The volatility in stock markets over the past two weeks needs to be read correctly to avoid making errors of judgment such as assuming this is a repeat of 2008. It is not. Neither do I believe it is a market rout, but it certainly is a repricing of the risks, that governments struggling with the debt crisis will not take the right steps to stimulate the economic growth necessary to grow their way out.
I have been expecting the floor to be hit early this week and some rally to occur as large amounts of cash on the side-lines comes in to buy cheaply. Companies throughout the developed world are enjoying cash levels on balance sheets that haven’t been seen for decades, corporate earnings have been strong, consumer debt has been declining over the past three years and the fiscal backdrop of very low interest rates would, ordinarily, be a nirvana for strong market growth.
It hasn’t happened because confidence is the issue. The disease is too much debt being carried by several OECD economies including the U.S. on the shoulders of tepid economic growth. The destiny is smaller government and the pain will be austerity where there is much larger emphasis on cutting spending fat rather than raising taxes. It is simply a statement of fact that in economies ranging from the U.S.A. to Ireland, there has not been enough net contributors to the tax pool to cover those dependent upon it – the welfare state and all of its attending quangos have simply gotten too big. And the tax base will have to be widened.
Ironically, Ireland is further down the road than most which is why Irish bond yields have been declining. Standard and Poors has downgraded U.S. treasuries from AAA to AA+ but the dollar still remains the world reserve currency. There isn’t another game in town at the moment, although it is possible, should Europe develop a much deeper fiscal union which will be needed to support the issuance of consolidated e-bonds, that the euro will eventually take over from a declining dollar as the world reserve currency. Italian and Spanish bond yields have also been falling as the ECB takes the unprecedented step of intervening in markets to buy these bonds. Europe is only another emergency summit away from e—bonds. Distil it all down and the end result, in my view, will be inflationary as Central Banks open up the printing presses to prevent a double dip recession.
In order for markets to grow strongly over the next number of years, confidence will first has to be restored that national governments are prepared to bite the bullet which is to shrink State spending, keep taxes modest and interest rates low, thereby helping improved tax revenues from economic growth to repair the historically high levels of debt to GDP which have been built up over the past couple of decades.
Markets will rise on a wall of worry or so the expression goes. It is as true today as it has been over many of the crises we have managed with our clients over the past two decades.
Throughout this period we have advised that holding good assets through thick and thin and avoiding the temptation to actively trade these type of very sharp movements, lowers the overall level of risk in a fund portfolio and produces better long-term results. Those who attempt to actively trade these type of sharp cycles typically sell close to the bottom and rarely recover their nerves in time to get back in to repair losses. This is not because of the first decision which is to get out (although the question these days is to get out to what?) but the decision about when to get back in again. There is also the secondary issue of the speed at which market events unfold in these days of software-driven trades which move so swiftly as to make a mockery of making effective counter-movements across fund ranges in time.
We are advising clients that there is not yet sufficient evidence to suggest a global double dip recession. There are mixed signals including strong U.S. job growth. Politicians and policy makers are behind the curve, to borrow that old expression and need to embark on cost cutting programmes that clearly convince markets and calm nerves. Expect this to happen since the alternative will be to see one’s national debt getting pummelled on bond markets. The great high borrowing game is now up including for national governments.
At the other side of this transition, economic growth after the pain of austerity should be steadier than what we have seen over the past number of years.
- Eddie Hobbs