Posted by:
Andrew Bell

5 August 2010

With scare stories of “the wrong sort of beef” filling the silly season’s penchant for unusual news, there has also been an outbreak of cloning of bulls in the equity markets. The mood of high anxiety that pervaded investment markets a few weeks ago has given way to one of sceptical optimism, or at least acquiescence that there is sufficient good news from corporate earnings reports to question the pessimism that prevailed in the early summer. The line of least resistance for equities has been upward since June, despite evidence coming through that the widely feared slowdown in growth is indeed occurring. The reason is partly that there was a substantial shift in relative valuation between equities and bonds in the second quarter. The FTA gilts index rose over 3% while the FT All Share index fell over 12%. The more important reason is that the shrinkage in growth forecasts looks modest and shows no sign of turning into a repeat of the self-feeding collapse in confidence seen in late 2008. According to Consensus Economics, the US for example is expected to grow at 3% this year and next, similar to expectations a few months ago. UK growth is expected to pick up from 1.2% this year to 2.1% next, notwithstanding the fiscal squeeze in prospect, while Europe is expected to generate a similar, if bronze medal, rate of 1.5% in both years. China is forecast to achieve a “soft landing” from 10%+ growth this year to 9% next. Although there may be some reporting lag in the forecasts, the mood of doom set in during early May so there has been a reasonable time for it to percolate through.

In the event, the better immediate news on growth (probably a near-term peak in developed economy growth rates) and encouraging news from companies has restored some perspective to market sentiment. As frequently happens, the thundering herd (a generic rather than specific reference) pushed valuations to a point where the direction of the next move was obvious enough not to require too much taxing thought. The financial markets are hazardous places for those inclined to believe in efficient markets - in the same way dyslexics ought to avoid Pamplona (given the risk of ignoring warnings about being bored by a gull).

All is far from rosy economically, however. The likely course for developed economies in coming years is for growth to fluctuate around a level of economic growth that is sedated by the need to reduce debt levels. Fluctuations around an average growth rate of (say) 1.5% are likely to produce periods of near stagnation, producing regular scares that recession is returning. In contrast, when recoveries in the past 50 years have been paced at 3% or more even the downward fluctuations still generate positive growth. So, the art (or artifice) required from policy makers is to try to make the debt reduction process (by individuals and governments) orderly, which requires growth to be positive (otherwise the debt reduction will take the form of defaults) and interest rates to be low (involving a more subtle transfer of wealth from owners of cash to borrowers).

In order to allow growth to flourish in economies dogged by either government deficits or consumer debt (or both) the magic solutions are investment and net exports. Exporting to the parts of the world with rapid growth rates and the money to pay for goods (the emerging economies) requires both a range of goods that are intrinsically competitive and a cost base that will hold and gain market share. It is difficult for all the economies under pressure to do this simultaneously – the capital goods markets and emerging markets consumers’ pockets are not large enough. So, the developed world is doing the equivalent of sharing an oxygen bottle, containing the heady fumes of currency devaluation. The UK inhaled deeply in 2008 and again in early 2010 before passing the mask to Europe, where the most plausible (which is not to say it is actually plausible) way of addressing its divergent debt and competitiveness problems is to make the Euro more competitive. Once the threat of immediate collapse in the Euro and its financial system faded, the gas has been passed on to the US, where the hitherto best in class recovery has been fading. With elections coming up and the US’s dislike of self-denial, the dollar has been slipping since June. Passing the oxygen around may be enough to keep morbidity at bay but does little to increase overall (economic) fitness. For that to happen, areas of the world with state surpluses and low domestic debt (many emerging economies and Germany) have to increase their spending, in synch with the desire of the deleveragers to increase saving and sell more goods and services.

There are limited signs that this is happening yet, though imbalances have not worsened. So, for now, devaluation is being passed around like a communal lifejacket to the swimmer whose legs are tiring most but with the result that the previous wearer has to worker harder to stay afloat until the jacket comes around again. The process is not completely static, given that debt is starting to reduce and the pace of adjustment is less of a headwind to growth than the initial shock in 2008. So, over time the level and reliability of economic growth can resume an upward slope but the timescale is years and will require stimulative policies for longer than generally expected - UK short term interest rates stayed below 2% for 20 years after 1931. The risk of policy misjudgement (or intervening events) over a long period of very gradual progress is not minor.

There are some sources of comfort despite this cautious homily. Policy makers broadly seem to recognise the challenges to growth and the importance of keeping recession away. They will probably succeed in doing the right thing (though, to paraphrase Winston Churchill, after having exhausted all other possibilities). The policy stimulus from low interest rates will fuel a sustained search for reliable sources of income (and growth) which can replace the evaporated returns from deposit rates and the olden days when government bond yields offered a premium to inflation (before and after tax). Emerging economies seem likely to continue building out their domestic infrastructure and allowing consumers to spend more of their (rising) wages. If these things happen, time is on the side of equity investors and valuations still look low in many areas of the market that are not at particularly exposed to the economic cycle.

Comments or feedback are always welcome at theblog@witan.co.uk.

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