ARE we seeing green shoots or mildew? Certainly, receding fears of further economic decline mean the second quarter has ended in brighter mood than the first.
The reason confidence has revived was not that economies suddenly looked rosy, but because it became clear that the authorities would do whatever it took to save the financial system and prevent depression.
Reality was never as bad as the “end of the world” mood in February, nor is it now untroubled. The stock market has performed its traditional role as an indicator of the tendency for sentiment to swing from depression to euphoria, with sometimes only a passing connection to reality.
Although headwinds against economic recovery remain, suggesting that the authorities will have to keep the accelerator pedal pressed firmly down if the upturn is to gain momentum, it is encouraging that forecasts for economic contraction in 2009 have flattened.
It will take many years of growth for the world economy to correct its structural problems, such as weak bank balance sheets, consumer indebtedness, trade imbalances and fiscal deficits.
The “victory” achieved by policymakers to date is to make it possible for these adjustments to happen in a controlled way, rather than through a disorderly economic collapse.
In the meantime, the hard-won stabilisation of confidence needs to be maintained. It is, therefore, important that the authorities do not move too quickly to reverse their stimulative policies.
Despair makes problems tower larger than they really are, while confidence shrinks them to a size that can be coped with. Keeping markets in “glass half full” mode is likely to make it easier to achieve the economic restructuring and rebalancing required, at lower cost than if they fell prey again to the depression of last winter.
Although we are all part of a global experiment in monetary policy, with no road map to show where it will end up, the gilt market’s recent shift in focus from deflation to inflation worries appears rather rapid, given the current low levels of inflation, the low growth forecast for 2010 and the amount of spare capacity globally. This may be a case of the bond market vigilantes getting in a pre-emptive strike to keep central banks on their toes.
Nonetheless, although inflation is currently subdued, a major issue for coming years is how far it will rise as a result of present policies. Given the absence of exchange controls, it is easy for capital to flee countries with irresponsible policies, so a major jump in inflation is less likely than official “tolerance” of moderately higher inflation. Yet political pressures may tempt some governments to take a risk with inflation.
To protect against this, investors should consider the merits of inflation-protected bonds and real assets such as equities and property.
The poor performance of equities in the past decade does not negate this. While the rebirth of scepticism and a better evaluation of risk is good, the bad side is the risk of overlooking that real assets offer some protection if the future is more inflationary than the benign price trend of the past 25 years.
Andrew Bell,
Head of Research,
Rensburg Sheppards
