Hamish McRae: How is world economy doing? That depends on your point of view
Sunday 04 December 2011
Share prices are really trying to go up.
Look at all the stuff that has been hurled at the markets in recent days: the eurozone meltdown, and with it the warnings of dire catastrophe from Angela Merkel and Nicolas Sarkozy; ditto David Cameron and George Osborne; double ditto Mervyn King. And yet, when the central banks carry out some quite limited injections of dollars into the European banking system, share prices have their best day for several years. Insofar as these things say anything, the markets were scrambling higher as we went into the weekend.
But why? There are two broad explanations and as usual there is probably a bit of truth in both.
The first is that trends in share prices are a proxy for those in global enterprise. The FT 100 index is a particularly good one to take because it represents not so much the British economy but rather the world economy, since at least two-thirds of the revenues of the companies on it, maybe more, accrue from abroad. By contrast, the revenues of large US quoted companies come much more from the US itself.
There is no doubt that the prospects for global enterprise are held back by what is happening in Europe. But while the eurozone is some 15 per cent of the world economy, it is only 15 per cent. There is another 85 per cent, and that segment has not only been growing much faster; it will continue to do so.
Further, even within the eurozone, there are companies that are doing well. I have my doubts about the likelihood of Angela Merkel's vision of a fiscal union being successfully created, let alone for holding very long. But large European companies have to be agnostic about its success or otherwise. Thus they are making their contingency plans for a break-up of the eurozone. Their primary duty is to their customers, their investors and their employees, not to any particular vision of Europe.
The share markets know this. Obviously they would prefer efforts at bolstering the eurozone to succeed. If they fail, there will be more disruption – and disruption is bad for business, at least in the short term. So when there is "good" news about the eurozone, they respond positively, as they did last week. But the ultimate driver of global share prices is the global economy, and that does not look too bad at all.
Apply this explanation to what is happening and you can make quite decent bull case, at last on a medium-term view. As the main graph shows, the world economy seems to be making a pretty decent recovery, dipping a little now but remaining above its long-term trend growth line. It may be that these projections are overoptimistic and they are calculated at purchasing power parity exchange rates, which overweights China and India vis-à-vis the developed world. Nevertheless, if growth does indeed remain above its long-term average through to 2016, some of that shine should wear off on the books of large global businesses. Rationally, so this explanation runs, shares are cheap.
There is a further argument here, expressed in a paper from Chris Watling of Longview Economics. This is that, in addition to this fundamental case, there is the argument about sentiment. He calculates an underlying valuation for share prices based on a number of factors and then looks to see whether they are cheap or expensive from an historical perspective. As you can see from the small chart, shares now are undervalued and at a "buy" level. The main thing holding them back, he argues, is the fear of eurozone disruption.
Well, here we have one explanation, and a pretty convincing one. But there is another and less optimistic way of looking at things. It is to ask: what else do you do with the money?
The line here is that shares represent a "least bad" place to invest and the fact they should be doing as well as they are says just how grave the world economic situation really is.
So what else do you do? Invest in German bonds and get a negative return in real terms? Invest in British gilts, with an even more negative one? Or buy Italian bonds at 7 per cent, which sounds fine until you ask why they're offering so high a rate?
Buy commodities? Well, many have fallen sharply as world demand has shaded off; even oil is still well off its peak. Buy gold at close to an all-time high? Or keep the cash, with a zero return? As I say, I think the true answer is some sort of mixture But there is a deeper puzzle here: why are so many businesses doing so well (or least not so dreadfully) under undoubtedly tough trading conditions?
Take Britain, where growth at best is only inching forward, where cash for investment is tight and where both the Government and the Bank of England are doing their best to stamp on any optimism that might sprout up. The public sector is shedding jobs for obvious reasons, but while there are periodic stories of job losses in the private sector and it is very tough for new entrants, companies as a whole seem still to be net hirers. German unemployment is coming down; so too in the US, though slowly and from a troubling high level.
It is a huge generalisation, but I think the answer is that well-run global companies have used the past three years of recession or sluggish recovery to make radical improvements in their underlying performance. As growth picks up they will inevitably and properly benefit.
None of this should be taken as an assurance that world growth will surprise on the upside next year. The sensible view of what is happening across the Channel must surely be to stress that disruption will continue and at best the eurozone will stagnate. At worst, there could be huge disruption and another serious (as opposed to mild) recession. My point is simply that there is a disjunction between what politicians are saying and what the markets are saying.
Usually the world of officialdom is optimistic, even bombastic, whereas the world of business is cautious. Now it is the other way round. Surely a cause for mild comfort.
Europe's beacon of light: what we can learn from the Swedish model
There is one spot of light among the European gloom and it is in Scandinavia. Sweden has now become the most creditworthy nation on earth in that it can borrow more cheaply even than the US.
Not that it needs to, or at least not to any extent, for it looks like running a budget surplus. Its banks are by and large in good shape. Unemployment, by European standards, is under control and exports are strong. How come?
Well, Sweden is not in the euro (nor indeed are Denmark and Norway – only Finland chose to go in) but it would be wrong to attribute its success to making that particular call. Rather, its success can be attributed to its errors in the 1990s, when it suffered from a catastrophic loss of confidence in its banks and a surge in public spending. Spending got up to 67 per cent of GDP and the country had a decade of fiscal consolidation. The experience of having to rescue banks also made it cautious about financial regulation, which changed the character of the banks themselves. As a result they largely avoided the errors of much of the rest of the sector.
Sweden, of course, relies on its export markets and faces all the obvious threats there. It also has had to cope with individual industrial problems, such as the uncertain future for the Saab car maker. Swedes worry about the pressure on public services and on the education system from what is, by previous standards, something of an austerity movement. But – this is what I find most impressive – politicians talk of the need to get national finances into shape to cope with the next downturn, not just to dig themselves out of this one.
Britons sometimes look enviously at Sweden's welfare model not just for the quality of its services, but for its flexibility too. But the public finance and bank regulation story is just as relevant. We have much to learn.
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