The monetary rabbit from a hat
The bull run that began in 2009 has been the US stockmarket's most dramatic rally by far of the post-war period. That naturally begs the question, are such pyrotechnics justified?
The American economy is indeed recovering, thanks to government handouts, but at what cost? The Federal Reserve has injected staggering amounts of liquidity into the banking system that sooner or later will lead to inflation. At the same time the public debt has gone through the roof. Inevitably creditors will demand real compensation for the added risk, in the form of higher bond yields.
Despite the authorities' considerable efforts unemployment has barely budged, and the housing market remains in a deep funk. As a consequence US consumer sentiment has failed to mount a genuine comeback from its all-time lows. The current recovery cobbled together by a government concerned about getting re-elected may fool some observers near term, but looking further down the road it lacks credibility. Small wonder, then, that households are wary about future tax increases and about job security. Investors are cagey as well. Burned by two stockmarket bubbles in less than a decade, after the second one burst they piled into reputedly risk-free US Treasuries. The buying spree drove bond yields down too far and has sewn the seeds of the next crunch. But are equities the better bet? Admittedly the forecasts for earnings growth—10-15% this year and again in 2012—are compelling, but besides being optimistic they will only be translated into higher share prices if the market P/E ratio stays flat. That is uncertain. To begin with investors are still quite doubtful about the sustainability of long-term economic expansion. Secondly a resurgence of inflationary pressure often causes earnings multiples to fall.
Over and over
A look at the total return on US equities relative to 10-year Treasury bonds is telling. Until 1995 this curve sloped gently upward, true to financial theory which posits that shares gain value faster than bonds do in the long run. Halfway through the nineties, though, things started getting out of hand owing to unduly low interest rates and the dotcom bubble. For five years the relative return on equities went into a vertical climb, leaving fixed income far behind. The deviation inevitably ended in catastrophe, but investors did not learn their lesson and by 2003 the US stockmarket was again barrelling ahead. This time the exuberance was fuelled by banks' bloated profits garnered on freewheeling credit. In a replay of 2000-02 shares collapsed along with house prices, while the value of Treasury bonds soared. The result was a new mountain of public debt that still has to be absorbed by the market. To make this process less wrenching, the Fed has been forced to churn out huge quantities of dollars ("QE2") to buy Treasury bonds. That story unfortunately is still being written, so no one knows how it will end. But two things are certain: the US economy has to be purged of this excessive debt and the bond bubble has to deflate. How in these circumstances can the stockmarket continue to plough ahead without a bump?
First jasmine, then lotus ?
A key to answering this question was given by Zhu Min, China's special adviser to the International Monetary Fund, at this year's Economic Forum in Davos. Mr Zhu raised the possibility of a three-speed recovery in which the emerging countries would romp in the lead with GDP growth of over 6%, followed by the US loping along at about half that rate and the euro area and Japan, of course, bringing up the rear. Actually this scenario would merely extend the pattern that existed before the financial crisis, and could thus mark a carryover of bad habits from the past. The upturn in American consumption might deter Asia from abandoning its export-driven, mercantilist model and prompt it to focus instead on developing domestic demand. Yet some observers such as Howard Davies, director of the prestigious London School of Economics, are quite confident about the emerging economies' potential. These were left largely unscathed by the hurricane that ravaged Western banks in 2008. Generally speaking their state budgets are balanced, and their public debt is not even half the level prevailing in the developed countries. Moreover, their age pyramid is much more desirable.
Based on purchasing power parity (used by the IMF to adjust for price differences between regions), the industrialising countries already generate half of global GDP. In ten years' time they may easily account for two-thirds of it. But to do so they will have to clear a number of hurdles. Unlike the advanced economies that are geared towards services, the emerging nations concentrate on infrastructure development. As a consequence they suck in vast quantities of raw materials, creating heavy pollution and a growing risk of shortages. Unsurprisingly, commodity prices are shooting up. After the Second World War the West enjoyed a long period of economic expansion driven by extremely cheap energy. Oil stayed below four dollars a barrel until 1973. A barrel now costs over $100, or 25 times more. If nothing reverses this trend the emerging countries' upswing could be stymied, even without a broad rise in interest rates. And oil is not the only challenge: agricultural resources are becoming a source of even greater concern. For billions of people food makes up more than a third of the household budget. A surge in prices, due for example to disastrous flooding and/or drought, could degenerate into social violence or revive ethnic conflicts.
These tensions are exacerbated by an endemic lack of social security and by soaring property prices that have made private homes a luxury reserved for a well-off minority. The risk of authoritarian or corrupt regimes being toppled is growing. After the Jasmine Revolution in Tunisia, why not a Lotus Revolution? Tiananmen may not resemble Tahrir Square today, but the fact is that loose monetary policies encourage a wasteful approach to resources. They induce business leaders and consumers to overspend. Witness Japan in 1990 and the US in 2007, just before the fall.
A three-speed world could certainly be viable, provided the errors of the past are not repeated. Spiralling budget deficits and money creation are not at all sound foundations on which to build the future. Problems have to be addressed urgently instead of being deflected, as always, until another day. Governments should play only a moderate role in economic development and should focus on shoring up their finances. How can they advocate restraint among their citizens while continuing to run up billions in debt, year after year? Real interest rates, i.e. ex inflation, have to be high enough to encourage savings and deter borrowing for speculative purposes. They are moreover a necessity to put an end to ten long years of falling share prices, punctuated by two uncontrolled bubbles, and to set the stage for real prosperity at last.
As an ancient Chinese proverb goes, it is by doing things well that we can feel well.
Michel Lagier