Wednesday 11 August 2010

A Financial Look Forward

Back in January, I forecast that the end of central bank quantitative easing would cause a contagion in sovereign debt in smaller, riskier markets (Greece, Ireland, Spain), and that the sale of public debt would be impossible to finance from purely market resources. (See my post The Coming Crash of 2010, January 19th, 2010).

Unfortunately, my forecast on the sovereign debt crisis has been amply borne out by the events in Greece and other Eurozone countries. Yesterday’s announcement by the US Federal Reserve that that mortgage bond proceeds would be used to purchase about $ 10 bln/month in US government bonds, confirm that QE will have to continue into the future. 

Obviously, there is no choice. The US government needs liquidity, whether in the form of a vast public deficit, or in the form of additional balance sheet adjustments, e.g. by treating the Fed as a special purpose vehicle to off-load mortgage-backed securities. Most European governments face exactly the same dilemma. In the next months to the end of 2010, we will see the Bank of England extend its Asset Purchase Facility spending on UK government bonds, and the ECB continue to refinance banks and governments through various active measures.

The portents, however, are far more serious than we may understand by looking at isolated events:

a.       US GDP growth is ostensibly in positive territory, although I have yet to see a quantitative analysis of how much of this is due to government stimulus spending at various levels of the economy. For instance, while recent annualised GDP growth rates have reached 3%, we should not forget that the government has disbursed at least $ 400 bln in various stimulous packages per year over the past two years, or about 2.7% of GDP each year. Indirect indicators, such as inventory stocking and unemployment, seem to show that the recovery may be far more fragile than anticipated. Federal, state and local public finances are in a parlous state, and unfunded pension liabilities are rising.

b.      With the Euro in its expected rebound against the US dollar, I expect exports and general economic growth in Germany to slow. Although manufacturing orders and confidence have been surging, a quick look at the destinations of exports does not portend well for the future. Despite all the positive press about Germany’s successful economic model, we should not lose sight of the fact that this depends on healthy international demand for Germany’s high-cost exports. With the Euro rising, and with corporate and consumer spending endangered in most export markets, I do not count on the German export boom to last long at its current rates. Factoring in increasing incoherence in the German governing coalition, and the prospects of a change in government in the next years which would resume a labour-friendly policy, makes me “short” on Germany.

c.       In Japan, public debt has hit 200% of GDP. The first, small-scale measures to raise bond yields have been taken to somehow convince domestic investors to continue investing in public debt, but how long can this continue? Any crisis involving Japan, for instance a major earthquake, a problem with China or a spike in oil prices to over $ 100/bbl, will create a major problem for Japan’s exports and its public debt. Unless serious measures are taken, we cannot discount the possibility of a Japanese default in the next 2-5 years. Such an event would be less serious for Western banks, given that most Japanese government debt is held by domestic investors, but the shock-waves this would send through the system will be critical.

d.      In China, the government has started the process of cooling domestic growth through regulatory adjustments to the real estate sector and tighter credit limits. As Chinese imports slow, and overcapacity in most manufacturing segments reaches record heights, the risk is that China’s export-led growth miracle will no longer sustain high GDP growth. While this is a boon for Western consumers (overcapacity will result in lower prices or higher price competition by Chinese manufacturers), it diminishes the capital-intensive exports from the US, Japan or Europe to that country. China’s 2008-2009 response to the economic crisis of vast loan disbursals to national businesses have created the conditions for deflation in most manufacturing segments, which will also inevitably lead to great price pressure for European, American and Japanese manufacturers.

e.       The ECB’s policy on a range of issues, from the European banking stress tests, to quantitative easing, to repo window financing of European banks, is increasingly calling the regulatory framework of this institution into question. The problem is compounded by very real fears that three of Europe’s five largest economies—Italy, Spain and the UK—are facing a double dip recession, either due to retrenchment in public spending (UK), or due to adverse conditions in key sectors (e.g. Italian exports; Spanish tourism & construction).

f.        We are long overdue for an inflationary correction in certain segments. I anticipate energy prices to increase. This is a factor of growing population growth and adoption of the automobile (particularly in Asia), rather than due to any economic recovery. I anticipate an oil price spike within the next 6 months due to unforeseen factors: turbulence in Iran and the Straights of Hormuz, supply disruptions elsewhere. I also anticipate the resumption of food price inflation. The recent decision by Russia to ban wheat exports is but one sign of this.

So we are in something of a bind: the only way to get a modicum of economic growth in 2010 appears to be further QE and government funding. Yet apart from China and India, nearly every major world economy is reaching historically unprecedented public debt levels (in peacetime conditions). Most world leaders (Barack Obama, Angela Merkel, Nicholas Sarkozy, etc.) have decided to take cosmetic measures in deficit reduction, while hoping that the resumption of economic growth will lead to the recovery of public finances. Yet apart from the 8 years of debt reduction under Bill Clinton in the 1990s (a time which was arguably unique in US history), there have not been too many cases of fiscal responsibility in periods of economic growth.

All this occurs against the backdrop of major demographic change and a paradigm shift in the availability of fossil fuels and the location of global manufacturing capacity. These forces will magnify the deteriorating fiscal conditions of most countries in the years to come.

Unless real, structural reforms are undertaken to (a) fundamentally reform the public sector and its relationship with citizens in most countries, and (b) create objective conditions for growth and employment, most countries are in for a very difficult time. So far, I don’t see many signs that such reforms are being considered on the necessary level in Greece, the United States, or elsewhere. Instead, we appear to be dealing with symptoms of problems, rather than their root causes, and sowing the seeds of future crises.

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