An upward curve
James Bevan picks his way through the debris of the credit crisis and is confident that recovery is underway – despite some inbuilt instability
KEY POINTS
- Companies are sitting on and not investing their cash
- This is no jobless recovery – the outlook for employment is good
- Bank bail-outs averted but did not remove disaster
- Trade wars present a significant risk to recovery
- Headline CPI inflation on track to hit four per cent
It may seem odd that on the one hand we have commentators suggesting that the global economy faces significant challenges and is only part way through an extended convalescence after the credit crisis, and on the other hand we seemingly have plenty of economic data from a range of economies suggesting that recovery is strong, well rooted and here to stay.
Improved global momentum
When faced with apparently irreconcilable statements, we might hope that a quick check of the facts would shed light on what’s what, but the more we look at the numbers, the more curious it can seem. Thus, the tensions for over indebted economies are clearly visible and we need no reminding about the scale of retrenchment and de-leveraging required across a swathe of developed economies, even if there is no clear consensus as to the best way forward.
Yet global economic momentum is improving with lead indicators now consistent with around 3.5 per cent to four per cent economic progress after inflation. And there are grounds for optimism that such progress can be maintained with corporations underinvested, US employment trends set to improve, emerging markets continuing to perform well, and money rates still exceptionally low.Grand words, I hear you say, but the facts are clear. Corporate free cash flow, what companies have to invest or distribute, as a proportion of overall economic activity is particularly high, while the investment share of economic activity relative to trend is very low.
In other words companies could invest, but aren’t doing so, but investment intentions, proxied by surveys in the UK, the US and elsewhere, are consistent with positive investment growth and there is already some positive momentum building. For example, spending on equipment and software in the US has been rising 17 per cent year on year, and this is the strongest pace in twenty years.
Positive underlying employment trends
There are concerns that more production doesn’t mean more jobs and if there are no more jobs, so there won’t be more consumption, and goods as produced will end up sitting on shelves. But despite widespread concerns that the US, for example, is experiencing a so-called ‘jobless recovery’, growth in non-farm payrolls relative to the rebound in economic activity writ large is roughly in line with its norm at this stage of the cycle. Furthermore, in absolute terms the increase in employment is slightly above the average for the previous four recessions, and in the UK, leaving aside the public sector’s travails, underlying employment trends are positive.
The emerging market growth story is important and depending on how the numbers are treated; growth from emerging economies accounts for a third to a half of overall global economic growth.
We should note that the key issue is about growth and change rather than absolute scale, even if the rate of emerging economy growth does mean that such economies are visibly becoming an increasingly important part of the global economic landscape.
Meanwhile, money rates remain abnormally low across a range of economies. But whilst this is good for growth, it does in itself jar horribly with the optimism on economic growth and the observable inflationary pressures, that aren’t just fermenting beneath the surface but are already being experienced.
In thinking through how we can reconcile these challenges and what messages there may be for the future, it is helpful to step back and focus on how the problems all began.
Unstable foundations
Once upon a time – and it was fairy tale too – there was a comfortable ‘arrangement’ which involved developed economies under producing, over consuming, over spending, and importing goods, services and capital, in exchange for promises of repayment in the future to those who had money and who were disinclined to spend. And there were plenty of people with money, at least in aggregate, and not much interest in spending, in fast growing emerging economies, which in turn can be seen to have over produced, under consumed, under spent and exported goods, services and capital.
At one level, this seemed benign, but as with so many unstable arrangements, there were unintended but logical consequences.
The recycling of capital with the buying of government bonds in developed economies kept interest rates low, and encouraged excessive borrowing and lending, which coupled with a reliance on matrix mathematics (the premise that risk can be accurately measured and offset), and securitisation (the bundling together and on sale of debt, deemed to carry a lot less risk than it really did) left the financial system fragile and vulnerable.
The emergence of the credit crisis revealed the extent to which so many transactions had been casino-like in structure and content. There followed shrinkage and impairment of banking activities, with reduced credit and/or higher spreads or margins for borrowers.
There was also a step down in levels of economic activity, with rapid destocking and everyone wanting and needing cash. Taken together, there was a dangerous and toxic cocktail of financial distress that looked and felt all too similar to the great financial carnage of the 1930s.
Yet central banks and governments recognised the extreme risks, and responded with a whole host of measures designed to stabilise banks and credit creation, support parlous economies and to keep the show on the road. It is these measures that have helped to create the recent tide of good economic news, and for that we can be grateful. But the measures have allowedsome continuation of the imbalances, and have not addressed the fundamental underlying challenges. We may reasonably conclude that we have had disaster averted but not cancelled.
Looking ahead, we can see signs as to where the instabilities and imbalances will next rear up. In developing economies, we have huge demand for commodities, with consequences for inflation.
We also have market concerns on those entities that are deemed to be over-extended and where credit rationing results – the economies of peripheral Europe – stand out as examples.
The inflation challenge
The inflation challenge is real and quite complex. The upward pressure on commodities prices is now more pervasive than at any time in the past 50 years, even including the 1970s, with rising living standards and reflation (for example, money creation in the developed world and credit creation in the emerging world) working together to create more demand for commodities, driving down the value of money in commodity terms.
This is happening at a time when supplies are tight in many markets. Higher food inflation rates will be felt particularly keenly in emerging countries where food costs have a greater impact on inflation than in the developed world. This will affect monetary, fiscal and exchange rate policies in these countries.
Tightening supplies and worries about food inflation have also started to trigger a few important export bans, such as wheat export bans in Russia, export quotas in the Ukraine and a ban on cotton exports in India, which was recently extended. In a world of growing government intervention to control trade and capital flows rather than to allow market pricing to resolve problems, more such interventions are likely.
Commodity price inflation extends beyond agricultural products and despite very different supply and demand dynamics in each market, the uniformity of the price increases reflects the macro influence that is cutting through commodities markets as a whole.
Meanwhile, it is quite possible that headline UK CPI inflation will hit four per cent, or slightly above, early this year. Of course tax changes are a factor and VAT changes have added perhaps 0.85 percentage points to the core inflation rate in the last 12 months. Taking out the effect of the VAT in pushing up consumer prices, UK core inflation is running at a rate similar to Australia and Canada but still over one per cent higher than in Europe and US.
This divergence stands out because of the similarities between the UK, the US and Europe, with all three having a significant amount of excess capacity and a low level of output relative to potential.
One factor, and with overall benefit to growth and export prospects, has been the significant slide of the pound relative to its trading partners, and this has boosted UK inflation in the past few years.
Although the currency move is now largely behind us (the significant drop was in 2008), the timing of the flow-through from a weakening currency to higher import prices and to higher shelf prices is not immediate due to lags in the supply chain and the ability to substitute with domestically produced goods. Import prices are currently rising at 6.2 per cent year-on-year, which is faster than at any time in the last decade other than 2008.
Who owns the risk?
Against this backcloth, there are clear risks of policy error by governments and central banks, with trade war potentially the ugliest reasonable scenario. But we should not be unnecessarily gloomy as it is clear that the key decision takers understand the risks and have plenty of levers and policy tools with which to act.
Certainly we should expect new bubbles to inflate, and there are clear signs of bubble pricing in some emerging economies already. And regrettably there will be more pain, much of which will be faced by those least able to shoulder it and least responsible for the underlying problems.
We should also look for signs of trouble in funding debt in the UK, with the risk of higher yields and more credit rationing. Yet arguably these risks pale into semi-insignificance when compared against the still unanswered challenge of sustainability and climate change, and the still unclear position as to who exactly owns the $600,000,000,000,000 of global derivatives risk.
Note: For further background on the wider financial markets and the economy, please refer to the Caritas Guide to Finance, December 2010
Author: James Bevan
James Bevan is chief investment officer at CCLA Investment Management Limited.
There are no comments on this article. Be the first to comment.