Against the Tide: Steaming economies will evaporate liquidity
The world economy is set to keep growing fast for the next few months. But this will take an inevitable toll on the cost of capital, which is already rising.
My view of the world is different from the consensus. Far from suffering a recession, the world economy will grow faster for the rest of this year. That will raise inflation and the long-term cost of capital. This will exert greater downward pressure on equity and bond prices than faster growth will support them.
Cracks in the liquidity boom that have driven stock markets to new highs are just beginning to appear, with rising bond yields, particularly in the key middle maturities, wider corporate debt spreads and tighter bank lending. The equity bull market might last through the summer but world bond markets are already sagging.
In the second half of this year, the OECD economies will steam at the seams, with growth moving nearer 4% rather than dropping to 2%. The global inventory correction in manufacturing is over. The US housing bust has gone the way of its predecessors in Australia and the UK. It has failed to spread to other areas of the real economy. Nor has it curtailed credit availability in other sectors. Take-home pay growth in the US remains powerful. American households continue to get wealthier, despite the fall in house prices. This is not the stuff of recessions.
Why it will get costlier to rebuild capacity
US resource utilization, standard deviations from average*, and real three-month interest rate deflated by core CPI (% yoy)
Source: CDIAC, CRU
The steamy global growth situation means that the job market and capacity utilization everywhere will tighten. Long-term interest rates will rise – and they have started to already. Central bankers will be forced to tighten more, and faster, so reversing expectations in many markets that interest rates will stop rising. That will increase stock market volatility. Consistent, transparent central bank policy is widely credited with making a big contribution to falling financial asset and currency volatility. Reverse one and you reverse the other. That’s symmetry for you! A strong world economy will throttle financial market performance. How come? The answer is liquidity contraction — not the sort of contraction of days gone by, when a booming real economy sucked spare cash off the balance sheet, leaving less for financial assets. Instead, it will jack up the cost of long-term money. And it is the long-term cost of money that is critical to liquidity creation in the new scheme of things, not policy rates.
The cost of liquidity rose sharply in the February global sell-off, based on fears that pressure was being released from the Chinese equity bubble and the yen carry trade was reversing. And the subsequent recovery has not entirely reversed that rise.
Yen borrowing to buy high-yielding assets globally has not returned to previous peaks. Top niche (AAA) US corporate debt yield spreads over treasuries have not fallen back to the lows in place before the February sell-offs. US bankers’ willingness to lend is no longer increasing. US interest rate swaps (the biggest section of the derivatives markets) are starting to point to higher 10-year yields down the road. And the spreads on credit default swaps have never fully recovered. Most significant, the cost of 10-year US debt has jumped to well over 5%.
Do these cracks in the liquidity pyramid spell a catastrophe? It is certainly not a forecast that I would stamp "imminent". But a booming world economy, with the US, EU and Japan all dancing the mad fandango, does promise the big C ultimately.
Why? Because there is, and has been for a very long time, a yawning mismatch between the cost of debt (low) and resource utilization (high). This is always (and will be again) resolved by rising inflation and cost of capital, which means a big time-shift for asset prices down the road.
David Rocheis president of Independent Strategy Ltd, a London-based research firm. www.instrategy.com