Despite a somewhat soggy global economic backdrop, I believe that the trajectory of global equity markets will continue to be up over the next six months, with Europe and Emerging Markets likely to be the best performing regions. Economic data in the U.S. is stable, albeit at a low level. “Core” European countries such as Germany have been on a steadily deteriorating path, while the economic backdrop in peripheral Europe continues to be extremely challenging. Japan remains stuck in the mud.
My call for the markets in the near term, despite this somewhat bleak economic underpinning, is driven by aggressively supportive monetary policy globally, which should overwhelm the impact of feeble growth.
- QE3 was recently announced in the U.S., entailing $40 billion of mortgage purchases each month.
- As noted in a recent Columbia Management Perspectives article by Daisuke Nomoto, our Senior Pac-Asia portfolio manager, upcoming elections in Japan are putting immense pressure on the Bank of Japan to radically expand monetary operations to stimulate their flagging economy.
- China has also been stepping up their stimulus program, adding to the powerful flood of liquidity that should fuel equity markets higher.
I believe the biggest swing factor however will be Europe. European Central Bank (ECB) President Mario Draghi recently announced the Outright Monetary Transactions program (OMT), the potentially large scale purchase of the short dated sovereign debt of any Euro Area country entering into a formal bailout agreement. Spain is widely expected to be the first recipient of this aid. Unfortunately, though not surprisingly, Spanish Prime Minister Rajoy has been reluctant to commit to a program due to the austerity and monitoring that are a prerequisite of the funding. The evidence so far on austerity programs is mixed at best, with Portugal, Ireland and Greece suffering massive economic downdrafts at least partly as a result of the enforced austerity. Further, no political leader initially submitting to a program has been re-elected, yet another powerful deterrent.
It is fairly clear that Spain will ultimately need bailout assistance. My guess is that when the logjam finally breaks and Spain formally requests assistance, the ECB will be very aggressive in buying debt, providing a major boost to global equity markets. It’s also possible that even in the absence of a Spanish application, Mr. Draghi will continue his string of creative monetary tactics and announce an alternative means of stimulating the Euro Area, such as through the direct purchase of corporate debt.
Despite this benign near-term outlook however, I believe an existential crisis in global equity markets resulting in massive wealth loss is a significant possibility over the next few years. This is premised on my belief that the developed world simply has far more debt than it can reliably support. At some point a major write-down of the value of this debt (like the subprime crisis in 2008 only with government debt) will be unavoidable, resulting in immense capital market losses around the world. The trajectory of these debt burdens is accelerating due to economic weakness and the reluctance of politicians to address entitlement spending that is no longer supportable.
The irony of the situation is that as long as the global economy remains weak, everything should be fine. Weak economic growth keeps inflation at low or negative rates, allowing the current zero interest rate policy (and variants thereof) to be maintained. With borrowing costs around zero, almost any debt burden is sustainable. The problem will arise when the global economy starts to strengthen, which will put upward pressure on inflation and ultimately interest rates. Given huge debt burdens across the developed world, higher debt servicing costs will quickly begin to consume progressively greater percentages of tax revenues, making the debt burdens facing most developed economies eventually unsupportable. Japan is in the most precarious position, and is therefore a likely catalyst for a market meltdown.
However, I don’t believe we will reach the tipping point gradually. The cost of some major shock to the system, such as a natural disaster, war in the Middle East, a SARS type epidemic, etc., will be what pushes us over the edge. There is just no slack in the system to absorb a big budgetary hit like this, and as interest rates ultimately rise, our ability to withstand such a shock will be even further diminished. Where the shock originates and who is most impacted is impossible to forecast, so the source of the instability could be almost any of the major developed markets. Given the pervasiveness of over-indebtedness and the interconnection of global markets however, the location is almost irrelevant as the shockwaves will likely be transmitted around the world and the resulting collapse in wealth and activity will be felt everywhere.
This type of negative outcome is certainly not a foregone conclusion. The resilience of human ingenuity in a crisis is always impressive, and there is even some hope that sufficient entitlement reform will occur once the pressure to do so becomes politically compelling. But the fact remains that there is too much debt across most of the developed world, and growth is likely to be subpar for an extended period of time, leaving us extremely vulnerable to shocks, political and monetary mistakes, and even the irrational mood swings of markets.
As long as weak growth allows us to prolong our zero interest rate policies, our debt burdens are supportable and everything is likely to be fine. Once an economic recovery takes hold, putting upward pressure on inflation and then interest rates, we will be at serious risk. Good news may turn out to be very bad news.