Following my piece last week, Grantham calls the top, a number of readers asked if we are headed into GFC 2.0. Let me say “no”, barring a major sovereign default.
But that does not mean that all is hunky dory. No indeed. I suggest you take a few minutes to review The Long View from the FT team at the CFA Institute Annual Conference in Edinburgh, which gives some idea of just how big the structural problems facing the global economy are.
Back to the moment, then, there appear to be two emerging narratives for markets from here. In one story, there is a clear slowing in global growth, services economies throughout the Western world remain in balance sheet repair mode and, that which has driven the real economic cycle to date, a huge rebound in global manufacturing, is under pressure as we take slow steps towards fiscal and monetary tightening everywhere. Look at this chart from The Economist this morning:
The slightly more positive interpretation of this slowing is offered by the preternaturally positive Jim O’Neill of Goldman Sachs, who reckons that the decline of commodity prices that we are seeing as a result of this slowing is a good thing and will enable global central banks to ease up on the tightening:
Many market participants appear to have forgotten the days of the 1980’s and 1990’s where economic strength was not symbolized through rising commodity prices. During that time, we had two decades of declining commodity prices and, while there were periods of recession, we experienced two decades of global economic expansion. Could such days ever return?
He then jots down three quick observations, which we’ll summarize:
- First, the sharp spike in commodities that has coincided with this latest round of global growth has created instability-causing inflation. It’s very plausible that recent weakness in some economies could be attributed to high oil and food prices.
- Goldman’s own proprietary measure of Chinese economic strength has been flagging, and historically it’s lined up with commodity prices well, and at this point suggests further commodity downside.
- If China’s 5-year plan is to be believed, the country’s oil consumption “will not grow even close” to the level that was projected for it back in 2004.
O’Neill concludes an equity rally sans-commodities is highly plausible.
So, which of these narratives is right? First, let me say that markets always have inherent bias to go up. And this little ditty from O’Neill is just the kind of twaddle that the market could use to excuse another rally.
In my view, however, O’Neill is pining for the dead growth model of The Great Moderation, that period from the early 1980s when goods inflation subsided in Western nations and asset inflation took off. But such was built upon the Bretton Woods II system of cheap goods from developing economies and cheap capital for developed. I offer you four main reasons for why this paradigm is dead:
1. The US services sector is poised to get worse, not better. The key is, as always, house prices, which continue to fall. In past cycles, when global slowdowns of this type occurred, the world had a built-in stabiliser in US housing. Because US mortgages are tied to its 30 year bond rate, as the globe slowed and money poured into the safe haven of US Treasuries, mortgage repayments fell, and the US would enter refinance booms. House prices would rise, wealth effects go to work, consumption and imports pick up, as well as exports everywhere else. This cycle is now largely dead with mortgage rates about as low as they can go and US housing sliding anyway.
2. This leads to the second conclusion, that the US can no longer drive world growth through its borrow and consume model. It must find external demand to grow. That means it must have a weak $US, which, because of its relative pricing position as global reserve, means higher commodity prices.
3. This is made worse still by US unemployment at 9%. Although employment is growing again, the Federal Reserve has made it abundantly clear that this figure is unsatisfactory. Therefore, at first opportunity it will provide as much accommodation as is necessary to reduce unemployment. They only possess the mallet of monetary policy. That means QE3 and more upward pressure on commodities.
4. These forces are all set to be made worse by US fiscal tightening, which seems now to be only a question of degree. From Goldman Sachs in New York:
Our analysis implies that even spending-based adjustments are likely to be challenging in the current environment. This is because without a monetary response, both spending and tax-based consolidations are likely to act as a sizable drag on growth … Meanwhile, barring another round of asset purchases, the best the Fed can do is keep monetary policy on hold to cushion the growth drag from the fiscal consolidation—independently of whether it comes through adjustments in spending, revenue or both. As a result, the looming fiscal adjustment should reasonably be expected to see policy rates—and probably longer-term rates too—at lower than normal levels for an extended period.
My conclusion from this is that whilst the mechanisms of Bretton Woods II linger, there can be no sustained economic cycle. And this is before we even entertain Jeremy Grantham’s notion of peak everything which clearly makes pressures on commodity prices even worse. As the West fights the deflationary undertow of thirty years of debt accumulation with the only tools it has, the world has entered a new era of boom and bust.
As reader “Janet” describes, we’re into a new epoch in which there’ll be “inflation in all you need and deflation in all you own”. That’s the reverse of The Great Moderation and, you might not be surprised to observe, captures the two halves of Australia’s two-speed economy.
Even Jim O’Neill grudgingly agrees:
As it relates to the directional trend of equity markets, however, the last week’s events do draw me to a conclusion that if equities are to develop another leg into higher prices, it probably won’t be sustained if it is simply the result of commodity prices recovering. If commodity prices go straight back up, it will add renewed pressure to headline consumer prices in China and elsewhere, probably resulting in additional monetary tightening.
