“Our clients are scared to death about where the world is heading,” says Jonathan Potts, managing director of Fidelitrade. So is everyone else: last Thursday the FTSE 100 suffered its worst one-day fall in two years, while the pan-European Stoxx 600 index has hit a two-year low. The FTSE All-World Index, even after a mild recovery early this week, was almost 20% down from its May high for the year.
Gold has soared to new records and the yen reached a post-war peak against the dollar as investors fled to safe havens. UK ten-year gilt yields have hit their lowest level since 1899, just above 2.3%, as prices have jumped. Their US counterparts have dipped below 2%, a 60-year low. German ten-year yields have fallen to a record low too. The immediate cause of the panic was yet more poor economic data. America and Europe “are hovering dangerously close to a recession”, says Morgan Stanley.
The eurozone crisis is an ongoing worry, with a default by one or more peripheral states, and hence a banking crisis, still a danger. “Unless investors… are convinced that northern Europe can properly contain and control the eurozone’s fiscal miscreants, then the former will continue to batter the bonds of the latter,” says FXPro.com.
They will be less than convinced after last week’s poor data, which showed that growth had slowed to a standstill in Germany and France. That implies that rescuing the south would put an unexpectedly large strain on the core’s finances. It also reduces the scope for the core to pull the periphery out of its slump.
This week another problem flared up: it seems the second Greek rescue package isn’t quite done and dusted. Finland has insisted Greece provide collateral against new loans. Now several other northern states want their portion of the rescue loan to be guaranteed too, which would raise the cost of the new loans for Greece. None of this will alleviate the ongoing rise in interbank lending rates in Europe that threatens to lead to a second credit crunch.
Global growth is fading
A major shock last week was the slump in the Philadelphia Federal Reserve’s business activity index. The Markit global index tracking manufacturing, moreover, shows that the sector is now barely expanding. Throw in deteriorating third-quarter data, fiscal tightening and a potential banking crisis, and it’s no wonder double-dip fears have flared up.
Nor can we count on Asia compensating for the developed-world downturn. As Morgan Stanley points out, domestic demand in the region is slowing anyway because of tighter monetary policy to squeeze out inflation and the crucial export sector has seen “close to zero growth on a month-on-month basis since March 2011”. There is “no escape” for Asia Pacific from weaker developed-world growth. Hong Kong, the most externally-driven economy in the region, actually shrank in the second quarter, says Henny Sender in the FT.
… and policymakers can’t boost it
A possible slide into recession is worrying enough, but “the really alarming aspect”, says The Daily Telegraph, is that all policymakers’ “weapons appear to have been used”. Having racked up so much debt already, governments fear that overextending their balance sheets “will turn [them] into the next Greece”, says Edmund Conway in The Sunday Telegraph. So there is no scope for more fiscal stimulus.
Meanwhile, an uptick in US inflation may thwart a third round of money printing – quantitative easing (QE) – by the US Federal Reserve. But QE didn’t work last time anyway. “It certainly pushed asset prices up… but there was no significant economic follow-through,” says HSBC’s Stephen King.
The problem is that central banks “are pushing on a string”, as PFP Wealth Management’s Tim Price puts it. Zero interest rates and free money aren’t working because “people don’t want to borrow”. Having racked up huge debts in the credit bubble, the private sector is working them off. Governments, having taken on a massive amount of private-sector debt with their bail-outs of banks and other sectors, are finding that these debts are as unsustainable for them as they were for the private sector, says Albert Edwards of Société Générale. So they are cutting back too.
This is why “anaemic and fitful” recoveries from recessions caused by financial crises are the norm, says John Authers in the FT. There is little underlying momentum given the sheer weight of the debt and economies are particularly vulnerable to shocks. So even if we do avoid falling into recession now, the basic problem remains. We can’t simply go back to “business as usual”, says King. Markets, which had assumed that “with enough stimulus, an economy can return to the path it was on pre-crisis”, are “belatedly” twigging that this just isn’t so. Instead, the deleveraging process is set to “be a drag on the developed economies for years”, says Capital Economics.
The West is turning Japanese
“So that’s where we are today,” says Conway, “on the brink of recession as the sugar high from the stimulus operations of 2008 and 2009 wears off; a world where the overhang of debt means that a Japanese-style period of stagnation is not merely a threat.” It’s not just the overall syndrome – anaemic growth caused by a huge debt mountain – that Japan and the West have in common. Another ominous development is that bond yields have slumped to historic lows.
With money flooding into bonds, cash that would normally be spent on consuming or investing is being hoarded, says Jeremy Warner in The Daily Telegraph. As risk aversion grows, a vicious circle of sliding demand, employment and economic activity can begin, spurring more anxiety and more hoarding and saving among companies and households. “In Japan they’ve had this phenomenon for 20 years.” This, of course, makes it even harder to generate the growth to tackle the debt load.
Political paralysis is another parallel between Japan and the West. The credit bubble seems to be unwinding in the same way in equity markets too. A comparison of the MSCI USA Index (comprising large- and mid-caps) and the MSCI Japan Index shows that Wall Street is aping Tokyo with an 11-year time lag.
The bear market is far from over
It’s not just the prospect of gradually working off the debt bubble hangover – whether we fully emulate Japan or not – that suggests that stocks are likely to struggle for years. Valuations imply the same. The Shiller p/e, or cyclically adjusted price/earnings ratio (CAPE), is among the few reliable long-term valuation gauges. It uses the average earnings over the last decade to smooth out the effect of the economic cycle.
In America, it is still around 19, compared to a long-run average of 16. In Britain, it’s at 13. As Simon Thompson points out in the Investors Chronicle, the CAPE “almost always hits single digits” before bear markets end. So this indicator also presages further falls or a long period of choppy sideways trading as earnings gradually catch up with valuations. Stocks, which have gone nowhere for ten years, will continue to disappoint. The next long-term bull market is only likely to begin once the West has recovered from the burst credit bubble.