Looking ahead
We have not formally amended the probabilities
associated with each of our prospective economic outlooks – as a
reminder, our third scenario ‘global recovery’ was given a 15%
probability – but it does appear downside risks have escalated. The
World Bank has issued a warning that global economic growth could
stall if there was a sovereign default in Europe – an event which
many commentators believe is, more or less, considered a given. The
IMF has stated that risks to the global economic outlook have
‘risen sharply’ and that policy makers have limited room to provide
further support.
As ever, we believe the US remains an
important barometer for the prospects of the global economy and it
does not take long to build a list of the worrying issues currently
faced. Namely: 1, Bank lending is very weak, leading to the growth
in broad money supply being weak too; 2, Another downward leg in
the housing market is appearing, now that tax credits have been
removed, and this will damage consumer confidence and further
dampen loan demand; 3, Companies, despite being very cash-rich,
have yet to increase hirings or increase capital investment, as
final demand does not yet justify this expenditure; 4, Household
leverage still remains very high; and 5, The structural growth
rate, according to some economists, may have permanently
fallen.
This leads us to the question we have been
repeatedly asking ourselves – will deflation or inflation be the
major shaping force as we look to the future? Our conclusion is we
must plan for both, but, as mentioned earlier, deflation is the
near-term problem. Thereafter, taking the five points listed above
for the US economy as a guide, we think deflation will ultimately
be tackled by monetary inflation, which will be fuelled by central
banks introducing quantitative easing, part two, to re-ignite
stagnating Western economies. Governments, faced with the threat of
debt traps caused by the ever-increasing burden of interest
payments and falling tax receipts, will also favour monetary
inflation rather than the issuance of more bonds. If this view is
correct, we are heading for a devaluation in paper currencies and
this should be countered by ensuring portfolios have exposure to
real assets, such as property and commodities – two themes we have
been building. The nominal price of equities should also rise in
this environment.
We accept this is a pessimistic outlook and
predisposes the imminent arrival of a double-dip recession, which,
in economic history terms, would be an unusual event. Corporate
newsflow has, in the main, remained very positive and softening
leading indicators are pointing to a deceleration in growth not, as
yet, the arrival of a recession. There is a case to argue, in the
face of extreme government fiscal tightening, that central banks
will target quantitative easing with the objective to push
long-term interest rates on bonds and mortgages closer to zero.
Consequently, businesses and homeowners will accept near-zero
interest rates are not a short-term phenomenon, but, instead, a
long-term feature of the post-crisis world. This could prompt a
willingness among business owners to invest and homeowners to spend
more money leading to a virtuous circle, which ultimately
stimulates growth.
These are polar views and representative of
the extremes asset managers are having to model as they build and
maintain portfolios. Our barbell approach caters for these
potential outcomes and it is a style we intend to keep while the
future remains as opaque as it currently is. For us, the only
certainty remains uncertainty and this will translate into
continued volatility. Our commitment has always been to protect the
hard-earned capital of our investors and it is important we keep
vigilant to this task in these challenging times.