“I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.” J.S. Mill
The AMP’s chief economist and strategist, Dr Shane Oliver says markets are in a very difficult place at the moment:
After the events of the last few weeks it’s easy to be bearish. After plunging nearly 20% from their highs earlier this year to the lows last week, global share markets have rebounded by around 6%.
But markets remain twitchy.
The slump in markets over the last month naturally raises a lot of questions: what’s driving it? are we seeing a re-run of the global financial crisis (GFC)? what’s the risk of a return to recession?
Can China save the world again? Have shares bottomed? How vulnerable is Australia?
Why the sharp fall in shares (& other growth trades)?
Put simply, shares have taken a tumble on fears of a return to recession in the US and Europe, and worries this will drag down the rest of the world.
A few months ago we thought that global growth was just going through a temporary soft patch (on the back of Japanese supply chain disruptions and the earlier surge in oil prices) and that even though shares might remain volatile and see further weakness through the September quarter, the trend would remain up as profits continued to rise and global monetary conditions remained easy.
But the events of the last few weeks have called this view into question.
Economic data has remained weak and debt crises in the US and Europe are increasing the pressure for more fiscal austerity at a time when growth is fragile.
Political bumbling on both sides of the Atlantic, Standard & Poor’s downgrade of America and fears of more downgrades to come have only compounded these fears.
Furthermore, memories of the 2008-09 GFC are still fresh in the minds of investors so the attitude seems to be shoot first and ask questions later.
Are we seeing a re-run of the GFC?
It’s still early days yet, but our view is this is very different to the GFC.
Public debt problems have been brewing for some time so exposures should be well known and more transparent.
The leverage and complex financial engineering that caused so much trouble in the GFC is not a factor now.
Interbank lending markets are much better supported by central banks.
Consequently, while interbank lending spreads (the difference between what banks charge to lend to each other and expected official short term interest rates – i.e. the OIS in the chart below) and credit spreads (the difference between corporate and government borrowing rates) are picking up, they remain relatively low.
While it’s early days yet, the risk of a complete seizing up in lending markets – including in areas like trade finance that helped spread the GFC to emerging countries – as occurred in late 2008, seems low.
However, the recent speculative attacks on French banks and moves by US money market funds to stop lending them $US funds are worth watching.
This is evident in the greater rise in European lending spreads compared to the US in the chart above.
What’s the risk of a return to global recession?
The risk of recession has increased significantly in Europe and the US.
Fiscal austerity is occurring much earlier than is desirable, and recent political wrangling has put public debt problems front and centre in investors’ minds and dealt a huge blow to business and consumer confidence.
Europe is probably the biggest risk.
It seems to be stuck in an ever worsening cycle of periodic investor panic over debt blow outs, causing more fiscal austerity causing weaker growth causing further budget deterioration causing more market panic causing more austerity and so on.
This process started in the peripheral countries but now appears to be spreading into Italy and France.
A fiscal union is a long way off and won’t solve current problems anyway, and the European Central Bank seems unwilling (or unable) to provide monetary relief.
And the US is now starting down the same path with fiscal austerity set to knock up to 2% from growth next year.
However, there are several reasons to believe that while the risk of recession in the major industrial countries has increased substantially, it will probably just be avoided:
- The fall in oil and commodity prices generally will take pressure off household budgets and business costs.
- Cyclical sectors that can push the US economy into recession are already at recession levels – e.g. housing.
- Longer term borrowing costs in the US have fallen to extraordinarily low levels and the Fed is effectively committing to keep them there for two years. This is enabling homeowners to refinance to lower rates.
- Near zero returns on cash are making it very difficult for US companies to continue adding to their already record cash stockpiles.
The incentive to get out and invest, or at least buy back shares or other companies, is huge.
It’s looking increasingly likely the US will head down the path of another round of quantitative easing (i.e. QE3 – which involves pumping more cash into the US economy).
While one can debate the seeming failure of QE1 and QE2 to spark a strong recovery, the US probably would have been a lot weaker were it not for these actions a
