G20 and All That
As expected, the G20 leaders all smiled for the cameras and said what clever folk they had been. So what did they achieve? Probably two things: first, by bolstering the IMF, they have underpinned international trade, and alleviated concerns about weaker trading partners in general, and Eastern Europe in particular; second, the psychological effect has been to boost confidence, where none previously existed, among those looking for an end to global financial travails.
Coincidentally there were some other shots in the arm. Economic statistics reported last week broadly suggested that a deceleration of the bad news is occurring. The agreement between Obama and Medvedev to restart nuclear arms reduction talks is also very positive. And in America so-called mark-to-market rules have been suspended, taking some pressure off the banks.
But there was plenty missing on a range of subjects, including bank recapitalisations, EU stimulus, financial regulation, and substance on protectionism. Was the optimistic reaction misplaced?
Probably. After hyperactivity from governments and central banks, it is very likely that there will now be a pause while they assess the success of their policy making. This should coincide with a period during which bad news is less bad than it has been. This is to be expected. The aggression with which companies have been destocking has been extreme, and they can only reduce their stocks so far. Strong companies can now gain easy access to finance, and there should be some trickle down effect. Traders have started thinking that this is a bad recession, not a depression.
But the difficulty is that this is a "balance sheet" recession, brought about by banks and households holding far too much debt, not the usual inflation-induced recession. All the remedies touch the banks and other financial institutions, but have not started to address the balance sheets of ordinary people. The psychological shock is likely to cause a substantial rise in the savings rates of individuals. Enormous numbers are losing their jobs. Many have seen their pensions decimated. The value of their homes has fallen sharply, and is still falling. This will cause negative feedback to the banks. To deal with bank balance sheets the assets have to stop deteriorating, but they have not. Morgan Stanley estimate that balance sheet shrinkage of 15 major banks has been £2,430 billion so far and that there is a further £1,360 billion still to come.
Economic growth has been driven by consumer spending for decades, but growth in the next few years will be weak by comparison. Governments, trying to manage the decline, will spend royally on the state sector and on infrastructure but, when the economies stabilise, they will ultimately raise taxes to pay for their largesse. There will not be a quick bounce back to "normality".
We do not know how effective policies will be in allowing credit to flow freely again, but banks are not out of the woods. Central banks will continue printing money, and are not likely to risk undershooting. That money can go to two places: real economic growth or inflation. If the latter, it may go into assets, in which case shares may rally further, or into commercial prices, and inflation as we recognise it. Ironically inflation allows the value of debt to be eroded. If you were Chancellor of the Exchequer, what would you hope for when your own debt is out of control?
In portfolios, we have been gradually reducing the more risk averse positions, of cash and gilts, which have served us well. Despite the rebound in confidence there is still great pessimism, and many assets look cheap on a longer term basis. We are therefore increasing exposure to other asset classes for more growth oriented portfolios. For some this means equities, for others it is more to inflation-linked assets, such as infrastructure, energy, gold or inflation-linked gilts.