Over the past month, equity markets have sold off sharply, volatility has spiked and Treasury yields have collapsed to levels not seen since the 2008/09 global financial crisis (GFC). The current sell-off can be attributed to causes such as the S&P downgrade of US credit rating, the enlargement of the European sovereign debt crisis and decelerating macroeconomic data etc. Not least important is that we believe markets are now pricing in an increased probability of recession.
Chart Source: Bloomberg
Although we had always argued that global economic growth post the 2008/9 GFC would be slow because the unwinding of credit bubbles usually takes years, we never expected a global double dip. We felt that the liquidity and fiscal support by policymakers would provide sufficient stimulus to keep the growth momentum going even if it was not very robust.
In any case, we had expected 2011 growth to be slower than last year’s due to the fading impact of the extraordinary stimulus measures. And we attributed the slower-than-expected economic indicators since 2Q11 largely to the high oil prices wrought by the unrest in the Middle East since the start of the year and the disruptions on economic activity from the Japanese earthquake and tsunami.
However, the disappointing first half GDP growth in the US economy which trickled to a less-than-one-percent annual pace and the expanding sovereign debt crisis on both sides of the Atlantic drove home the point that the structural mass of debt continues and will continue to weigh heavily on global growth.
Unfortunately, unlike 2009, policymakers do not seem to have the will and the wherewithal to solve the debt crisis and to boost their economies. The Fed no longer has the ammunition for another “shock and awe” strategy after stretching its balance sheet to almost USD3 trillion with two rounds of quantitative easing (QE). Even if it did, we know now that its impact on the real economy is at best mixed. The ECB may have climbed down from their dogmatic stance in the past weeks and started buying Italian and Spanish papers to drive bond yields down. But the 0.5% point interest rate hikes since the start of summer must surely look foolish in the current context.
Meanwhile, politicians are all stuck in second gear! European leaders have run out of ideas to solve the debt crisis which is now threatening to move on to the bigger countries including France. The markets are growing tired summit after crisis summit and the band-aid approach with politicians making just enough promises to hold off the rising tide for a few days before the floodgates open to another wave of pessimism. Meanwhile across the Atlantic, US lawmakers are gearing up but not so much to solve the pressing economic problems of stalling growth and runaway debt. Rather they are busy posturing for next year’s Presidential Election.
Our concerns stem from this vicious cycle of pessimism that is feeding the rounds. All this wrangling has taken a toll on consumer and business confidence. The weekly Bloomberg Consumer Comfort Index’s monthly expectations gauge dropped to minus 34, the weakest since Mar-2009. Businesses facing an uncertain future continue to shed jobs at an alarming pace.
Consequently, we are revising our growth estimates down. Our baseline is for the developed economies to experience slow anaemic recovery for at least the next few quarters. We maintain our base case that a double dip can still be avoided. Recent data suggest the labour and housing markets may be stabilising. The Chicago Fed Index is pointing to slow but positive growth. The Conference Board Leading Economic Index has been higher in 11 of the past 12 months. In the one year leading up to Lehman Brothers bankruptcy in Sep-2008 this measure contracted or was flat for 11 of 12 months.
From a policy viewpoint, the US is now in the hands of the Fed. Congress will remain dysfunctional until after next year’s presidential election. All eyes are now on Chairman Bernanke when he speaks at the Fed’s annual symposium at Jackson Hole this week. Last year, at the same function, he soft launched QE2 under similar threatening environment kicking off a 28% rally in the S&P500 Index that ended in April this year.
We expect the Fed to continue to pump the monetary tap even if the impact is diminishing. The idea is to stabilise the situation sufficiently for the “animal spirits” to return and long enough for a more functioning government after the election.
For Europe, we reckon there are only two possible end-games – break up or speed up towards a “Eurobonds” market. Both are unpalatable options. A break-up would certainly be damaging and painful but may allow affected countries to go back to their own pace with their own policies that are unique for their circumstances. However, there are sure to be consequences that are unpredictable and unintended which may put the entire union at risk.
The other option is to introduce “Eurobonds”. The idea is to replace individual countries’ debt with Eurobonds which are then backed by a joint guarantee of all member states. As expected, strong objections are coming from those countries with strong finances. First, the pooling of debt will raise the rates paid by the most creditworthy. Second, the lower rates enjoyed by the more profligate members will surely remove pressure to right their balance sheets and we are back to square one in terms of moral hazard.
We believe that the Eurobonds option has a fighting chance to work if it can be modified to account for the above criticisms. Ultimately, the question for the stronger economies is how much is saving the Euro worth, and for the others, how much control are they willing to cede to a central authority.
Alas, politicians are likely to take the path of least resistance and continue to muddle along until renewed pressure to act. With no end-game in sight, we expect volatility to remain high as the global economy is extremely vulnerable to further shocks.
Slow growth and more shocks to be expected. Where does that leave us in terms of investment strategy?
We continue to advocate caution and as always stay diversified and stay within the bandwidths of your strategic asset allocation. But within each asset class, we say go East! Go East to where the fiscal situation is healthier, balance sheets stronger and growth faster. Furthermore, most emerging markets, led by China and Brazil, have taken significant tightening measures to combat inflation. With the notable exception of India, which was late in raising interest rates, they appear to be near the end of the tightening cycle. This also means that when push comes to shove, they have the means for fiscal and monetary stimulus to boost their economies.
In a panic, these markets would often fall as much if not more than the developed markets. But we expect that when the situation stabilises, their superior fundamentals will exert themselves and outperform. We will continue to add Asian equities, fixed income and currencies on dips and market dislocations.
