FROM A GEOPOLITICAL perspective, just about everything that might have gone wrong in the first half of 2011 probably has: earthquakes, political turmoil in the Gulf, new foreign wars, another Greek crisis, and (as of writing) still no funding agreement for the trillion-dollar US deficit.
While at first seemingly uninterested, equity markets more recently moved sideways amid mixed economic data and political noise, confounding the strategists and frustrating the efforts of active global managers. Give the markets even a thin diet of good news, though, as in early July (the Greek austerity vote finally passing and the reports of a post-earthquake surge in Japanese industrial production) and investors seem quick to march to a tune of strong cash-flow, inflation-busting dividend increases and company earnings expectations stubbornly refusing to dim. All in all, investment markets seem to be reacting modestly to bad news and rather well to good news — a little good news today could go a surprisingly long way.
The world economy and its three major economic zones — the US, Europe and China — certainly seem to be at important inflection points. In the US, economic shocks in the form of higher oil prices, supply disruptions tied to Fukushima and bad weather have triggered a slowdown well in excess of the impact of the shocks themselves. Such disproportionate slowing highlights the fragile nature of recovery from a debt-induced correction. What is more frustrating, however, is that it is accompanied by a tacit acknowledgement by central bankers that monetary policy alone cannot be a panacea this time around. Quantitative easing might have been successful in reviving confidence, but it seems to have been less effective in creating real demand in either the US or UK.
Meanwhile, China’s ‘funding model’ for its spectacular investment-led growth, which relied heavily on rising property prices, is increasingly at odds with the centre’s attempts at economic cooling. The spotlight on local-government finances paints a rapidly deteriorating picture for local banks. Roughly a third of all infrastructure projects (10 per cent of GDP) are devoid of cash-flow. It is likely that tighter credit conditions and rising non-performing loans (NPLs) will force China to adapt its growth model away from infrastructure towards consumption, in turn dampening its growth potential.
Finally, in Europe, as politicians buy time to resolve the debt crisis, the risk that political mistakes trigger a banking crisis remains high. Greece’s toxic combination of a 160 per cent debt-to-GDP ratio, a 15 per cent bond yield and no growth means that a muddle through is unlikely to work beyond the very short term. Absent a credible euro-wide banking solution/fiscal union, we are likely to revisit this funding crisis from time to time, with ‘flare-ups’ in the bond markets of Spain and Italy increasingly common.
WHILE DEVELOPMENTS IN the US, Europe and China paint a weaker and more volatile picture for global growth, there are positive triggers that could break this economic stalemate. At the risk of being unfashionably optimistic, I see hope and political opportunity in three areas.
First, in the US, and the indebted world more broadly, fiscal policy needs to pick up the baton from monetary policy. However, with almost every country approaching the limits of fiscal sustainability, this needs to done in a manner in which government spending is targeted at raising the longer-term growth potential. America’s net indebtedness is still an affordable 65 per cent of GDP, and the US bond market continues to rally, indicating that there is little current problem funding this. Thanks to a last-minute agreement on the debt limit — albeit not fully satisfying — the US should manage to avoid either cutting spending massively in the short-term or defaulting on its debt and may even alleviate the rating downgrade fears.
Second, longer-term political stability and a lower-risk premium in the Middle East could lead to further declines in the oil price, transferring money from oil-producing economies with a low propensity to consume to oil-consuming economies with a high propensity to consume. The recent (but only temporary) decline in prices was encouraging.
Third, the establishment of an EU framework that would allow for an orderly default of a sovereign member is required. This could be either by creating an EU-wide banking sector mechanism to absorb losses, or a larger fiscal union that allows for sizeable transfers between the core and the periphery, in exchange for greater fiscal harmonisation. Although it can be seen as a short-term solution only, as it includes some sort of private sector involvement, the recent new Greek bailout can also be considered as another step in the right direction. Could this ultimately lead to improvement in risk appetite and greater risk-taking by cash-rich corporates?