Be careful what you wish for: the perils of a V-shaped recovery

Max King, strategist at Investec Asset Management in London, sets out the dangers of a V-shaped recovery and argues that investors would be served far better by a steady recovery than by a re-inflation of the credit bubble

After the sharpest global recession for 50 years, the media and political establishment are desperate for signs of a V-shaped economic recovery. Economic growth is associated with greater optimism, falling unemployment and rising living standards. The recent movements of markets appear to support the view that investors are in a similar mindset. In early October, news of a continued rise in unemployment in the US and a setback in the ISM New Orders Index caused markets to dip, as they had done in June when hopes of a recovery faltered. Experience and logic, however, show that a long and steady recovery would be much better than a fast and furious one for markets, and almost certainly for the population at large.

A V-shaped recovery would mean that companies, which have cut costs hard, would struggle to meet orders. Costs would rise, their ability to keep costs down would diminish, they would have to hire staff and invest in increased capacity. On a global level, raw material prices would rise and, on a national level, wage pressures would intensify. Revenues would rise but margins and return on capital would lag. Investors would be cautious about re-rating equities both because of sub-optimal returns and because they would suspect that the boom would not last.

With the economy expanding rapidly and inflation pressures rising, bond investors would take fright and central banks would raise interest rates, initially back to normal levels and then further, to slow growth down. If companies had been fooled by the growth into over-expanding, consumers fooled into spending rather than saving and banks into excess lending, the boom would be followed by a bust. Markets would fall sharply and governments would discover that the improvement in their fiscal position was only cyclical.

It is hard to imagine all this happening so soon after the last boom and bust cycle we have endured in the past 18 months, but rising p/e ratios make markets vulnerable to any threat of higher interest rates while the spread of corporate over government bond yields is no longer enough to protect their value if government bond yields rise.

Most investors are relaxed, expecting growth, after an initial spurt, to be modest. This is because banks are likely to be cautious about lending, consumers should continue to rebuild savings and governments intend to reduce their huge deficits. This should encourage central banks to keep rates low.

Still, it would be foolish to ignore the historical lesson that the deeper and steeper the slump, the stronger and faster the recovery. This time around, the data may be weak but the leading indicators suggest recovery could be sharp. This risk is increased by the flaws in economic data, which tend to understate the pace of recovery until it is too late. As a result, central banks (and notably the US Federal Reserve in 2003-7) are usually too slow to raise rates and governments are too slow to tighten fiscal policy, wrongly assuming that any fall in the deficit is attributable to their budgetary skill rather than cyclical factors. With the authorities still traumatised by the crisis and desperate not to kill off a recovery, it would be remarkable if historic mistakes were not repeated to some degree.

For now, there is no cause to panic but we believe the long-term interests of investors would be served far better by a steady recovery led by investment and accompanied by the easing of global and national imbalances than by a re-inflation of the credit bubble. It should be obvious that this is also in the interests of the wider population or the next crisis will loom all too soon.