Investment report: An acute phase in an era of broken promises

What looked like a cyclical upswing from a short, sharp shock proved a mirage. The game has changed
January 25, 2012

A year ago, the world economy was growing steadily. The consensus was that after the credit crunch it had undergone a short-lived and wrenching trauma and survived it. After a stressful 2011 for Euroland, it is the European debt crisis that now dominates concerns. As much of southern Europe plunged deeper into recession and sovereign credits were downgraded to junk, investors were forced to reconsider the definition of a “risk free” investment. By the end of the year, the future of the monetary union, or at least of its membership, was openly called into question. The US, Japanese and British economies, on the other hand, were merely disappointing.

Emerging economies also hit trouble. Many had felt that they could be a haven from the problems of the rich world but, while economic growth initially held up better, stock markets had heavy falls. By the end of the year, growth had started to ebb with leading indicators pointing to further weakness ahead.

With conventional wisdom confounded, it was an altogether wretched year for most investors. Double-digit losses for stock markets were commonplace, with China hit particularly hard. Commodities, notwithstanding the supposed existence of a “commodity supercycle,” fell heavily. For bond investors the so-called “European convergence trade,” the strategy of investing in higher-yielding government debt to reap the excess return, came spectacularly unstuck. As Italy and Ireland both struggled, the old adage of “never lend money to a country with green in its flag,” looked poised for a comeback. The winning investments were long-dated government bonds in the US, Britain, Germany and Japan. British inflation-linked gilts (bonds that pay a return adjusted to include inflation) led the pack, rising more than 20 per cent and now offer a return below the rate of inflation. It’s safe to say that this was not a widely-recommended investment.

Three years on from the start of the financial crisis, much of the developed world’s banking system still depends on the kindness of governments, not least in Euroland, while the single biggest engine for global growth over the past decade, China, remains largely a command economy. Politics looks firmly reinstated as the master science, but even for politicians the debt crisis is a game changer. For decades, the ability to borrow meant that governments could distribute net largesse to their electorates. Increasingly this is not the case. Partly due to the European Monetary Union’s brutal strictures, Greece, Ireland and Portugal are introducing new austerity regimes even as, in Portugal’s case, the country enters its fourth year of recession in the past five. Britain, facing public sector strikes over pensions and a weak economy, is already experiencing the consequences of a modest fiscal consolidation. For the US, the adjustment still lies in the future, the budget deficit for 2011 will be $1.3 trillion, 8.7 per cent of total economic output. An adjustment is coming.

For the first time in 20 years, both the US and China face leadership changes. Budgetary problems have already led the US to reconsider its overseas defence commitments. In his final speech, retiring US secretary of defence Robert Gates put Europe on notice that it needs to do more for itself—something that has been largely ignored so far. As the process of reducing the deficit gets under way, hard decisions await US policymakers. A full-on Tea Party economic programme that includes constraining the central bank’s ability to act as a shock absorber would be intensely deflationary but, fortunately, this is not the most likely outcome even if the Republicans were to win the election. There’s little doubt however that elements of the Tea Party’s fiscal ideology have permeated the political mainstream.

China’s economic model faces a daunting transition as export demand slows. The rapid economic growth of the past decade cemented a materialistic consensus, which dampened the clamour for greater political freedom. In spite of the forthcoming “elections” in October, China remains a largely unreconstructed communist state. China’s response to the financial crisis was to increase construction and infrastructure spending enormously. Investment booms on the scale of China’s over the past few years, far exceeding that even of Korea in the 1960s, have never ended well. As the economy loses altitude, rivets are already popping in the Chinese banking system.

The Chinese banking system remains an enigma. The position of a market based system of allocating credit is necessarily an ambiguous one in a command economy and China’s banks are only ostensibly capitalist organisations. Alongside their role in executing policy based lending, however, it seems that they have been increasingly eager participants in a much more capitalist enterprise— “unofficial” lending where borrowers who lack the credentials to access state sponsored lending happily pay much higher interest rates. A sharp or prolonged slowdown, of the type that has punctuated China’s growth miracle in the past, will reveal the size and scale of their exposure. Prepare to be surprised.

The members of the European Union will confront fundamental questions such as the limits to national sovereignty while financial markets force a brutal pace. The French elections in the spring will be the first big test of how European issues will play in national politics. The budgetary accord agreed at the EU summit on 9th December would, if implemented, make nonsense of the economic agenda of Sarkozy’s socialist challenger François Hollande. Clearly something will have to give.

There will be rising pressure for referenda on the new budgetary arrangements in a number of smaller European countries including Ireland, where a referendum is mandatory for a constitutional change. Europe’s electorates can be notably recalcitrant when asked to vote for more Europe. Maintaining “discipline,” to use Barroso’s phrase, will be difficult. Although the German elections are not until the end of 2013 the tendencies of the latest move towards a closer union will be closely watched. The object of EMU was that Italy would become Germany—not the other way round.

On Europe’s borders the consequences of the Arab Spring should become clearer even as the situation in Syria deteriorates. Sabre rattling over Iran’s nuclear programme and the threat to close the Strait of Hormuz (an unlikely, if worrying prospect) has already raised oil prices. One of the lasting consequences of the war in Iraq has been the increase of Iran’s influence throughout the region. Naturally Israel regards this with growing disquiet. The possibility of unilateral military action by Israel, something which the US would not prevent even if it were not prepared to sanction it, will occupy Obama’s strategists, particularly in an election year. Russia too, is showing the first symptoms of popular unrest. A disorderly collapse in Greece which, while not the most likely outcome, is certainly possible, would open a wedge of instability stretching into the Balkans. Here too the financial crisis is heavily implicated. Most of the region is very dependent on the Greek, Italian and Austrian banking systems. The so called “Vienna accord” in 2009 kept credit flowing to eastern Europe; this time the pressure is on to restrict lending to “core” activities, intensifying the credit crunch in a region where a number of countries, notably Hungary, are already in severe economic and financial distress.

Many of these stresses and disappointments are, of course, the reason why financial markets have been so turbulent over the past year, although the consequences of US budgetary austerity and a further slowdown in the Chinese economy are still not fully appreciated. It is also true that some bear markets are already quite mature by past standards. The share price of Nokia, darling of the tech “new era” has fallen more than 90 per cent from its high and the European stock market index nearly 40 per cent. (One should be careful of the arithmetic however; a price that falls 90 per cent is one that falls 80 per cent and then halves again.) Government bonds have now provided a higher return than equities over the last 30 years in the United States and over the last 50 years in Germany and Japan. Many would argue that such observations argue for a period of better stock markets.

Short-term movements in markets are inherently unpredictable. Even though the eurozone crisis has followed a predictable—and predicted—course, it has gone through periods of remission as well as acute phases. More helpful, perhaps, is to consider whether we are coming to the end of the current set of monetary arrangements. It’s fairly clear that this is the case in the eurozone. The currency union has endured in one form or another for more than 20 years, a good age for a monetary compact by historical standards. Politicians and markets alike clearly recognise that the union has reached a fork in the road. A broader question is whether the persistent trade imbalances facilitated by global monetary transfers means the entire mechanism is now defunct. Underlying this are even more profound questions about the role of debt and monetary policy.

The period of economic equipoise which preceded the financial crash of 2008 and which Alan Greenspan called the Great Moderation, now looks like something rather different. Like the New York hot dog of folklore, the less one thought about the ingredients the more agreeable the experience. Median wages had been stagnating for years and consumption was growing only because consumers were able and willing to borrow. China’s integration into the world economy was a very deflationary event and the bubble economy, the boom in asset prices and employment in associated services were the consequences of leaning against this tendency. Its legacy is the current high levels of debt.

The financial crisis marked the point at which the private sector’s ability to absorb more debt was exhausted. The subsequent need to consolidate public sector finances marks the beginning of the next phase. European economies are now heading into recession without having fully recovered the lost output from the 2008 slump. A new economic orthodoxy, supposedly one that is to be written into national constitutions, dictates that the faster the economy contracts, the more rapidly government spending will be cut. For some countries in southern Europe the population will be asked to make sacrifices which are unprecedented in peacetime, other than in the period of rearmament immediately preceding World War Two. In other countries the situation is not so extreme but is nevertheless similar in kind.

These are circumstances which pit creditors against debtors, one country against another, public sector against private, retirees against people in work and one generation against another. The politicians who hold the ring and decide how the pain is to be allocated are already unpopular themselves and will become more so as it becomes better appreciated that their past generosity was at the recipients’ own expense. John Templeton’s famous dictum was that the most dangerous words in investment are “it’s different this time,” but in an important sense it is different this time. The reason is that the ageing of the rich world is without precedent. It is with this profound and irreversible change that the intractable issues of debt are inextricably linked. There is a strong temptation to treat the financial crisis as something that has been lived through and survived. It is better regarded as an acute phase in a drawn out period of broken promises.