Tyndall Monthly Commentary: Another Year of Two Halves
As we enter the second half of the year, it has become increasingly apparent that much of the optimism that greeted the start of the year, both in the financial markets and in the real sectors has faded, as indeed we suspected that it might. In particular, we note that the optimism that greeted the European Central Bank's "LTRO" strategy has not so much faded as reversed (in fact, the policy was ill-thought out and may even have been counterproductive in that it allowed the bank runs that have destabilised much of southern Europe to occur) and we would also note that much of the early year improvement in the global real economic data appears to have been due to faulty seasonal adjustment algorithms within the data, rather than to "real events". The timing of the Global Financial Crisis and the Japanese Earthquake in the first quarters of their respective years has led to the computer-generated seasonal adjustment factors becoming erroneously skewed towards ‘always' producing strong data in the first quarter (at the expense of weaker data in the third quarter).
Tuesday, July 10th 2012, 10:17AM
by Andrew Hunt
It is perhaps worrying that the legions of analysts that pore over the economic data largely failed to recognise these rather alarming facts during the early part of the year but we suspect that they were being implicitly swept along at that time by the feelings of euphoria that seemed to be sweeping the financial markets at that time. For our part, we believe that this feeling of optimism within the markets was caused not so much by hopes for a global economic recovery but rather by a new expansion of credit within the financial markets which looked (and indeed felt) remarkably reminiscent of the events that occurred back in the mid 2000s before the Global Financial Crisis. Certainly, we find that the investment banks were very active over the quarter, although not always with positive outcomes as JP Morgan was subsequently to reveal....
Over recent weeks, however, clear signs have emerged that the new leverage boom within financial markets has come to an abrupt end. One of the lesser known impacts of the Global Financial Crisis has been to oblige most lenders to require the depositing of suitable collateral when they extend credit to a borrower and, as more and more securities are downgraded by the rating agencies, we are finding that there is now a shortage of suitable or eligible collateral within the system. This is one of the reasons that US, German and Japanese bond prices are so high currently; these instruments are deemed as being eligible collateral and hence there is now a huge demand for these instruments that has been made even more acute by the nervousness created by the latest instalment of the Euro Crisis.
In fact, over recent weeks, the shortage of collateral appears to have evolved into an outright famine with the result that many borrowers, be they sovereigns, corporates or financial sector borrowers are finding that they simply cannot afford to buy the collateral; assets that would then allow them to borrow. Consequently, we have seen a marked and we believe very significant tightening in credit conditions within global financial markets over recent weeks and this has in turn robbed the financial markets of the formerly strong funds flow that allowed them to pursue their ‘risk on' mode earlier this year.
In fact, now that they have been deprived of the ‘weight of money', markets have to look more closely at the state of the global economy and it seems unlikely that they will like what they see. In Europe, and despite numerous rescue packages, the Euro Crisis seems still to be accelerating with several of the large southern Euro Zone economies now falling prey to full-blown balance of payments crises which thus far the Euro system has just managed to contain, albeit at huge potential expense. Meanwhile, in the real economies, it is clear that Europe is firmly back in a recession and even Germany looks to be succumbing as the weakness in its trading partners drags it down.
Moreover, we also find that the economic situation within the once much-hyped BRIC economies also seems to have deteriorated of late. As global credit conditions have tightened, both India and Brazil have found it more difficult to finance their now significant current account deficits with the result that their currencies have fallen and their banks have found it less easy to finance their own balance sheet expansions. Hence, their domestic economies are slowing and their inflation rates are threatening to rise as import prices increase, a situation that is unlikely to be positive for their equity markets. Similarly, China's economy has also slowed sharply over the last six months and we suspect that underlying growth in the economy is now sub 5%, an outcome that while still good by current global standards represents something of a hard landing for the country. Moreover, with core inflation still elevated and accelerating capital outflows threatening to weaken the currency (these flows are largely the result of - rich - Chinese savers increasingly seeking better returns abroad), China's central bank has been unable to ease its policy settings in the way that some had expected. In fact, we suspect that China's economy will be obliged to take an enforced ‘time out' for the rest of this year and much of next year.
Fortunately, there are some bright spots still within the global economy and one of these remains the US consumer. Although their incomes remain under pressure as a result of the lacklustre labour market and rising tax bills, US households are maintaining their level of expenditure growth at a remarkably consistent 4% annual rate in nominal terms, thanks to their use of relatively heavy levels of consumer credit and student loans in particular. The student loan system, which offers subsidised credit and clearly was not designed for this purpose, seems to have nevertheless become the lender of last resort to the ever active US consumer and at present we see little danger of this situation changing, with the result that US consumer trends may yet surprise on the positive side. We would also note in this vein that US manufacturing also seems to be defying the global trend by virtue of its strong competitiveness at present.
Another - and in this case we would suggest long overdue - positive factors centres on Japan. Over the last year, Japan has faced numerous and often tragic headwinds but the corporate sector seems almost to be making a virtue of the necessities implied by the strong Yen, disaster recovery process and aging population. Japan's economy appears to have become one of the fastest growing major economies as its service sectors both meet the changing demand patterns of the aging population and improve their own productivity growth. It is of course early days, but there are signs that following the challenges it has faced, Japan's economy is beginning to restructure and if this is continued it should provide a further boost to Japanese corporate profits, although both JGB prices and even the value of the Yen may ultimately be casualties of this process.
Clearly, this is already not a bright economic environment and yet there are already new problems threatening to emerge, such as the prospects for a significant and potentially arbitrary tightening of US fiscal policy next year. Moreover, as we note above, the Euro Crisis is far from solved despite numerous leader summits and this could create yet more bad news in the coming months. This unattractive situation leads us to remain cautious over the outlook for risk assets over the medium term but we are also aware that, while equities are cheap on a valuation basis, the safe havens such as high quality bonds are expensive and we fear that if central banks were to manage to find their way around the collateral famine, then the price of these bonds could fall and equity prices rise, if only temporary. We therefore expect financial market volatility to persist, doubtless to the chagrin of ‘real investors', and at the margin this uncertain environment may favour the US dollar on the currency markets.
Andrew Hunt
International Economist, London
Andrew Hunt International Economist London
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