FT Wealth More than once during the global financial crisis, the words of John Maynard Keynes have framed our dilemmas. He once said: “The long run is a misleading guide to current affairs. In the long run we are all dead.” He is also held to have said: “The market can stay irrational longer than you can stay solvent.”
Neither of these famous quotations comes from the economist’s published work. But they are widely attributed to Keynes and they represent important truths for investors.
What is the long-run prognosis for the global economy and why might it be misleading?
In the long term, the desperate measures that appear to have averted the “nightmare scenarios” of a banking collapse followed by a second Great Depression will have an impact. That impact will not be positive. By pumping money into the economy and artificially lowering the price of credit, UK and US governments are deliberately stoking inflation.
Mild inflation would reduce the cost of the debt that got the world into trouble in the first place. But accelerating inflation would be something entirely different. Central banks’ task will be to judge when that risk has become predominant and then slam on the brakes by raising rates. Tellingly, the US Federal Reserve did this too soon during the Great Depression, forcing the second recession of the 1930s.
Alternatively, bond markets will finally revolt at the amount of debt the US is issuing to pay for all the stimulus it is trying to inject into the economy. This again would have the effect of pushing up interest rates and cowing the economy and stock market.
In the long term, the demographics of the developed world also look dire. The post-war “baby boom” generation is about to retire. To fund themselves in retirement, they will start spending the money in their pension funds, and that will mean net sales of stocks, pushing share prices down. At a macroeconomic level, it will be harder to grow when a higher proportion of the population is not productive and needs care that is growing increasingly expensive.
The problem of toxic assets has not gone away either, though the US has done a brilliant job of getting people to feel calmer about it. Both delinquencies and foreclosures of “prime” mortgages – the kind that would have been made even before the financial services industry lost its head – are already at unprecedented levels, with every reason to fear that they will rise further in the years to come.
All of these are strong arguments against a return to the robust economic growth the world has enjoyed during the past quarter of a century.
Nevertheless, the long run may not be a good guide to what is about to happen in the short term. At the time of writing, world stock markets have rallied 40 per cent since their slough of despond in early March, and there are reasons to believe the rally could carry on for much longer.
Some of this is down to what might be called the momentum of markets. Surveys suggest that most institutional investors have steered clear of the rally. This could be embarrassing for them. They have performed much worse than their peers, which could damage their careers. So, as the trends in the markets point clearly upwards, they are likely to lose their nerve and jump back in.
There is also the physics of the real economy to worry about. During the crisis months, companies cut output as fast as they could. Now new orders are exceeding inventories by the kind of extremes usually only seen just before a growth spurt. To replenish their inventories, companies will boost production – helping the economy. That in turn could push up earnings forecasts. When earnings forecasts rise, share prices tend to rise with them. So the arguments for dipping back into the market begin to look good.
If all this makes you feel uncomfortable, it should. But remember what Keynes said about the market staying irrational longer than you can stay solvent. In 2003, a similar injection of adrenaline to the heart of financial markets, in the form of cheap money from the Fed, led to an unsustainable rally along exactly the lines that looks possible now. Its long-term prognosis was always dire, but it lasted four years and you could have more than doubled your money.
The situation is so turbulent and unpredictable that a big bet in any direction makes little sense. Better to cover against the risk of a big rally, while being ready to get out instantly if some new accident in the credit markets or a geopolitical event makes clear that optimists have got ahead of themselves.
To quote Keynes one last time: “There is no harm in being sometimes wrong – especially if one is promptly found out.”
