ASSET MARKETS HAVE soared while upside surprises in economic data releases have maintained the momentum of optimism. There is growing confidence that economies are not only bottoming out but that a sustainable recovery that brings the global economy back to normalcy is now very likely. Unlike late 2008, there is now little fear of new financial shocks severe enough to cause systemic damage. But, as the optimism grows, the wiser investor should be looking out for what can go wrong. After all, the recent crisis taught us a thing or two about being cautious about asset price booms.
What is the state of play in the global economy?
There are, of course, many positive trends emerging in the global economy.
- First, aggressive government intervention has substantially strengthened the financial sectors. There is little chance of a major failure in financial institutions that could destabilise the economic recovery. Sure, there will still be many financial stresses that emerge but the combination of government support measures, a rising tide of liquidity and strengthening economies suggests that these financial problems are likely to be resolved without causing too much damage. The recent troubles involving CIT, a major US lender to small- and mediumsized businesses are an example — there were substantial worries about CIT collapsing but it was able to stave off the worst and financial markets took its travails in stride;
- Second, massive fiscal and monetary easing has created the conditions for an economic recovery in Asia in the coming months — a recovery that is set to be quicker and stronger than expected. Official economic lead indicators are now turning up while other forward-looking indicators such as new orders and hiring intentions are also signalling an upturn. Moreover, business confidence is improving steadily, to the point where hiring intentions appear to be improving, signalling a recovery in hiring as well; and
- Third, while many still doubt the fundamental underpinnings of the recovery in financial markets, it is still the case that rising equity prices have allowed banks and other companies to raise capital to strengthen their balance sheets. This has helped to reduce risks to the economy going forward since stronger bank and corporate balance sheets will contribute to greater resilience.
Nevertheless, once the initial euphoria over the faster-than-expected recovery is over, what are financial markets likely to focus on? It is the answer to this question that will determine the sustainability of the recovery in asset prices — whether equities or real estate — across the world. This is where the problems start:
There are still some financial shocks in the pipeline: There are serious problems building up that will be visited upon financial institutions in the US and Europe by year-end. In the US, rising defaults on commercial property are becoming a significant worry, adding to the concerns over deteriorating personal credit and construction loans. In Europe, the economic and financial crisis in the Baltic states and increasing chances of a similar crisis in the Black Sea states (such as Hungary, Ukraine and Bulgaria) are set to put the Western banks that have high exposure to these countries at risk.
Policy is working but what about the costs of policy?: We believe that markets will soon be forced to assess the impact of the sharp deterioration in public debt across the developed world. In the US, one estimate is that the public debt to GDP ratio will double from 41% in 2008 to about 80% in 2012. When other costs not explicitly included in this estimate such as the costs of new healthcare reforms and financial bailouts are added in, the true figure will be one that financial markets will find hard to digest.
Adjusting to the post-crisis global economy will involve more pain than markets seem to recognise: Recent data on US personal incomes and savings show that the necessary increase in the household savings rate is happening, but rather slowly. The most recent data indicates a savings rate of just 4.6%, well below the 8% to 10% levels that many economists feel will be optimal. Economists estimate that about US$5 trillion ($7.18 trillion) of household debt has to be eliminated in the coming years. The large rise in savings rates that is needed will depress consumer spending. Economic growth will therefore slow in the US. Other adjustment processes are also needed, for example, continued deleveraging by financial institutions and governments and restructuring of production processes to reflect the higher costs of energy and climate change. All this involves some degree of pain or difficulty.
There are signs of a return of speculative activity. Whether it is residential property in Singapore, Hong Kong and South Korea or commodities elsewhere, easy money and low interest rates are spurring the kind of speculative behaviour that precipitated this crisis in the first place. It does not appear that markets are giving due weight to these risks. This is particularly the case in Chinese asset markets.
HAS CHINA OVERDONE IT?
It is in China where the pre-conditions for a major bubble are falling into place. Just look at some recent data:
Liquidity is expanding at dangerous rates: Foreign exchange reserves rose at a record pace of US$178 billion in 2Q2009, reaching US$2.132 trillion. There are substantial monetary consequences of this increase — the M2 measure of broad money rose by an unprecedented rate of 28.5% in June after rising 25.7% in May. New loans continue to be issued at a massive rate — outstanding renminbi loans rose 34.4% to RMB37.74 trillion ($7.93 trillion) at end-June.
Causing speculative behaviour to return: Urban citizens’ confidence index for owning stock shares rose from 18.6% in 1Q2009 to 52.3% in 2Q2009. There is clear evidence of widespread speculative behavior that is distorting prices. In the copper business for example, all kinds of groups unrelated to the industry — ordinary individuals, financial institutions and some small businesses are reported to be buying and storing copper solely on the expectation that prices will go up. One estimate puts the amount in speculative hands at a mind-boggling one million tonnes. If this is happening in copper it is most certainly happening in other commodities as well.
It is also clear that while policy makers are concerned enough about speculation to fine-tune their expansionary measures, they have no intention to materially tighten monetary conditions. Consequently, the economic recovery that is now underway will accelerate, producing substantial upside surprises in economic data in the next six to nine months. That will, in turn, keep asset prices bubbling upwards for a while.
THE BOTTOM LINE