and Italian debt yields down to more sustainable levels and stop eurozone financial fragmentation. Europe’s politicians are also tortuously getting around to setting up a new financial regulatory authority. That will open the way to recapitalization of the banks – a crucial element in breaking the fatal link between banks and the sovereign. And the European Stability Mechanism, the permanent bailout body, has been passed as legal, for now, by the German Constitutional Court.
It’s even possible that the Bank of Japan will make more concerted efforts to boost liquidity than hitherto. In emerging markets, Brazil is likely to grow again because of wide-ranging and mostly inappropriate short-term policy measures that will weaken the structure of the economy in the long run. South Africa will remain a mess – but not one that will blow up the world. That should be just enough to make emerging markets pass muster, without delivering the stellar performance that once characterized them.
All this marks a dramatic step forward for markets, if not for the economies. The risks to this positive view are that Spain does not apply for any bailout package, or Italy continues to play silly games and moves towards a political vacuum after Mario Monti steps down as prime minister next year.
The other big risk is China. The risks there are the hidden bad assets of local government, real estate and the shadow banking system. It is hard to imagine that China’s way out of the economic slowdown – boosting fixed-asset investment to 50% of GDP – is not indicative of inappropriate investment.
However, as the Chinese state is involved at every level of the process, it can avoid collapse and stimulate the economy enough to achieve a rather weak growth rate associated more with the middle-income trap than the China miracle of yore.
The geopolitical joker in the pack is a potential Israel-Iran war. This is probably unavoidable, even if it is delayed until after the US presidential election. The consequences are unpredictable. With the risks against the autumn positives quite high, gold remains a hedge against calamity. And I would hold US high-yield bonds. Equities might benefit from central bank largesse. But the emerging market growth model (excessive savings ploughed into exports of manufactured goods) is kaput and the transition to domestically driven growth models is at best inchoate. And corporate profits in the US are set to stagnate or even decline over the next year. So autumn’s codas might eventually pass into winter.