The rally in equity markets has spread a little optimism around a global economy that is still in deep funk. Some argue this is precisely how new bull markets begin. Others, including your scribe, assert it is an impressive bear market rally. The latter case has been made consistently since it began, and maybe that is a reason why it may continue for a while. It is certainly the pain trade par excellence, that is, the risk of not being involved is becoming increasingly painful. However, this rally will stall eventually and then reverse for three important reasons.
First, the structural credit system dysfunction in advanced economies hasn’t been fixed yet. Some previously blocked credit arteries have been opened up a little, and credit risk in the banking system has receded thankfully, but we are still a long way from a viable, solvent banking system that intermediates credit independently. Surveys suggest banks have become a little more willing to make loans, but they lack creditworthy borrowers. The biggest hurdle of all, as David Roche highlighted in this column yesterday, is that the great debt restructuring, especially of mortgages, has barely begun. The collapse in asset values has left household and aggregate economy debt ratios (in relation to GDP, net worth, income and cash flows) at record highs as of March 2009. These ratios will all decline markedly over the next 2-3 years as debt restructuring occurs.
In the meantime, markets will face two strong balance sheet headwinds. The increases in household savings and unemployment will be outside our ‘normal’ experience, accentuating the household sector’s balance sheet repairs. And banks’ assets will continue to shrink as they too deleverage. In fact, we should continue to see financial institutions lining up to sell assets and issue equity into a rising equity market, and looking to dispose of non-core businesses. In the US, the rush to issue equity to pay off Tarp funding and meet stress test capital requirements has raised about $40bn in the last two weeks, though this is just 13 per cent of what would be needed. These observations underscore the essential truth about a deleveraging crisis, namely that it is a multi-year work in progress. Banks have been at it for less than a year, and households have barely begun.
Second, the rise in equity markets has occurred hand-in-glove with the improvement in sentiment about the global economy. However, investors should heed the complex strands of this argument. The good news is that the recovery in China and some other emerging nations, which experienced a steep but quite familiar downturn, looks genuine. And it is surely of consequence that oil and some other commodity prices, especially softs, have risen in spite of the aggregate demand weakness in richer nations. However, even in emerging markets, growth optimism has to be tempered to the extent that they rely on exports to western consumers, whose spending and borrowing will remain subdued.
It is, however, in the west that economic recovery prospects carry the loudest health warning. We are currently experiencing some cyclical noise related to the inventory cycle and to fiscal and monetary initiatives, but these are unlikely to evolve into a sustainable expansion. For that, we need to see higher spending on capital formation and consumer durables. With debt financing put out to grass, the financing can only come from a durable improvement in employment, incomes and profits, and a normalisation of credit flows. This may not happen until 2011 at the earliest.
Third, regardless of the pattern of GDP in 2009-10, how can markets realistically price the large uncertainties surrounding the global economy in the medium term? We can assess probabilities about the avoidance of more drastic protectionism, the return of global imbalances, the exit strategies from quantitative easing and asset purchases, and a fiscal credibility crisis. But probabilities are as far as we can go, for we have no reliable templates, and that alone argues for sustainably higher risk premiums.
We do know, though, that a higher cost of capital and weaker trend growth, not least because of demographic change, are baked in the cake. We also know that the reflation trade will probably endure for as long as rising unemployment, bankruptcies, defaults and debt restructuring continue. The stall in nominal GDP growth can and will be reversed by central banks, but neither they nor we can be sure how the split between real GDP and inflation will be distributed. In that vein, investors may continue to be attracted to the gold, energy and other commodity sectors. Reflation may also finally claim the US dollar as a victim, but while the world is awash with US dollar debt that it is seeking to reduce, the dollar should be stable or even stronger. Anyway, the big currency move should be against China and others in Asia, and they aren’t ready to acquiesce yet.