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Not the New Year markets we were expecting

Andrew Hunt says there are "relatively strange global weather patterns" impacting global financial markets, but once you cut through the bad short-term forecasts, the longer term looks good.

Sunday, June 15th 2014, 8:15PM

by Andrew Hunt

As many readers will no doubt remember, the first quarter of this year was supposed (as is now customary) to have been the period in which the “global economic recovery” became entrenched.

Unfortunately, we find that, according to the latest crop of data releases, both the US and Italian economies actually shrank over the first quarter; the German economy expanded but the French economy did not; Japan produced some growth ahead of its “fiscal cliff”’ but China’s economy slowed appreciably.

Unsurprisingly in this weak environment, world trade trends, which had picked up slightly over the fourth quarter of last year on the back of seemingly better Eurozone and Chinese trends, seem to have weakened once again and, perhaps more worryingly, world trade price trends have deteriorated sharply as more and more countries and regions have attempted to simultaneously improve their current account balances by cutting their import bills.

These disappointing global trade trends serve to confirm the generally weak message that has been offered by the latest crop of GDP releases.

In short, this was definitely not the type of global growth environment that the markets had been expecting to unfold only a few months ago.

The relatively strange global weather patterns that have been experienced so far this year may have exerted some impact on particular countries’ growth trends: cold weather in the Northeast of the US and a drought in the West seem to have subdued US trends to some extent (although not by as much as we suspect that people have supposed) while warm weather in Europe evidently boosted German construction and investment – but reduced activity in the gas-producing Dutch economy.

Overall, it is our conclusion that changing weather patterns impacted parts of the global economy in different ways but, “on average”, their effects were probably about neutral for the world as a whole. 

Therefore, rather than blaming the weather for the lacklustre growth numbers, we would instead tend to focus on the still-extremely-weak household real income trends around the world and (to a lesser extent) on the fact that, unlike the situation that prevailed during much of the similarly-income-constrained Noughties, households have not been able to circumvent the income constraint on their spending by using more credit or by withdrawing equity from their homes.

These would seem to represent much more fundamental constraints on the global economy’s ability to grow than some unusual weather patterns and we would suggest that these are factors that are likely to remain in place throughout 2014 – or beyond.

We are not certain, though, that markets have yet fully recognised that the weakness in growth may not be transitory.

As it has transpired, we have visited many of our clients around the world over recent weeks and we have also spent some time looking at who and how many people have been opening our regular emailed reports.

If we have one “general conclusion” from our albeit rather unscientific observations, it is that despite the reasonably consistent message that the financial markets and the objective economic data have delivered to the contrary, most investors still want to believe that the global economic recovery has already begun and that the central banks will soon be exiting their quantitative easing policies or even raising interest rates.

In fact, we might go so far as to suggest that it seems that people are simply tired of weak growth stories and actively looking for good news on growth if only to break the “monotony” of recent years.

Meanwhile, we also suspect that parts of the sell side probably feel unable to revise down their own forecasts and expectations following all the effort that they put into telling the growth rebound story at the turn of the year. 

Despite this forecast inertia, though, we are beginning to get the sense that this “recovery is imminent” view is finally beginning to come under a degree of pressure as central banks have – with one or two notable exceptions – started to produce some rather more dovish noises (such as the PBoC, the ECB and – to the markets’ evident surprise – even the BoE).

Even the Federal Reserve, which has at times been talking “tough”, seems to be loath to actually taper its bond purchases aggressively.

During April we did find that the Federal Reserve’s five-week rolling bond purchase totals averaged around US$61 billion, which while lower than March’s US$70 billion monthly average, nonetheless represented a still-massive US$750 billion annualised rate of implied debt monetisation.

Given this rate of liquidity creation by the FRB, we have not been surprised to find that US broad money growth has remained robust, that bank lending to the financial sector has remained strong and that capital flows from the US into the EM and other locations have evidently increased over recent months.

Rather intriguingly, and in another break from the consensus view, we find that the one central bank that seems to be giving more equivocal or even hawkish noises has been the Bank of Japan.

Perhaps because of the impact that the weak Yen has exerted on household real income trends and the nominal current account balance, or more likely as a result of the amount of “government bond risk” that the BoJ has been obliged to acquire under Abenomics in return for seemingly little or no structural reform from the government, the BoJ has slowed its rate of net acquisitions of JGBs in general this year and it seems to have announced a suspension of its buying activity at the long end of the curve.

Meanwhile, in private, the BoJ also seems to have become rather more critical of Abenomics and we sense that it may be at least considering some form of exit.

On a probability basis, it is probably still more likely that the Japanese central bank will ease again over the next few months but we suspect that the probability has dropped from 90% to 60% over recent weeks.

Even without the BoJ’s help, though, it does seem that the FRB, ECB, BoE and perhaps even the PBoC are currently signalling or at least operating a more dovish stance than the markets were anticipating only a few weeks ago (although it seems that even now the markets do not fully believe what they have been hearing) and one result of this seems to have been a reflation of global capital flows. We are already seeing a resumption of flows into “cheap EM”; continued massive credit flows into China; and until last week at least, continued flows into the Periphery of Europe. 

Overall, we would attribute the recent generally “okay-ish” performance of developed world equities, the rally in the EM and the strong performance from fixed income markets to the fact that there has been remarkably ample liquidity within the financial system of late, primarily as the FRB’s continued heavy levels of bond purchases.

In the real economies, though, we have witnessed weak growth, a further rise in inequality and a growing threat from deflation that we would argue will one day pose not only a threat to developed world earnings but also a more concerted “political threat” to the markets. 

We find that politics is already moving steadily towards creating an environment of more (economic) nationalism, more state interventionism (that is, directed lending in the UK or minimum wage legislation in the US) and, ultimately, these developments will, we suspect, serve to undermine the financial markets. 

Therefore, it seems to us that unless the global real economy’s condition improves, there will be growing resentment of the financial sector that will eventually force a (further) political reaction that may ultimately undermine the prosperity of the financial sectors.

As the last five years have revealed all too easily, it is far from easy to revitalise global growth and average incomes and we suspect that, in reality, the authorities really only have two or three viable options in this regard.

The first option is simply to trust to luck and to hope that capital spending and employment pick up for essentially exogenous reasons. We believe that a surge in innovation and invention could lead to more capital expenditure, more productivity and valued-added growth and hence more household income growth.

Such an event is a complete wildcard that would be hard to predict, although we would suggest that governments could make this outcome rather more likely through enacting appropriate tax reforms as well as structural and financial sector reforms that encouraged entrepreneurism and risk-taking in the real economies rather than only in the financial sectors (and QE is probability guilty of creating the opposite situation…). 

The adoption of these types of strategies by the authorities would represent a gamble or leap of faith, but arguably governments might like to consider dismantling some of the less useful parts of the financial sector while attempting to encourage capital spending in the real economy to help foster the type of productivity renaissance that we believe is necessary to foster a sustainable supply-side-led global economic recovery.

Unfortunately, we observe few politicians that are willing to embrace this type of strategy, not least of all because the “pay-back period” may well be after their term in office has ended.

Therefore, it seems to us that if the “‘supply-side-led” solution that we describe above is unlikely to be adopted, then it will fall yet again to “demand-side” or standard quasi-Keynesian policies to address the situation, despite the fact that we suspect such policies traditionally only affect cyclical rather than structural factors.

Central banks have been attempting to provide some form of demand stimulus through their various iterations of QE and asset purchases for the last five years, with seemingly little in the way of sustained economic growth returns, but we would argue that this does not imply that further QE cannot be made to work more effectively, at least in the short term.

If we were to take a very simplified and arguably rather jaundiced view of the operation of QE2 and QE3 in the US over recent years, we would suggest that all that the FRB achieved when it purchased trillions of dollars’ worth of bonds was to allow domestic companies to issue huge amounts of corporate bonds that they then used to buy in their own shares rather than finance real investment and jobs growth; or it created easy issuance conditions for Emerging Market issuers so that the latter could build yet more tall buildings and excess industrial capacity that the world probably did not need.

Hence, QE2 and QE3 seem to have yielded little in the way of a global economic recovery.

We should also remember, though, that QE1 did in fact appear to work, in that although it did not create a surge in global capital flows, it was in fact associated with a rebound in economic growth and trade flows.

We would argue that the relative success of QE1 and its counterparts elsewhere was because the FRB and the other central banks were not at that time just buying bonds so that companies and investors could simply play Zaitech/Financial Engineering games within the confines of their own sectors.

The central banks’ bond purchases were instead directly funding an expansion of fiscal deficits. These expanding deficits explicitly gave US households more money to spend while the drop in the national savings rates that they implied were highly constructive for corporate profits. 

In short, QE1 involved directly monetising expanding budget deficits and this implied that the money that the central banks were creating was poured directly into the real sectors in which it was then spent, rather than lost within the financial sectors or lost to the types of global capital flows that frequently produce perverse or unhelpful outcomes.

The notion of expanding budget deficits and rising public sector indebtedness has become “taboo” or perhaps forbidden of late, primarily we suspect as a result of a certain book by Rogofff and Reinhardt that preached the “benefits” of austerity (or at least it provided the fiscal conservatives with a suitable framework for their opposition to expanding fiscal interventionism).

We do suspect that “It’s Different This Time” played a large role in ensuring that QE2 and QE3 primarily benefited the financial sectors rather than the real sectors.

To be fair to R&R, we would not advocate an unbridled fiscal expansion.

Were this to occur, and more and more of the global economy fall under the implicit control of the state, then we suspect that we will get more minimum wages and more white-elephant “Concorde”-type projects that ultimately serve no useful purpose but which contribute to the formation of the type of public-sector-controlled sclerotic and ultimately stagflationary state that the UK and others experienced in the 1970s.

Nevertheless, though, if one wants to see a “near-certain” economic recovery in the near term, policymakers may find that they need to junk austerity and instead follow Italy’s lead into a resumption of expanding and heavily monetised budget deficits. Interestingly, we wonder whether this is to where political developments are already taking us.

Therefore, we suspect that if the weakness that the world experienced within the first quarter turns out not to have been a weather-affected one-off but rather the result of more deep-seated problems, then we will see something of an end to fiscal austerity later this year (although the situation in Washington may hinder the US in this regard).

There would be, though, clearly a risk embedded in this policy that this “cyclical response” will evolve into the type of “structural policy creep” that led to the 1970s and so, while we might well advocate a little fiscal expansion later this year, we are more than a little concerned that this could (in much the same way as QE2 and QE3 did) be allowed to overstay its welcome and ultimately become a problem in its own right.

In a perfect world, we would see politicians give up on QE and embark on supply-side reforms but we doubt that this will occur.

Instead, we suspect that the recent disappointing growth numbers and the growing threat of deflation will lead central banks to be easier than the markets expect in the near term and ultimately we may find that governments around the world will look to heavily monetised wider budget deficits in 2015 as a solution to the global malaise.

In the longer term, such an outcome may be unwelcome but for the next few months at least, we suspect that financial markets will simply just follow the (easier) money.

We suspect that unless world trade price deflation accelerates too much further this quarter, risk markets may well move higher in the near term despite all of the problems that we have noted above.

Andrew Hunt
International Economist, London

Andrew Hunt International Economist London

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