Straw, stick or brick – how strong are the foundations of the current economic recovery and when will the central banks’ big bad wolves will come and blow them down?
These are the key questions for financial markets as they look forward to the outlook for 2010. We do not agree with the optimistic view that the recovery is built of bricks (or even baked in BRICs).
The record monetary and fiscal policy expansion is unlikely to allow the seamless progression from the inventory led rebound to higher investment expenditure. This translates to higher unemployment and lower consumer expenditure, and calls into question the ability of the global economy to withstand the gradual withdrawal of monetary and fiscal stimulus.
The Panglossian view is based on continued record stimulus for a prolonged period of time, coupled with a V-shaped recovery. We do not believe that either condition is likely or even desirable from a policy perspective. Indeed, there is a slightly greater risk that the recovery is based on straw. The headwinds or tight lending criteria and financial and consumer sector deleveraging could slow the industrial economies back into recession once the inventory bounce has taken place.
However, our central forecast continues to be based on the view that if you throw enough money at the global economy it will grow. But if you take this money away, growth will falter. Thus the recovery is built upon sticks and can be blown away by tighter central bank policy. At this juncture only Norway and Australia have tightened interest rates. The RBA is expected to vote for another 25bps next month and should continue until its policy rate reaches 4%. At this point it is expected to pause, awaiting complementary tightening from China and or the Fed.
We still believe that the Fed will start to tighten in the second quarter. There is no risk of imminent tightening as the third quarter GDP data is likely to be revised down to 2.8%, less than the 3.5% annualised stimulus provided by fiscal policy during the period. We expect growth to accelerate to 3.5% in the fourth and first quarter, putting pressure on the Fed to withdraw liquidity. This suggests that the medium term trend for treasury forwards is bull flattening.
The number of the beast has featured prominently this year, having set the closing low for the S&P 500 in March. The number was hit again on Friday for 2yr yields. Rates subsequently bounced off this level ahead of this week’s $110bn funding program. This illustrates that with markets being driven by central bank liquidity, investors are nervous about progressing through the traditional dip in market liquidity in the run up to Christmas.
The Bank of England’s MPC minutes for November revealed a 7-1-1 vote for more quantitative easing. The Bank discussed and dismissed reducing interest rates on reserves but did not reject future use, although the market reaction was excessive given the prospect of higher inflation over the coming months. This suggests that curve flattening is much more likely than steepening. This week’s GDP data is likely to be revised up from -0.4% to -0.2%, but questions remain over the weakness of small businesses and investment expenditure.
The next major factor for gilts is the Pre-Budget Report on the 9th of December. The Treasury tried to stress that the wider PSBR in October wasn’t another sign that the deficit is likely to overshoot its £175bn target. This suggests that the presentation will be highly political and very short on detailed measures to reduce the deficit. The danger is that this lack of clarity reduces international investors confidence in fiscal austerity.
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.