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October 6, 2010

The Uncertainty Principle

By Spear's

For now, large-scale fiscal and monetary stimulus appears to have saved our collective bacon — but that phase of recovery is ending, and the question is, what next, says Guy Monson
THE FIRST STAGE in what is likely to be a long haul out of the post-Lehman crisis is drawing to a close, not altogether unsuccessfully. Revolutionary policy stimulus (both fiscal and monetary) on a scale not seen in 50 years has succeeded, for the most part, in reinvigorating economic growth, stabilising global trade and triggering a massive rebound in financial markets.

The challenge in the next stage will be to see if the stimulus applied has real durability, or whether — as soon as policy makers start to withdraw parts of the programme, by cutting spending or reversing quantitative easing — we slip back, Japanese-style, into near zero deflation.

In the US, two of the main growth drivers — the inventory rebuilding process and the fiscal stimulus — are running out of steam. Weak spots have (re-)emerged, such as the housing market and sluggish employment report, intensifying fears of a double-dip. A cocktail of weak economic momentum, largely exhausted fiscal policy and core inflation at a near 50-year low is troubling for a central bank chairman determined to avoid deflation.

James Bullard, the St Louis Federal Reserve Bank president, recently released an academic paper extolling the virtues of more unconventional money policy, arguing that the Federal Reserve should use further aggressive purchases of Treasuries (instead of committing to keeping interest rates low for an extended period of time) to combat low and declining inflation expectations.

While only time will tell whether or not Bullard’s views will sway the remainder of the Federal Open Market Committee, we can be sure that the continuing debate within the Federal Reserve will be about how best to deploy its limited arsenal and create new ammunition to give the economy sufficient escape velocity from jaws of deflation.

Elsewhere, with a slower economy in the US and China and fiscal austerity at home, inflationary pressures in the euro area are unlikely to emerge, making the European Central Bank (ECB) exit strategy from its loose monetary policy unlikely before mid-2011. Moreover, despite the success of the EU stress tests in restoring confidence in the European banks, the ECB will need to continue to provide these banks with ample liquidity, as the wholesale market (where they access short-term funding) remains closed. Further support to the euro area member states through additional purchase of government bonds will also take place.

In Japan, too, economics minister Satoshi Arai stated that the government needs to work with the Bank of Japan (BOJ) to respond to the sharp rise in the yen against the dollar (as a recent intervention showed). He added that the government was in discussions with the BOJ on the yen rise, and he would be monitoring its potential prevention of a self-sustaining economic recovery — another global candidate for an imminent quantitative-easing programme.

Such economic uncertainty has lately been all-pervasive, with extremely low summer trading volumes (about 50 per cent below the five-year average for the S&P 500), exaggerated by ‘Quant’ and computer-driven trading models, leaving the market paranoid about ‘macro news shocks’.

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Indeed, over the past three months, according to Goldman Sachs, the S&P 500 has fallen by 80 basis points on days when major macro data is released, and risen by an average of 32 basis points per day when the economic diary is clear. They calculate that such a focus on ‘macro’ days is unusual and occurs typically after major market shocks (such as 1988, 2002 and late 2008). A similar obsession with the economic downside is reflected in the ‘skew’ of the options market, with downside protection far more expensive than upside participation, implying a tail-end, macro-risk mentality as the key driver of current investor sentiment.

The irony of these macro-economic misgivings, though, is that it is difficult to find them reflected in what appears to be an increasingly upbeat corporate world. Corporate earnings remain extraordinarily robust (up 37 per cent in the last quarter in the US, with a near record 75 per cent of companies beating estimates), with similar trends across all major markets. Although the forward-looking ISM index has started to roll over and US inventory levels are creeping higher, analysts are still seeing material thematic opportunities in global companies almost regardless of the economic backdrop.

Nevertheless, economic uncertainties are driving investors into the arms of government bond markets, condemning even the very best of blue-chip equities into a frustrating market trading range, seemingly regardless of the quality of earnings or dividends they produce. My hunch is that this won’t last for much longer — either economic growth stabilises, bond yields normalise and stocks rally, or else central banks release more liquidity, yields fall further, and ultimately investors buy blue-chip stocks for their balance-sheet strength and yield — but investors will need to be cautious on higher-risk investments for a while longer.

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