I have a little book called The Optimist’s Handbook. It describes one of its authors thus: “in her dazzling early career launching exhibitions, publishing magazines, editing books and writing for television, Petra Cramsie added considerably to the gaiety of nations. She now lives in a rural idyll above Herefordshire’s Golden Valley, secure in the knowledge that tomorrow will be even better than today and blessed with children.” Sounds good doesn’t it?
But the book comes with a companion, The Pessimist’s Handbook. This describes the owner of the above life rather differently. “After years spent toiling at various unrewarding employments, Petra Cramsie left London to face the vicissitudes of middle age. She and her dependants live in a wind-tormented spot opposite the Black Mountains. When she is not up to her eyeballs in relentless domestic drudgery…” It goes on, but you get the point: nothing is so good it can’t be made to sound bad, and there’s almost always a way to get some good out of a bad story. So it is with the global economy – and possibly with stockmarkets.
We have been a pessimistic lot at MoneyWeek in the ten years since we launched. That has been the right call. The credit bubble did eventually burst. We did get our great global recession. And as Tim Price of PFP Wealth Management points out this week, global equity markets as measured by the MSCI World Equity Index currently stand 22% below their level at the start of 2000. So we got our bear market too. Take dividend payments into account and things don’t look quite so bad. But nonetheless it would be hard to pretend that being fully invested in equities would’ve been a particularly good idea over the last ten years or so. The question now is whether we should extend our pessimism for another ten years.
I think we won’t. That’s absolutely not to say that things aren’t still bad. Of course they are. House prices are still falling all over the place; the two big emerging economies that are supposed to be saving us all from depression – China and Brazil – are seeing noticeable slowdowns in growth; Europe’s sovereign debt (and hence banking solvency) crisis remains unresolved; unemployment numbers in the US are consistently worse than expected, and would be here too were they not so consistently fiddled; and the levels of private debt that have been hampering consumption across the West continue to do so.
But, worst of all for growth prospects, the banks still aren’t lending. Due to massive losses taken by the financial sector in the wake of the US real-estate crash, it has been impossible for the sector to increase its lending to the private sector – even as central banks have slashed the cost of credit. In previous post-war recessions, the rate of growth in loans and investments has tended merely to slow as recession kicks in. But as Paul Kasriel of Northern Trust points out, this recession has seen the “first instance of an outright contraction in private financial-sector-issued credit”.
For some time now the Fed – and the Bank of England – have been “revving up the monetary engine” but finding that the “rpms are not being transferred to the wheels of the economy”. This makes this a cycle “unlike any other in the post-war era”. No wonder that, as even Ben Bernanke admits, “the outlook is unusually uncertain”. And no wonder investors – still unconvinced the $15trn-odd thrown at the crisis by terrified governments is enough to sort things out – remain very nervous.
The fact is, says MoneyWeek’s house misery guts James Ferguson, that the rate of US GDP growth is falling (from 5% back in December 2009 to 2.4% in June) as the inventory rebuild comes to an end and final sales fail to take up the slack. This puts sales growth and profit margins at risk. The US economy is not just running out of steam again: it “never had any steam in the first place outside of inventory adjustments and policy stimulation”. That means that growth there and across most of the rest of the West is set for another slowdown. So much for the V-shaped recovery.
But none of this means either the end of capitalism as we know it, nor of centuries of impressive global growth. Baillie Gifford’s James Anderson recently pointed out that global growth is “closer to exponential than linear in the long term”. Global growth was a mere 0.01% during the years 1 to 1,000, but had hit 0.2% by 1500 and 0.3% by 1820. By 1914, 2% was “commonplace” and with a little spurt towards 5% during the 1950s and 1960s it has been around 3% pretty much ever since (to the extent that we can measure it, of course). Even in 2008 the global economy grew by 3%.
Long term, says Anderson, there’s very little to worry about. The main drivers of growth – imitation and innovation – remain entirely intact: emerging economies are copying the successes of the West and both emerging and emerged are coming up with enough new technology to keep growth moving and living standards on a generally upwards path (albeit with the odd hiccup).
But it may be that we also have less to worry about in the short term than we think we do. The two things we should be most frightened of are deflation and inflation (which is fine at low levels but has historically been very damaging when it’s persistently above 4%). I’ve wavered between fear of the two over the last few years, but the market appears to have reached a consensus that deflation, which historically has had hideous effects on stockmarkets, is the one to worry about.
However, regardless of the consensus that it is just around the corner, it isn’t happening yet. Sure, in Japan core Consumer Price Index inflation is at its worst on record at -1.5%. But here we’ve had the worst recession for generations and we still have high inflation, with our CPI running at 3.1% (for more on this see Lessons from Weimar). The same goes for America, where, according to Simon Ward at Henderson Global Investors, inflation might not be as low as it seems. Indeed, recalculate it using the European Union’s “harmonised index of consumer prices (HICP)” methodology, and it turns out that US consumer price inflation is almost the same as UK consumer price inflation. It’s hard to see how things could be much worse than they were in 2008, but even then deflation was much more talked about than seen.
And another thing has just happened that makes me wonder if that will ever change: US banks have finally expanded their balance sheets. In July, for only the second time in the last 21 months, US commercial-bank total credit expanded at a healthy-seeming annualised rate of 8.3% (see the chart below). The increase wasn’t actually a result of rising loans (although the rate of contraction here slowed), but of an increase in securities acquisitions. That might sound like it makes the point irrelevant – but it doesn’t. The purchase of securities by banks still means they are using their capital to take some risk, and that matters. It is, says Kasriel, “an encouraging sign that banks may finally be confident enough about their future capital positions to start currently increasing their earning assets”.
The general consensus has long been that banks simply don’t have the capital to make lending possible. But this isn’t actually so. Over the last two years they have been endlessly recapitalised, via their capital-raising efforts in the markets and taxpayer-injected capital. They are now, if not brilliantly, at least “adequately capitalised”. But they still haven’t been willing to lend due to uncertainty about two things.
First, they don’t know exactly how dodgy their commercial property portfolios still are (and so how much of them they will have to write off – too much and a well-capitalised bank could fast become under-capitalised). Second, they don’t know the extent to which regulators are likely to increase required capital ratios (essentially the amount of capital banks have to have compared to the amount they’ve loaned out). These two uncertainties have made them more prone to hoard than to take on any risk at all.
The July figures, while they could, of course, be a one-off, suggest this may be on the verge of changing. Note that they weren’t the only good news. A recent US survey also showed some easing in the terms of lending to commercial and small business customers. That’s a “very positive sign”, says Kasriel.
This doesn’t mean headline growth won’t still disappoint, or even that we won’t see a double-dip. There is generally a time lag between credit growth and rising demand. So we should still expect to see terrible statistics on GDP, consumption and employment for some time to come. But the key point is that while headline growth is slipping and investor angst is growing (bulls are oddly thin on the ground this month), actual underlying medium-term conditions might be improving.
So should you buy? Hedge fund guru Crispin Odey, manager of Odey European, thinks so. Back in 2005-2007, investing was hard, says Odey, “no assets yielded me more than 6% gross and I could see consumer spending overinflated by Ponzi credit”. Today he’s sleeping easy. Why? Because he sees a world that’s “halfway through its recovery programme”. The policy mistakes of 2005-2007 may have demanded a massive bail-out of banks and obliged governments to take on their private liabilities. But today the wiser governments, such as that of the UK, “are in the process of cutting public expenditure and following a flight path back to stability within five years”.
We are only half way through all this, says Odey, so “of course it feels scary”. However, the problem is now well understood by the authorities, and anyone investing is being paid well to take risk in the first place. “I find myself talking numbers and strategy with companies and feel that their targets are achievable and not priced in by markets.” Odey’s portfolio is, he says, “at most on a p/e of nine-times net profits”. Shares are “cheap”.
Odey may well be right. But I still wonder if now is the right time to buy in. As growth disappoints, it still seems reasonable to expect a proper growth scare – as the last believers in the V-shaped recovery capitulate and deflation suddenly seems more likely than ever. That would lead to a market sell-off, which, along with lousy growth numbers, would surely prompt further policy action – more quantitative easing.
That would make the market every investor’s dream – cheap, turbo-fuelled by a bit of money printing and inflation expectation and, best of all, underpinned by an improving economy. We’ve regularly recommended putting money into solid global growth-orientated blue chips here (although we haven’t exactly agreed with Odey on the banks – see below). We’d keep doing that, but we’d also keep a good deal of powder dry in the expectation that in the next few months we might really get what Société Générale’s Albert Edwards calls “a once in a lifetime opportunity to invest in equities at bargain-basement valuations”.
Reasons to be cheerful
We’ve been worried about a huge number of things over the last few years and we’re still worried about most of them. But here’s a quick look at the other side of the coin – reasons why the optimists say you shouldn’t be worrying about much, be it a bubble in China, or the collapse of the eurozone.
Europe
It seems to us that the eurozone can’t survive as it is – not with so many different economies moving at different speeds. Not so, says Baillie Gifford’s James Anderson. The way forward is actually surprisingly clear: austerity will continue but in a “limited” way, and the European Central Bank is likely to “loosen its morality… stop pretending the euro is the deutschmark” and relax monetary policy. The solution is simply “solidarity.”
Government deficits
Expecting a sovereign default? You shouldn’t be, says Anderson. “Government deficits frequently prove to be both more cyclical and more powerfully eroded by inflation than the current angst suggests.” However, it is the anxiety that provides the wall of worry that suppresses equity valuations and creates opportunity.
Anderson then quotes a piece of recent research, which shows that “equities gain strongly in real terms in the decade after debt peaks”. Overall, Anderson can’t see why a combination of “vibrant world growth, intense monetary stimulus and modest austerity” can’t work out most debt burdens – particularly as there is a “clear history of sustainable reform” when it comes to debt (think of the cases of Sweden and Denmark in the 1990s).
China
China is often “decried as a bubble”, says Anderson. However, the scepticism that surrounds its growth is “uncannily similar” to that displayed towards America by British fund managers 100 years ago. Britain has “never been graceful” at acknowledging the ascent of others and “sadly we seem to have passed this habit across the Atlantic”.
Anyone prepared to be more open minded should note that there is “dramatic and plausible” scope for China to rebalance away from exports and towards domestic consumption (something that should help the entire global economy).
Strikes at the likes of Honda and the fast-rising wages – which are justified by productivity gains – we have seen in China recently should therefore be seen as a “welcome part of the Chinese scene”. The more Chinese people earn, the more attractive investing in the producers of the Western world should be. Note too that it is not just the economies of coastal China that are booming – inland China is too. Too many people are seeing China as a “looming disaster”, when they should instead be seeing it as “the greatest secular growth story in history”.
Banks and their capital
Hedge-fund guru Crispin Odey reckons the banking crisis part of this cycle is all but over. What July showed, he says, is that the authorities understand the problem. Both Basel III (the new regulations on banks’ capital strength) and the stress testing of the European banks showed one thing: that banks have got enough capital for the job. Note that JP Morgan recently claimed to have surplus capital equal to 42% of its market capitalisation. Odey’s favourite banks are Barclays and Lloyds, both of which trade on five times his own earnings forecasts.
• This article was originally published in MoneyWeek magazine issue number 500 on 20 August 2010, and was available exclusively to magazine subscribers. To read more articles like this, ensure you don’t miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now
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