PORTFOLIO POINT: The recession is over, but it's too early to call a new bull market.
The global recession is over. In the weeks ahead it will become clear that world output has stopped shrinking and started growing … albeit weakly.
True to form, the stockmarket anticipated this and, this time at least, got it right, rising 37% from March 9. The bear market ended on that day, with the All Ordinaries index hitting a low of 3104, but it’s too early to say a new bull market has begun.
That’s because we are now in uncharted waters. There has been a Great Global Reflation Experiment and we don’t really know what the consequences will be, beyond knowing that it prevented Armageddon last year.
On balance, however, the results are likely to be pretty good: low inflation and rising asset prices. Here’s why.
There have been two parts to the Great Reflation: a huge increase in government deficits, and debts, and an equally large increase in central bank balance sheets, accompanied by reductions in policy interest rates – in many cases to zero or close enough to it.
This has led many analysts and economists to conclude that rising inflation will be inevitable. Money markets are pricing in a rate rise later this year as a result.
But I think you need to separate consumer price inflation and asset price inflation.
The global “output gap” – that is the difference between potential and actual GDP – is now so large as a result of the collapse in credit markets that ordinary CPI inflation is out of the question for a long time.
That doesn’t mean interest rates will not start rising in the next 12 months – they almost certainly will – but only because they don’t need to be so low and central banks have an inbuilt urge to “normalise” interest rates whenever possible, not because they are seriously concerned about inflation.
Asset prices are another matter, though. There is not an oversupply of shares and property as there is with labour and consumer goods, and demand for them is growing because of the sudden reappearance of excessive liquidity.
When Milton Friedman famously said that inflation is always and everywhere a monetary phenomenon, he meant that inflation is fundamentally an expansion of money and credit that exceeds the growth needs of an economy, expressed as credit growth in excess of GDP. But he didn’t distinguish between asset and consumer price inflation; it can be either.
I borrowed the term “Great Reflation” from an essay written last week by the former chairman and editor-in-chief of the legendary newsletter The Bank Credit Analyst, Tony Boeckh, published on his new website, as well as in John Mauldin’s excellent newsletter, Frontline Thoughts.
Boeckh pointed out that after 1982, private sector credit in the US rose rapidly for 25 years in relation to GDP and the ratio is now double what it was in he early 1980s. “The magnitude and length of this rise is probably unprecedented in the history of the world.”
As a result, the panic and crash of 2008-09 was on track to be equally unprecedented – until the bailouts, the speed and magnitude of which aborted the meltdown.
But it did not prevent a massive destruction of global wealth: the Asian Development Bank estimated recently that the value of financial assets had declined by $US50 trillion, equivalent to a year of global GDP. And that’s without taking property losses into account!
Retirement incomes have been devastated, lives ruined and the general appetite for risk has shrunk dramatically.
Tony Boeckh says: “Massive monetary stimulus is good for asset prices in the near term (eg, stocks, bonds, houses, commodities) in a world of very weak price inflation and a soft economy. That is true as long as the economy does not fall apart again, which is very unlikely given all the stimulus present and more to come if needed. Therefore, investors who can afford a little risk should own some assets that will ultimately be beneficiaries of the wall of new money being created and thrown at the economy.”
Already the Great Reflation of 2009 has produced a 50% increase in the global MSCI share index.
Boeckh concludes that the main risk is to the US dollar, which is “fragile and unstable, and must fall over time”, but even then he says there is likely to be a sort of “balance of terror”, because foreign central banks hold $US2.64 trillion worth of dollars and don’t want to see their reserves collapse in value, or to see their own currencies rise too much. Nevertheless, his main advice to American investors is to diversify out of US dollars.
That doesn’t apply to us, of course – in fact the reverse applies: if the US dollar resumed its decline, then the Australian currency would rise, as it did in the first six months of the global financial crisis.
The Australian dollar nearly hit parity with the US dollar in July last year, but collapsed back to US62¢ when there was a flight of cash into US bonds and dollars during the height of the post-Lehman panic. That has since been partly reversed and the Aussie is back to US83¢ – getting back slightly more of the post-Lehman collapse than the sharemarket has (60% vs 50%).
The point is that if all we have to worry about is a rising Australian dollar, then we have astonishingly little to worry about. It wouldn’t be great for exporters, but a strong currency would hardly be a calamity.
Tony Boeckh might be wrong about the benign outlook, of course, but please note that even Gerard Minack broadly agrees: in today’s article, he says: “The upside surprise is becoming the upside base-case”. That’s “upside” from Gerard’s previously bearish base case, don’t forget.
Indeed, the base case now looks more like a combination of weak global growth for a few years, led by China and Asia, continued low inflation and possibly deflation in some countries, and rising share and property markets.
That’s because all the new money that was created to prevent Armageddon has to go somewhere, and it looks like going more into savings than consumption. That means rising “savings prices” (assets) but not rising consumer prices.
If only governments and central banks had done this in 1930, instead of raising interest rates and tightening fiscal policy instead. Who knows where the world might have ended up.
