Through 2014, a key question will remain at the forefront: whether the authorities have really ‘fixed’ the financial system and created a self-sustaining recovery? While unconventional monetary policy initiatives, such as quantitative easing (QE), have bought time and benefited investors in risk assets, some investors have been inclined to interpret cyclical improvements in the developed economies as evidence the world has finally shrugged off the depressive grip of the financial crisis.
Should economic expansion undershoot, the official response is likely to be more unconventional stimulus. If this stance proves correct, we would expect a continuation of ultra-loose monetary policy. Were the response of the authorities to succeed in delivering a more robust pick-up, the outlook for interest rates is likely to change radically and make it more difficult to hold down debt-servicing costs. Either scenario would seem to set the stage for continued volatility. A further complication is that policymakers are increasingly seeking to link their interventions to economic variables, such as employment, meaning short-term market movements will become increasingly dependent on data.
Short-lived support assumes permanency
The financial crisis merited a life-saving jolt in the form of previously unthinkable levels of state supportand intervention on a global scale.The balance sheets of the world’scentral banks have ballooned to morethan US$20 trillion since 2007 (roughlyhalf of this in the developing world)through intervention in local bondand foreign exchange markets.
Emergency support for the global economy was intended to be temporary. Whatever the expectations for QE, the unprecedented monetary interventions were intended to give politicians time to put in place the necessary structural reforms and fiscal consolidation. However, painful adjustments hardly ever fit modern electoral processes or cycles.
Although the rhetoric of central bankers is aimed at instilling confidence (and market participants have taken policymakers at their word by building in expectations of more growth and higher bond yields), the authorities clearly harbour doubts about whether recovery is indeed self-sustaining. They remain deeply concerned that economies are still fragile and prone to deflation. Doubts we share.
Debt burden borne by governments
We have long argued the difficulties facing the developed economies (debt burdens, worsening demographic trends and increasing competitiveness in a globalised world) represent a challenge for politicians, largely because any action is likely to affect growth adversely in the short term. (The credit bubble has left many economies carrying levels of debt that materially impair their economic prospects. As debt is reduced to more manageable levels, an extended period of relatively low growth and higher economic volatility can be expected.)
In the recession that followed the boom, governments stepped in to fill the void left by a retreating private sector. If the crisis was caused by private-sector debt growing more rapidly than the ability to service it, the post-crisis era has been marked by public debt growing faster than GDP. In aggregate, the world has been deficit spending, adding some US$23 trillion to sovereign debt liabilities since 2007 (according to the Bank for International Settlements).1 In total, liabilities have not been reduced but have actually grown by some 30%.
Demographic trends mean this increased debt load needs to be serviced by a shrinking working population, which, in turn, also faces ballooning costs related to ageing and healthcare expenses. Weak growth in productivity in the major economies, rigid product and labour markets, falling real incomes and historically low savings could translate into restrained growth in consumption.
Economies that pursue policies that cheapen money and use asset prices as a tool of policy become overly dependent and sensitive to those same asset prices. The financial system, which is supposed to serve the economy, begins to drive the economy; the ‘cart’ is put before the ‘horse’. The danger with this is that the horse will stand still, munching grass, so moving the cart takes ever bigger efforts.
Against this backdrop, we maintain a focus on stable, sustainable and predictable companies, which should be well positioned to prosper when the day arrives that economic data releases disappoint, as we believe they will inevitably. We retain our emphasis on capital preservation, while accepting some risk and volatility in order to achieve a return.
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