The purple patch for financial markets has rolled on almost without interruption since early March, but is the tint about to change towards a more “reddish” colour?
If we were emerging from a typical recession, this would be of peripheral concern. The real issue for investors is that even though the recession probably ended in June or July, there is nothing typical about it, or its causes, or aftermath. Higher volatility seems a given, but there is little confidence in the directional bias of markets. This is not about valuations, but about liquidity, deleveraging, and economic fundamentals.
The credit crunch has clearly abated and liquidity conditions have improved significantly. Indeed, benign liquidity conditions are set to continue in the face of what policymakers still see as a very fragile recovery. The Bank of England increased and extended quantitative easing at its August meeting. The Federal Reserve’s August meeting extended for a month but did not increase the Treasury purchase programme. This was always the junior part of QE. The decision about the far bigger, $1,450bn programme of agency and agency mortgage-backed security purchases will be made late this year.
The Fed, Bank of England and ECB may begin to implement exit strategies over the coming year. In China, the authorities are already talking the markets down a bit, and moves to tighten capital requirements and restrict loan growth overtly are likely before long. However, the need for, and economic effectiveness of, liquidity are not the same thing. The latter is hostage to the deleveraging of the financial system, which continues. Regulatory reform, deleveraging of balance sheets, changes to securitisation, and greater transparency in relation to loan losses and accounting practices, may take a long time to complete.
The crucial credit arteries of the financial system have become slightly less blocked. However, the restoration of normal credit creation should not be expected, until the economy has adjusted to the disappearance of shadow bank credit, and until banks have created the capacity to resume lending to creditworthy borrowers. This is still about capital adequacy, where better signs of organic capital creation are welcome. More importantly now though, it is about poor asset quality, especially as defaults and loan losses rise into 2010 from already elevated levels.
Financial markets need confidence in self-sustaining economic growth, which the deleveraging cycle has compromised. Without credit, demand growth depends on aggregate employment and income, both of which are liable to deteriorate further in the coming year. Household consumption will remain depressed as record household debt ratios are reduced, savings continue to be rebuilt, and many households cope with negative housing equity. Company balance sheets have been under pressure too. In the second quarter, the US enjoyed a 6.4 per cent annualised growth in productivity. But, having virtually exhausted non-labour cost-cutting opportunities, companies have been cutting man-hours faster than output has fallen. This hardly bodes well for household consumption.
Investors should heed the information content of two indicators – the low frequency data on nominal GDP, and the traditionally lagging indicator of unemployment. In the US, UK and eurozone, nominal GDP is about 2 per cent lower than a year ago. Even if central banks can reverse this trend in the next year, nominal demand is unlikely to grow much faster than 2-3 per cent, half the rate of the boom years. Companies will find this a tougher environment, and so will investors, who will have to discriminate carefully between the quality of company securities.
Unemployment is a lagging indicator in a normal cycle. In a deleveraging cycle, the unemployment rate tells us much more about the underlying capacity and willingness of the household sector to spend or save. Moreover, headline unemployment rates should be understood in the context of other data reflecting hidden unemployment and under-employment.
Although US July unemployment slipped to 9.4 per cent, discouraged workers, and those forced to accept part-time work continued to rise to 10 per cent and 16.5 per cent, respectively.
Despite the deafening chorus of warnings about rising public debt and inflation, investors have little cause to fear either for the time being, or maybe for a considerable time. In a deleveraging, low nominal world, most bonds won’t generate high returns, and default rates and refinancing problems will continue to rise, but the much-feared imminent collapse in bond prices is much exaggerated. Equities, on the other hand, could change from purple to red, and back again, quite easily and frequently.
Did someone say Japan?
George Magnus is senior economic adviser, UBS Investment Bank, and author of ‘The Age of Aging’
