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Are we looking at a new norm?Have the true implications of the crisis and the stimulus measures to deal with it unfolded yet? This is the question that Mark Appleton set out to answer as he takes a look at the issues.
This time last year, the world was looking over a precipice. The financial system was facing systemic collapse for a number of reasons that have already been well documented (and which will not be repeated here). The failure of Lehman Brothers proved to be the catalyst for global financial panic.
I was en route to Beijing to attend a conference focusing on Chinese banking and property investment when the bankruptcy of my hosts was announced. The world I left when I boarded that aeroplane was very different to the world I witnessed on landing.
All hell was breaking loose – everywhere. United States treasury bills were perceived as the only port of safety and yields were driven into negative territory.
History will show that the crisis was averted when global authorities vowed to do “whatever it takes” to bring stability back to the financial system. So what exactly did it take?
• Massive fiscal stimulus for one, and huge monetary stimulus for another;
• Government guarantees were handed out liberally and significant spending plans were adopted;
• The private sector was de-leveraging and governments were attempting to step into the breach; and
• Monetary authorities adopted an aggressively low interest rate policy stance in order to free up credit markets and in some instances, resorted to “quantitative easing”, which is effectively the same as printing more money.
The world has begun to emerge from “The Great Recession”. Financial markets have reacted positively and are back to pre-Lehman levels. The fact that a catastrophe was averted provided meaningful relief, and nearly zero interest on money market alternatives has proved a significant incentive for global investors to take on more risk.
The question is: have the true implications of the crisis and the stimulus measures to deal with it unfolded yet? Let us look at the issues.
The level of government debt is becoming a problem: huge spending and declining tax collection from weak economies has resulted in elevated debt burdens. Ability to take on more debt is constrained.
The US budget deficit is likely to be pushed to around 12% of gross domestic product for 2009. As of June 2009, the International Monetary Fund estimated that developed economies have provided direct support amounting to 10% of global GDP. This cannot continue ad infinitum and, as the BCA puts it, there has to be “payback”.
Recent analysis by Rodney Sullivan, CFA, suggests that the impact of fiscal policy is weaker for economies that have higher levels of debt relative to GDP. This is due to an ultimately higher cost of debt and a crowding out of private investment.
He surmises that fiscal policy actually detracts from economic recovery when debt exceeds 60% of GDP. The US number is now significantly in excess of this, and the average G7 country has a debt-to-GDP ratio closer to the 80% mark.
This would be exceptionally problematic in a normalised environment, but right now the negative effects have been kept at bay by very low inflation and a still strong demand for government debt from many quarters, including foreigners.
The problem is that as the situation normalises, the necessary withdrawal of government stimulus will put a damper on the strength of the recovery.
The same goes for monetary policy. As soon as inflation starts to respond to all the cheap money, interest rates will have to rise again.
So what does all of this mean?
Do we return to normal, or will a world of lower growth be the “new normal” as coined by Bill Gross from the Pacific Investment Management Company? The days of excessive consumption driven by the US are clearly unlikely to return.
Global growth now needs to be stimulated by internal demand generated growth from China and other emerging markets. It is a big ask.
So where does that leave us from an investment perspective?
Markets have rallied strongly, perhaps too strongly given the risks of sub-par growth.
Further strength in the market is only likely if the private sector begins to show meaningful signs of recovery and corporate revenues (not only profits from cost cutting) start
to recover.
To end, a quote from the late Peter Bernstein: “The way we have to manage our affairs in an unknown future is not to try to maximise our returns, but to try to manage our risks.”
Be careful out there.
