The ‘wrong type’ of growth
Over the past few years we have heard many ingenious excuses such as the wrong type of snow and leaves on the tracks. However, last week I attended a presentation where the speaker mentioned that a key concern across markets is that over the past few years we have seen the ‘wrong type’ of growth and inflation.
What limited growth there has been, over the past few years in the main developed economies, has been driven by the unusual stimulus given by low interest rates and easy monetary policy. The immediate concern is for economic prospects as these policies start to revert to ‘normal’. Yet the concept of what is normal, is challenged by the fact that the period running up to the credit crisis was far from normal, being fuelled by debt-financed consumer spending and rising house prices. The key question we are asking ourselves is why we want to go back to ‘normal’ when the normal we saw in the middle part of the last decade was so flawed.
Although the policies implemented during the financial crisis can be judged “successful” – in that a second Great Depression and deflation were avoided – there are now fundamental concerns about prospects. The economic growth achieved in many economies from 2009 onwards was driven to a large extent by policy stimulus. Very low interest rates and fiscal stimulus drove economic policy. Now, however, fiscal stimulus is turning to austerity; and monetary policy is being normalised. Different economies are at different stages of this transition but the general trend is clear.
Of arguably greater concern is the fact that before the financial crisis growth, many Western economies were highly dependent on debt-fuelled consumer/ government spending, supported by rising house prices....and the wrong type of inflation. Deleveraging, debt repayment and weak house prices are now the predominant themes What we know is that the excessively low interest rates over the past decade have resulted in a misallocation of capital on a titanic scale, driving that capital into public debt and risk assets, including the residential property market.
Much of the debt created by this misallocation of capital remains on lenders books and will be subject to severe haircuts, probably starting with Greece as the monetary-stimulation-fuelled speculative boom in risk asset prices fades.
Post 2007 the US has strived to get through the recession without putting its fragile growth at risk. It has offered tax cuts, borrowed heavily, lowered interest rates, created money out of thin air and devalued the currency. Whilst this has allowed them to continue spending at alarming rates, the money intended to restore the economy has by and large been siphoned off and used by the Investment Banks for speculation or lent to Hedge Funds for speculation, sorry investment! This speculation across the financial market has been actively (and openly) encouraged by the US Federal Reserve which now regards “the wealth effect” as a third leg to its formal dual mandate. The formation of continuous bubble conditions has created a bonanza for Wall St. and other global investment banks but does not lend itself to stability
One of the largest natural outlets for this speculation has been commodities, which are generally priced in dollars. Consequently as the dollar has weakened commodity prices have continuously risen. Yes China needs to import massive amounts of raw materials to maintain its own economic policy but we have seen rises in some commodities exceeding the rises you would expect to see from just this type of demand. For example we have seen some research that has looked in detail at oil futures traded in Chicago. It is estimated that only 1 barrel in every 80 traded on the exchange is for actual delivery the other 79 are being purchased by speculators. This phenomenon is repeated across almost all commodities from precious metals, food to the industrial metals. Consequently we were neither shocked nor surprised when we recently read that something like 80% of Investment Bank equity trading activity/profits are being made in options on Exchange Traded Funds at the moment.
The situation in America over the past few years resembles what was seen in Japan in the last decade where their Government did almost the same things to try and drag their economy out of the mire. This resulted in the infamous Yen carry trade where hedge funds and investment banks borrowed Yen and invested the money almost anywhere apart from Japan to improve the return. We are seeing this with Dollars.
However now that the US Authorities have hit their spending ceiling and cannot “print” any more money they have to start planning to live within their means and repaying their debt. The politicians have to reach some sort of agreement about controlling debt and at the same time maintain some economic growth. We know that they only have until the beginning of August to plan what they intend to do and now that the credit rating agencies have put in on record that the AAA American credit rating is under review we could see increased uncertainty in markets, which in turn will increase the volatility whilst we wait for an announcement of when they plan to start resolving the issue.
To use some very un-grammatical expressions we could therefore see the markets reduce their “risk on“ positions i.e. start to sell the commodities and emerging market investments that they used to boost the return on the borrowed dollar investments.
In addition to our concerns about the state of America and the potential implications on the commodity markets, the contraction of consumer / governmental spending and the ongoing absence of meaningful investment in businesses and the state sectors indicate that prevailing economic conditions are likely to continue for some time. This is having a profound effect on unemployment. So awful have employment prospects become that many people have given up looking for work altogether. In some developed countries in the eurozone youth unemployment is close to 50% and conditions are so dire that many have now taken to openly venting their frustrations on the street. With nothing to do these people have nothing to lose. This is a dangerous situation indeed.
The longer the solution takes the greater the danger that, as Dr Mark Mobius, the hugely influential Chairman of the Templeton Emerging Markets fund, identified on Tuesday 31st May, the next financial disaster will be even worse than the last one. In his view none of the issues raised by the financial crisis of 2008/09 have been addressed and a train wreck is no longer a matter of if, but when!
Conclusions Stay defensive
