It is not fashionable to be an optimist right now and I certainly do not believe that the UK is on a smooth course to new sunlit uplands after BREXIT. However, in one important respect I am an optimist and that is the world’s economy.
Back in May I wrote an article entitled ‘V for victory’ in which I argued that a V-shaped economic recovery was more likely than investors were then thinking. My arguments were the scale of monetary and fiscal support being provided by central banks and governments, and the pessimism of investors as measured by their risk appetite.
The unfolding monetary response since then has been far greater than after the 2008-9 Global Financial Crisis. The total impact of broader liquidity has been about 150% higher than pre-COVID levels, while global money-printing as measured by M1 has been around four times higher. No surprise that the prices of many assets, and in particular financial ones, have not only recovered but risen to new highs: the new “money” amounts to something like 25% of world GDP and it has to flow somewhere. If owners do not wish to invest in the real economy, it will go into financial assets. In essence this is exactly what has been happening in the West since 2009.
Monetary theory predicts that this surge of money will eventually have an impact on the real economy. Our friends at CrossBorder Capital point out in their latest research that while their measure of monetary liquidity (ie. money and credit) has a negative correlation with current economic activity, it has a significantly positive one with activity 18 months’ ahead.
On some indicators we already have a V-shaped recovery in just six months: for example, business confidence and shipping activity is close to pre-COVID levels. In comparison it took the world two years after the GFC to reach this spot. But it doesn’t yet feel at all like that on the high street, which is why pessimism abounds.
The exact time lag between a monetary stimulus and the economy reacting has historically varied depending on what form of it takes. Broadly the more that ends up in retail bank accounts, the clearer and quicker the causality and the effect is. In contrast under austerity after the GFC most of the boost was delivered to wholesale markets and 2020. This time the support for workers and businesses tells us that much more will end up in retail bank accounts. We therefore believe the world’s economy will continue to strengthen significantly over 2021.
However, that may not be such good news for stock-markets and financial assets. As investors’ confidence to invest in the real world grows, they will sell bonds and equities. We are particularly wary of bonds, clearly at risk from a move to ‘risk-on’. While we do not expect inflation to take off in the near term, we can see some cost-push pressures coming through to the high street from commodity prices and shortages caused by trade friction. We will be writing about this in more depth in our ninth annual update on inflation trends at the end of the year.
At the same time liquidity is almost bound to decline: on CrossBorder’s measurement it has been standing at close to an all-time peak for the last three months. We also note that financial investors are still quite pessimistic as measured by their risk appetite. We conclude that the trumpets are not yet blowing but when they do it will be time to take equity money off the table.
That is not to say there will be an equity bear market but simply that investors will be waiting for confirmation that the earnings growth they have been factoring in when paying high valuations (think the FAANGs in particular here) is actually coming through. It may be time for catch-up from some of the more neglected corners. Anyone for Emerging Markets, value or industrial commodities? Or even the ultimate pariah, UK equities?