In the global struggle for dominance of investment markets between the optimists and the pessimists, the optimists continue to win.
Share prices continue to rise, with some nervousness apparent in America offset by great strength in Japan, the second most important market, as well as bullishness in Britain and Germany, the next two most important.
Bond prices remain strong, despite signs of higher inflation in America and an end to deflation in Japan.
Property markets also remain strong globally, although the residential sector has flattened out in “bubble” markets such as Britain, Australia and South Africa, where homes have become so expensive that first-time buyers can no longer afford them.
Oil, gold and most other commodities remain strong despite some signs of weakening demand from end-users, probably because of sustained speculative demand.
The pessimists continue to warn against pending disaster for well-known reasons:
America’s massive and still-increasing deficits – in foreign trade and government finances. For how much longer will the rest of the world be willing to continue lending most of its savings surpluses to the Americans to finance their consumer spending spree?
Here’s one measure of it – investment bank Morgan Stanley says consumption’s share of national production has reached 71% in the US, compared to only 58% in Europe, 55% in Japan and 42% in China.
The fear is that if foreign central banks and private investors start to lose their willingness to pour capital into America, that will deliver multiple inter-related shocks – a collapse in the dollar, soaring long-term interest rates and a fall-off in consumer demand, the principal force that’s been driving world economic growth.
If the US economy loses speed because consumers lose their appetite for increased spending, financed through taking aboard more debt – or, even worse, start to reduce their debts by saving more – there are no other substantial economies likely to take up the slack.
Although Japan is looking better than it has for a decade, there are still doubts about the sustainability of economic recovery, with growth still largely dependent on export markets. The European economies show no sign of breaking out of their straitjacket of profligate welfare spending and over-regulation, with electorates digging in their heels against reforms. The UK economy is sliding towards recession.
China’s economy, which has been so important for global prosperity in recent years, has become dangerously dependent on exports (now accounting for almost half its annual growth), and is showing increasing signs of the distortions and stresses of over-expansion. Here in Hong Kong, from where I’m writing to you, the investment bank CLSA Asia-Pacific Markets is forecasting growth could slow to perhaps as low as 3% in 2007.
Fiddling with the figures
A new wave of inflation is inevitable because of the continuing abundance of cheap, easy credit. There are already signs of its coming through in the US, where in any case the official figures are politically manipulated to keep them unrealistically low, via “hedonic” accounting (adjusting for additional value not shown in prices), and exclusion of major costs such as energy.
Inflation will produce higher interest rates, pushed up by central banks fearful of rising prices, and by private-sector investors seeking to protect the real value of their savings. Higher interest rates will be bad news for most kinds of investment, especially bonds.
Residential property prices have become dangerously bloated in many countries. When the bubble bursts, it will be even more damaging to economic growth and investors’ general confidence than the stock-market collapse of 2000-2002.
Yet, despite the strength of these arguments, investment markets continue to ignore them and push asset prices even higher. Why is that?
Because the optimists have many good arguments, too…
Foreigners will continue financing the US’s twin deficits because it’s in their interests to do so.
The export-growth-driven model favoured by the Asian countries, which has proved to be phenomenally successful for more than half-a-century, requires them to keep their currencies cheap in dollar terms and to continue financing the Americans’ appetite for imports. If it looks as if the US economy is slowing down, that will strengthen, not weaken, the case for providing financial support.
There are other factors affecting private investors. High (and rising) interest rates in America relative to those of other countries, especially Japan, make US fixed interest investments attractive.
In any case, there is a dearth of alternatives in their own countries. Even with a slowdown, it looks as if the US will continue to deliver much higher economic growth than other major nations, and the breadth and liquidity of its investment markets is without equal.
Central banks continue to flood the world with money, which will underpin economic growth and continue to lift asset prices.
Although much publicity is given to the US Federal Reserve’s steady process of quarter-point increases in short-term interest rates, the fact is that the Fed is (I quote Morgan Stanley) providing “ongoing monetary stimulus.” In the first quarter of this year total credit grew at an annual rate of 30% of GDP. And if you look at the chart of the money supply measure M3, it looks like the launch of a space rocket.
As important is the fact that, having raised its interest rate to 3.75%, the Fed has rebuilt its capacity to give a huge future boost to cheap, abundant credit should the economy slow down to the degree that it causes political discomfort.
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How low could rates be cut? How about to 0.1 per cent? That’s the rate at which the Japanese central bank has been lending money for years to underpin its economy.
Would the Fed refrain from cutting so harshly, or even adopting “unconventional” policies such as buying shares? Don’t be so naïve! In major democracies the authorities are the captives of what my friend David Fuller calls “social pressures and expectations” to maintain economic growth. All three of the most likely candidates to succeed Alan Greenspan at the helm of the Fed when he retires next year are not the types to court political unpopularity by “snatching away the punchbowl at the party,” as one former central bank president once put it.
Politicians aren’t about to catch a dose of responsibility, either. In the US, the $200bn injection for reconstruction in the wake of Katrina won’t be financed by higher taxes, but by even greater borrowing. That alone is expected to give a 1.5 percentage point boost to US economic growth next year.
In Europe, no fewer than ten of the member-countries of the European Union are breaching the terms of their fiscal responsibility pact to keep fiscal deficits below 3% of GDP, with major nations such as Germany, France and Italy the major violators. In Britain, too, finance minister Gordon Brown increasingly resorts to Enron-type fiddles with national accounting statistics to hide his government’s profligacy.
Intense competition keeps a lid on rising prices
The argument about an inflation threat is dubious for several reasons. Even allowing for the undoubted fiddling of official figures, price rises are quiescent considering the relatively strong economic growth experienced in America and some other countries in recent years.
And in any case, an abundance of cheap, easy credit doesn’t in itself generate inflation if it doesn’t stimulate demand for goods and services relative to supply. That’s been proved by the experience of Japan over the past decade. Instead, it flows into boosting the prices of investment assets.
Morgan Stanley argues that inflation rates such as 3% plus (very low by the standards of the past half-century), won’t be around for much longer because of deflationary forces – global competition in manufactured goods (and now in some services), global labour arbitrage (Central European workers cost a fraction of Germans, and are almost as competent), price-aware consumers, and absence of linkage between wage costs and prices.
So many fundamental factors support strong, even rising, asset prices. Interest rates are still very low in real (inflation-adjusted) and nominal terms. Inflation is no threat to bonds or equities.
Corporate earnings growth rates – a key factor for equities – remain strong worldwide and continue to surprise on the upside. After years of cutting costs, reducing excess capacity, selling off the dogs and paying down debt, major companies generally have very strong balance sheets.
Share valuations, at least outside the US, are not high relative to interest rates. Dividends are rising faster than earnings, and in some markets are now higher than investors can earn from bank deposits or bonds. Merger and acquisition activity is accelerating, which adds buoyancy to stock markets. High oil prices have (so far) done little to depress economic growth.
My conclusion?
The pessimists will eventually prove to be correct – but not for some time, perhaps rather a long time. Bubbles have a way of continuing to inflate for much longer than almost anybody expects.
David Fuller says investment markets are driven by sentiment and liquidity. The current strength of the markets suggests that sentiment is still, on balance, strongly positive. And liquidity remains abundant, thanks to our generous-spirited and politically-sensitive central bankers.
It’s a time to stay relatively fully invested, while keeping a substantial stake in defensive investments such as gold and major-nation government bonds as insurance.
By Martin Spring in On Target, a private newsletter on global strateg