Darkest before the dawn?
It’s obvious really. Global growth is slowing. Earnings disappointments abound. The tech boom has bust and the euro is doomed to continued weakness. Sell equities. Buy high quality bonds and overweight cash.
At first glance this makes sense. However, look more closely and you begin to question the conclusions.
Growth is slowing in many areas, especially in the US but also in Europe and the UK. But should we be surprised with this? Central banks have been increasing interest rates for more than a year with the specific aim of slowing growth. By most measures they have achieved their objective. Given this, it is arguable that we are at the peak of the global interest rate cycle.
This perception is reinforced by the continued good behaviour of inflation. The rise in oil prices over the past 18 months has increased headline inflation but it still remains low. Core rates are lower still. This is testimony to structural disinflationary forces that continue to flow through the global economy. Globalisation, competition, technological change and deregulation are the key drivers behind this. They are not about to go away.
Even if a cold snap forced a spike in energy prices over the next few months it is unlikely to have a more than a temporary effect on inflation. In fact, it could tip the current deceleration into an aggressive slowdown. What would your inflation projection look like then?
The case for monetary easing would only be strengthened. Falling interest rates are typically beneficial for equity markets. If that is the case, the worst may be behind us.
Of course, much depends on the extent of the slowdown. Various calculations suggest that equity markets are priced for recession. Discounted cash flow and comparisons with bond markets suggest that equities are no longer expensive. In some cases, analysts think that they are cheap as the earnings growth implied in their prices suggest that a recession is at hand. If this does not happen, equities will soon look cheap.
Of course this varies between industry groups. Various technology and telecom shares are priced more on hope than opportunity but it is undeniable that equity markets have become more discriminating recently.
The days of an easy ride by investing in any dot com or telephone company are long gone. Technology will not continue to play an important - even increasing - role in various economies and businesses. As a result, a structural bias in favour of these sectors will continue to be important but stock selection skills will be tested more than in the past. As much as American companies continue to provide the lead in technology, this also argues for a structural bias in favour of the US.
Slower growth, falling inflation and monetary easing are typically good for bonds as well as equities. However, governments in the US and Europe are no longer tightening fiscal policy. This fiscal boost is one of the reasons arguing against a move into recession. Although we are a long way from significantly increasing government bond supply, it should be noted that the positive effect of reduced government issuance has finished. As with equities, provided recession is avoided, the yield on good quality corporate paper is beginning to look attractive once again.
This outlook relies upon a relatively optimistic view of growth. It protects against earnings disappointments and opens the possibility of easier monetary policy. Surely, it can’t be that simple? Not really. Credit problems could quickly arise. Wide corporate spreads and dire warnings from ratings agencies suggest that the current situation is finely balanced. This, however, should bias central banks away from tightening policy, especially if individual credit problems reduce the effectiveness of the entire financial system. That said, much of the expansion in debt has been funded in credit markets rather than through bank loans. As a result, the prospect of a system wide credit problem associated with slower growth should be more remote.
Then there is the dollar. The US is running a large current account deficit. The dollar has been strong in spite of this due to capital inflows amounting to around $1bn per day. For much the same reason, the euro has been weak. If these flows should reverse, so too would the directions of the currencies. By any measure, the dollar is now over valued.
The main question must be whether the adjustment will be dramatic or spread out over a few years. It is in everybody’s interest for the latter to happen. In a world of modest but slower growth and with a US central bank more disposed to easing than the ECB, that must be considered a real possibility.
Ian Bright is group economist with Baring Asset Management in London