“Recent events in Dubai and Greece are a foretaste of heightened global macroeconomic volatility expected over the next few years. Those who live by liquidity are condemned to die by the withdrawal of liquidity. Global financial markets have been propelled by the $9tr worth of government stimulus over the past year. Central banks have lowered interest rates close to zero and key economies have engaged in unconventional quantitative easing. The net result has been to replace financial sector leverage with public sector liquidity, restoring overall leverage to 2007 levels. However, public sector leverage operates on lower multipliers and is ultimately unsustainable. Central banks will try to withdraw this liquidity over the next twelve months.”
“To paraphrase Warren Buffett “you only find out who isn’t wearing any swimming trunks when the tide recedes”, or more precisely those markets who live by liquidity are condemned to drop on its withdrawal. The threatened and actual withdrawal of liquidity and implicit support from Greece and Dubai illustrates how sensitive global markets are. Neither market represents systemic risk for the global financial system. While volatility is likely to remain elevated as global liquidity naturally fades into the end of the year, this is only temporary and central banks continue to pump money into the global financial system through the first quarter.
“The ECB is likely to be ‘last in – first out’ of the liquidity game, with officials already openly discussing exit strategies. Talk is cheap and we do not expect a move to variable rate tenders until March. However, these discussions have already led to higher peripheral spreads. The cessation of QE in the UK and US by the end of the first quarter, followed by the inevitable discussions over the unwinding of this liquidity, will force higher short dated government forward rates and weaker risk assets. This will be the catalyst for return to recession by 2011.
“The recovery does not need credit in its early stages; this leaves room for growth and puts pressure on central banks. However, sustainable growth requires new credit and there is no evidence that banks have ceased to deliver. Public demands for banks to repay public money to help limit budget deficits are counter-productive since they encourage banks to restrict credit and starve small and medium sized companies of necessary funding.
“The gap between small and large companies is becoming increasingly acute. Large companies are driving the improvement in business confidence in the US and Europe, while small and medium sized companies are being restrained by bank balance sheet impairment. This has opened a noticeable gap between the payrolls and unemployment data. Payrolls are biased by large companies and are expected to start growing in the first quarter. The improvement in the second derivative is expected to slow in November due to the seasonal impact of Christmas employment in the retail sector and should contract by an additional 150,000.
“Weaker than expected UK PMI shows that contraction in adjusted money supply growth is constraining companies’ ability to rebuild inventories and suggests that UK growth will continue to underperform Eurozone and US rates during the fourth quarter. This presents a subdued background for next week’s Pre Budget Report, which is expected to tread a thin line between Darling’s honesty and Brown’s dissembling.”
For Stuart’s full commentary please see his blog at www.ratesviews.com.
These are the views of the author and do not necessarily reflect those of Ignis Asset Management.