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The recent meetings of the largest central banks have increased the sense that the ones that matter are rudderless and their ability to command markets is on the wane. That increases the probability that economies will drift on, without a decisive break up or down or any big policy shifts.
Often have I sat in a train waiting for it to depart. When it does, it is the world and time that seem to slide by the window while the train stands still. The illusion lasts but a moment. But it is disquieting. We are on such a train.
It is ingrained in us to think of destinations. But if the world stands still as time and places spin emptily past us, we may never reach them.
What matters to investors are the destinations of recession or recovery.
The outcome for assets is a dichotomy. But there is the possibility that little changes and we get to neither destination but drift on as we are, in stasis.
Recession would zap equities, for all their advantageous dividend yields, because dividends would prove unsustainable and, by definition, there would be no profit growth.
Central banks would invent yet more extreme measures – such as helicopter money, which would take the form of the direct monetary financing of fiscal spending.
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On the other hand, continued recovery would be led by the US and shouldered, to a lesser degree, by the eurozone and hardly at all by Japan. The US Federal Reserve would resume tightening at an accelerating rate as labour market slack is absorbed and wages respond – with a lag. And global capital, not just US capital, would be repriced.
But what if the present economic world is in frozen stasis and it is time and places that slide by?
The components of this scenario already stare at us gloomily. Economically, Japan continues to do what it does best: impersonating a corpse. Europe bumbles along at a statistical error of emblematic growth closer to 1% than 2%.
And though the US does better, it turns out that, despite low productivity having transformed corporate America into a labour guzzler, labour has no pricing power. This is because the types of jobs being created are low-paid, for the low-skilled workers, of which there may be rather a lot that can still be leached from a rising participation rate. The upshot would be that the Fed would ‘never’ tighten – never meaning the next two years.
Equities would be weak or flat. The discount rate would not rise. But the profit cycle would continue south and much of today’s yield support would be eroded by falling profits.
It is likely that this sort of low-growth world with economies, both developed and emerging, teetering on recession, central banks losing their remaining credibility and out of firepower and equities heading south, would be very volatile.
Momentary illusion
How much of this scenario is already built into market expectations? Quite a lot. The market is pricing in almost no Fed rate increases over the next year and barely much more over two. However, the stasis scenario is probably also wrong. The minutes from the Fed’s April meeting showed that the monetary committee is still looking to hike its policy interest rate this summer and probably again once the US presidential elections are over, in December.
Like the momentary illusion of immobility of a moving train, the current expectations of a static world will fade. Expectations are more likely to move to my central thesis of a gradually accelerating US recovery, relative to the rest of the world, than to stay unchanged or relapse into recession.
Indeed, I expect US growth to mount a strong rebound over the remainder of the year while inflationary pressures should also heat up. Prices will be underpinned by a tight labour market, supporting the continuing recovery in wages and now higher oil prices. That should be enough to drag out two hikes from the Fed this year and for tightening to continue at a similar pace next. At the same time, the ECB and BoJ should continue to ease.
That means I expect the dollar to recover against the other main currencies as the interest-rate and growth differential that the US has over Europe and Japan widens again.