Hamish McRae: Is this a genuine recovery or just a bubble caused by central banks' easy money?

Economic Life: On a 10-year view or even a three-year view, investing in the emerging markets is a no brainer. On a six-month view that may not be the case
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The Independent Online

It all depends on your perspective. Let's start with three facts. First, share prices worldwide are this week at a two-year high. Next, commodity prices are also at a two-year high. And third, world output is back above its past peak, having risen above the level of spring 2008 by the summer this year. So viewed globally it is business as usual. Doesn't feel quite like that here, though, does it?

There are two explanations for the rise in share and commodity prices, both of which have merit, and the problem is to distinguish the balance between them.

One is that the developed world has depressed interest rates far below the rate of inflation and the central banks, particularly the US Federal Reserve, are pumping out money and spraying it around the world. The money has to go somewhere and since bonds are not very attractive, a lot of it is seeping across into shares and commodities. A sub-section of this argument is that the dollar is particularly suspect, hence the switch of some of this money into gold, now at a record high in dollar terms.

The other is that the emerging economies have seriously outpaced the so-called advanced ones and continue to do so. That has sustained demand for commodities worldwide but it has also given a justification to the surge in share prices in the emerging world. Indeed, shares have become something of a two-tier market, a bit like the world economy itself: in the emerging world they are racing ahead and bouncing around new peaks, while in the developed world they are recovering but still convalescent. So the rise in commodity and share prices is largely the result not of money hunting for a home but of real growth of demand in the emerging world.

So which is the more important? I personally incline towards the latter but let's go through the arguments. Start with commodity prices. You can see from the first chart, taken from the new IMF World Economic Outlook, what has been happening to a number of different commodities since the beginning of 2003, together with some projections for the next couple of years. There are several points here. Obviously both energy and metals have risen solidly from their troughs in December 2008. The energy market did go slightly mad in 2008 but now seems pretty solid. Energy demand in the develop world has fallen along with the recession but this has been largely offset by rising demand elsewhere. Metals demand has continued to be strong for the same reason: real demand for the emerging world. Demand for the other types of commodities is also solid, though there may be some froth in grain markets at the moment.

Looking at this picture as a whole, this is hardly one of a flood of dollars seeking a home. You can push up a market such as the oil one for a while – and the summer of 2008 did surely see a speculative excess – but we are not seeing a sudden peak or peaks. It is more a gradual climb. That is clearer if you look at the second graph, which shows the S&P commodities index for the past three years. There was a speculative boom; now there has been a steady rise.

What about equities? Start with the real GDP trend graph. The gap between what is happening in Asia and the rest of the world is stunning. We all know what is happening but I don't think we fully appreciate the full implications for equity investment – or indeed personal wealth. I did see some stats this week that suggested that there were more female billionaires in China than in the US; soon no doubt there will be more male billionaires too.

A lot of work has been done on emerging market equity investment by Goldman Sachs and the pie chart comes from that. The basic message is this. Rapid economic growth and capital deepening will increase the size of developing equity markets, with the result that they will pass those of the present advanced economies within the next decade or two. Obviously you cannot be precise about this but the projection for 2030 shows that the Chinese market might have a larger capitalisation than the US one, and double all the European markets put together. There would be a 60/40 split between the emerging and advanced worlds, in favour of the former.

There are a number of reasons to suspect that this transition will be bumpy. In recent years emerging equities have been particularly volatile and it may well be that there is a bit of a flight of hot money into these markets at the moment. A number of smaller emerging markets are seeing their currencies pushed up by an inflow of funds and China has been struggling to slow down the rise in the yuan.

So I think there are reasons to be wary of the surge in share prices in the emerging world. In other words, there is not much evidence of a commodity bubble, except perhaps in gold, but there may be an emerging market share price bubble. On a 10-year view or even a three-year view, investing in the emerging markets is a no brainer. On a six-month view that may not be the case.

The thing to look for in the coming months will be further signs of concern about US monetary and fiscal policy. I have been troubled in recent weeks by two aspects of US economic policy, one fiscal, the other monetary. There is really very little discipline being imposed on US fiscal policy either by Congress or by the markets. Yet the US not only has the running deficit of around 10 per cent of GDP to finance; it also has an unusually high rollover of debt to refinance in the next year. For the moment it seems totally able to borrow very cheaply, for it retains its "safe haven" status. But we shall see.

On the monetary side it looks pretty clear that there will be another bout of quantitative easing: more money flooding into the world. That expectation is one of the things driving the markets. You might say that so far this is generally regarded as benign, at least in the developed world if not in China. Maybe that is right. But all the experience of the past three years is that confidence can evaporate very suddenly.

There have been periods in the past when US policy has come under suspicion and the dollar has been under great pressure. What we are seeing now is nothing like the turmoil of the early 1980s. But while the recovery in markets is mostly to do with the gradual rise in confidence worldwide that a recovery will be sustained, there is a twitch. A bit of it may be to do with the possibility that it will be better to invest in anything other than the dollar: commodities and emerging market equities inevitably top the list.

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