Hamish McRae: More volatile perhaps, but market fluctuations are following a familiar pattern
Economic Life: There is strong evidence that cuts in public spending do not do nearly as much damage to long-term growth as increases in taxation
Friday 02 September 2011
Do markets reflect what is happening in the real world or do they seek to predict what might happen in the near future? The holiday period has been a pretty dreadful one for financial markets, with August showing the worst reverses on most major markets for more than a decade. Things have now recovered a little, but yesterday the Footsie was still almost exactly where it was a year ago, and, while the Dow is up a bit on the past 12 months, the Dax is still down.
Click HERE to view graphic (57k jpg)
Share prices are more a measure of mood than of substance, at least in the short and medium term. So too, to some extent, are the usual forward-looking indicators of corporate confidence, the various purchasing managers' indices – which are mostly wobbling around the 50 mark, the point that suggests neither expansion nor contraction. The all-important US data yesterday remained a whisker above that level, but actually I don't think it makes sense to be too pernickety in trying to analyse the data. The big picture matters but the detail does not. That big picture, of course, varies from country to country and from sector to sector, but, in summary, global companies are certainly not as optimistic as they were three or six months ago. They are not expecting another sharp fall in demand either – more a very slow market for some months to come.
To try to stand back from the present swings in corporate and market mood, have a look at the top graph. It shows what has happened to the OECD global leading indicator this cycle compared with previous cycles. Two things stand out. One is that the amplitude of this cycle – the mood swing you might say – has been of a different order of magnitude from previous cycles. In that regard what we have been experiencing is quite different from what we saw before. But the other thing is that the other cycles show a similar slump/boom/reappraisal pattern, so, amplitude apart, what we have now is not particularly abnormal.
The second graph looks at the earnings for European quoted companies over a 40-year period. As you can see, at present earnings are pretty close to the centre point of their long-term trend, a wee bit below it in fact. Evolution Securities, which pulled together these charts, notes that sharp declines in company earnings have typically occurred only when they have been at the top end of their historical range. The same holds true whether you are looking at US, UK or European firms. It concludes that the sort of fall in profits that are currently being mooted – 40 per cent or more – are unlikely to happen in the near future. Dividends, too, are below their long-term trend.
The further conclusion is that investors should not allow themselves to be too dismayed by the fact that many of the purchasing managers' surveys are now dipping below the 50-point level. That does not necessarily signal recession. In any case the August declines took this adverse outlook into account. In Evolution's view, we are facing a slowdown rather than a return to recession.
Those of us who agree with this relatively sanguine perspective have, however, to acknowledge that there are real risks that are different to the risks in previous recoveries. The principal one on most people's radar here in the UK is the pace of fiscal consolidation; in Europe it is sovereign default; and in the US it is the debt burden, the housing overhang and the paralysis in policy-making. A word about each.
As far as Britain is concerned, it would be perverse not to admit that growth has been lower than many of us had expected, even allowing for the probability that the official figures have been understating what has actually been happening. The very latest employment and unemployment numbers are somewhat discouraging too, suggesting that the labour market is somewhat weaker than it was six months ago. The private sector is still hiring but not as fast as before. But to attribute this disappointing growth largely or entirely to fiscal consolidation is surely wrong. For a start, the deficit is being corrected only slowly: the real squeeze is still to come. More substantial must be personal financial consolidation – the rate at which people are paying off personal debt – and the squeeze on real incomes from higher-than-expected inflation.
However, higher taxes don't help to boost consumer confidence and that particular aspect of the squeeze may loom larger in the coming months. My own view, for what it is worth, is that fiscal consolidation may well become more of a drag on recovery and that flexibility on taxation that may well be needed. There is strong evidence that cuts in public spending do not do nearly as much damage long-term to growth as increases in taxation.
The size and flexibility of economies matters too, and that may help us. Some research by Goldman Sachs last month suggests that: "the 'speed limit' to fiscal consolidation – the pace of tightening after which the corrosive impact on growth starts to undermine the fiscal position itself – is therefore likely to be lower in large closed economies (like the US or Japan) and in countries with fixed exchange rates (European periphery) than in small open economies (UK)."
As far as Europe is concerned, not many people will be surprised at the disarray over the still-not-concluded second bailout for Greece. What most people outside the country will not be aware of is the way commercial life in Greece is grinding to a halt as businesses find they are simply not being paid. Many European banks are extremely fragile, not so much because they hold dodgy sovereign debt (though of course they do), but because people are withdrawing their savings from them.
Against this background the new raft of spending cuts and tax increases being proposed across a whole swath of southern Europe must carry dangers. Those of us who feel that the pace of fiscal consolidation in the UK is probably about right are allowed to feel uneasy at the pace at which this is happening in much of Europe: Goldman Sachs's point that the speed limit there is lower than the speed limit here. So the popular perception that the worry in the UK is the pace of fiscal consolidation may be better applied to the European fringe. As for default, maybe better to get that all out of the way rather than mess about pretending a country can meet its obligations when it clearly can't.
And the US? At a personal level quite a bit of the de-leveraging has taken place. Taken in aggregate, debts are being paid off. But the overhang of the housing market remains and until there is some clear bottom to house prices it is very hard to see a sustained consumer recovery. As for the country's fiscal position – nothing significant is going to happen until after the next presidential election. As a note yesterday from the US brokers Charles Schwab notes, Washington is at a loss.
"The debt crisis debate shook confidence of businesses and consumers alike, and the current environment lends itself to little in the way of needed reforms getting done prior to the 2012 elections."
For the record, the brokers do not expect recession in the US, but they have become increasingly concerned that this might happen in Europe. European leaders have, in their view, been successful in finding new ways to undermine business and financial confidence. We can all agree on that.
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