8 minAnalysis of the situation in ten points
In the following I have tried to sum up in ten points my analysis of the economic and financial situation.
1. In the past 30 years, the world economy has become very leveraged.
This is due to the declining cost of borrowing (i.e. interest rates), following the success of the monetary authorities in fighting inflation. Debt increased in two waves – the first in the 1980s, followed by consolidation in the 1990s, and a second wave which has been underway since 2000. It is the second wave of debt that has undermined the economy, initiated by the Federal Reserve's irresponsible monetary policy in the wake of the bursting of the technology bubble. By maintaining its key interest rate at an artificially low level, the US central bank encouraged recourse to debt (consumer credit rose every month between February, 1998 and July, 2008) which notably gave rise to a real-estate bubble and the multiplication of activities having no economic added value. Other phenomena, such as the deregulation of finance, have intensified this trend. Debt levels are now very high by historical standards.
2. Two important economic players - US households and banks - have embarked on a process of deleveraging.
Just as the process of leveraging up boosted growth (borrowing money to buy a car stimulates consumption), the process of deleveraging will weigh on growth (the money used to pay back a loan cannot be spent on other things). The problems experienced by US households mean that the growth model of the past three decades – world economy driven by the United States, US economy driven by private consumption, private consumption driven by recourse to debt – is now a thing of the past. The influence of the US consumer has been even greater because the growth model of other countries or regions is often primarily based on exports rather than internal demand. Whereas in the 1970s, the world was in a situation of excess demand, today we have a situation of excess supply (which also explains why the current environment is characterised by deflationary pressure - in the 1970s, it was marked by inflationary pressure). In this situation, the US consumer was to some extent ‘the consumer of last resort'. From the beginning of 1992 to the end of 2007, there was an unprecedented 64-quarters uninterrupted string of rising consumer spending.
3. To make up for the deleveraging in the private sector, the public sector has opted to get into debt.
Over the past two years, we have seen an unprecedented increase in the level of government debt. This is due to the governments' desire to save the banks and launch stimulus measures to offset the weakness in the private economy. The situation is even more concerning in light of the fact that in many countries, demographic trends will increase pressure on public spending in coming years. Also, a big percentage of government debt in a lot of countries will have to be refinanced within the next three years.
4. The very high public sector debt levels are undermining the economy and bringing about new risks.
In their book, ‘This Time is Different', economists Carmen Reinhart and Kenneth Rogoff note that history has shown that once the public debt to Gross Domestic Product ratio approaches 100%, economic growth slows and there is greater risk of sovereign default and/or galloping inflation as well as of a systemic crisis. Added to this is the prospect of social tensions linked to the end of the Welfare State model based on using debt to finance untenable electoral promises.
5. The high level of debt is a problem in the industrialised countries but not in the developing countries.
In most developing countries, the degree of debt is low at all levels of the economy - households, businesses and governments alike. This means that the next public debt crisis will not occur in these countries, contrary to what we had got used to seeing in the period 1980 and 2000, with the Latin American and Asian crises.
6. The European and US authorities will maintain their interest rates at very low levels for a long time.In an environment characterised by high levels of debt, weak economic growth and fiscal austerity, the European Central Bank and the US Federal Reserve will wait a long time before tightening their monetary policy. Given that the return on a money-market investment is directly linked to the central bank rates, the yield on a ‘no-risk' investment will remain very low in the coming years. ‘Doing nothing' is therefore also a decision and the opportunity cost of such a decision is high in a context of short-term rates close to zero.
In the longer term, the main challenge for the European and US monetary authorities will be to uphold a highly accommodating monetary policy without giving the bond markets the impression that they are abandoning their inflation control target. If this were to happen, medium- to long-term interest rates (over which the authorities have no direct control) would increase with disastrous consequences for public finances in a number of countries.
7. The myth of the ‘no-risk' government bond is being put to the test and investors will increasingly differentiate between countries.
One year ago, the yield on the 10-year German government bond was 3.7%, while Greek bonds were offering 5.5%. Today, the yield is 2.6% and 8.1% respectively. Investors have cast doubt on the ability of Greece to honour its debt and the country has entered into a vicious circle in which the rise in medium and long-term interest rates pushes up the cost of servicing its debt, which accordingly increases the risk of restructuring and in turn justifies a further rise in the level of interest rates. In contrast, Germany is benefiting from a 'flight to quality' and finds itself in a virtuous circle. The diverging developments in the cost of financing in the two countries further widen their competitive divide, born out of the diverging developments in unit labour costs. If we generalise a little, we could say that what is true for Germany is true for northern Europe, while Greece is representative of southern Europe. The competitive gap between these two regions will result in increased pressure on the euro. The single currency's survival in its current form is dependent on a massive solidarity effort between the European countries and unprecedented fiscal austerity in some countries. Fiscal austerity will however weigh on these countries' economic growth and they risk loosing on the tax revenue side much of what they save on the spending side.
Apart from a few exceptions, bonds issued by the governments of the industrialised countries are no longer attractive. Either they offer a very low yield, or they involve a more or less significant risk of payment default (not to mention the risk, to which some are alluding, that the increase in public debt will result in significant inflation through recourse to the printing press). Government bonds issued by the emerging countries are enjoying better fundamentals but yields on these bonds have already fallen a lot and selection will have to be made on a case-by-case basis. The same is also true for corporate bonds.
8. The traditional distinction between high-risk assets (= equities) and low-risk assets (= government bonds) makes less and less sense in the current environment.
This distinction exists because investors are used to associating risk with volatility. While share prices are known to rise and fall by 10% or more in a short space of time, this kind of variation is less common in government bonds and practically non-existent in money-market investments, which, in principle, can only rise in value unless there are negative short-term interest rates. In the current context, we could nevertheless also consider that the risk of an investment is that investors will not receive their coupon, will not get their money back, or will see the value of their investment significantly diminished by inflation.
In comparison with government bonds, equities currently offer two major advantages. First, unlike what is happening at government level, many companies are in excellent financial health. Second, equities represent real assets and for this reason offer, in theory at least, better protection against inflation.These risks should certainly no longer be ruled out and affect particularly fixed-income investments.
The fact that money-market rates are so low is obviously another factor that could boost the equity markets. I have often said that low interest rates are not a good enough reason for buying stocks - particularly when, as is the case now, low rates are the result of an extremely fragile economic situation. However, the fact remains that when interest rates are low, investors are more eager to buy stocks.
9. There is little upside potential for the US and European stock markets from current levels over a three to five year horizon.
This conclusion may be surprising coming after a particularly bad decade for the stock markets of these regions, with most indices today some 25% below their end-1999 level (excluding dividends). Under normal circumstances, one would expect that after such a disappointing performance, US and European equities would be cheap and ‘ripe' for a new structural bull market (just as the poor performance of the markets between 1966 and 1982 gave rise to the bull market of 1982 to 2000). But this is not the case. The poor performance of the US and European markets in the past 10 years is due to equity valuations reaching extremely high levels at the start of 2000. Since then, multiples have become more reasonable. However, they are still much higher than those that in the past marked the beginning of the major bull markets, especially in light of the fact that the phenomenon which pushed up valuation multiples in the 1980s and 1990s - the decline in interest rates - has now more or less run its course.
The stock markets of the industrialised countries are therefore expected to remain volatile characterised by bull and bear cycles similar to what we have seen in the past 10 years. However, they are not likely to be much higher 5 years from now (and may even be much lower). The conclusion is that a passive buy-and-hold strategy will produce disappointing results and that an active strategy is much more appropriate in the current environment. One aspect of an active strategy is stock-picking. We give priority to quality companies (low levels of debt, high return on equity), which are strongly exposed to regions with higher growth potential and are able to pay attractive dividends to their shareholders. The (justified) premium that the market usually grants to such companies has now disappeared since they significantly underperformed during the stock market recovery in 2009.
10. The emerging markets are in a structural bull cycle.
In simplified terms, we could say that whereas the 20th century belonged to the United States, the 21st century will be Asia's. The stock markets have begun to realise this and in the past few years, the developing markets performed much better than the industrialised markets. The trend is set to continue in light of the good fundamentals in the developing countries.
An investor should however be aware of the fact that the emerging markets will remain volatile, continuing the trend of the past few years. This is mainly due to the dependence of the emerging countries on Europe and the United States - economically dependent as they wait for internal demand to grow, and financially dependent as their financial markets remain strongly influenced by foreign capital.
