The ‘double dip’ debate

The global economy has recovered far better than most people imagined a year ago. Asia and much of the emerging world have rebounded strongly; the US, the world’s largest economy, has delivered three quarters of solid growth and corporate profits globally are sharply higher on a year ago.

And yet as followers of financial markets will be well aware, few investors or commentators express optimism in the economic outlook. While most stock markets are still trading well above their crisis lows, no meaningful progress has been made over the past nine months.

The pervading concern has become the risk of a “double dip” recession – a scenario whereby a fragile economic recovery relapses into recession. Proponents of this view either argue that the stimulus-led recovery witnessed so far is unsustainable or that the risk of a negative shock or policy mistake are so high that recovery is likely doomed. What explains such thinking?

Sovereign debt, banking fragility and the age of austerity: The actions of governments and central banks around the world were crucial to averting the Great Depression II. Bank rescues, stimulus packages and automatic stabilisers helped to avert a depression but in the process transferred debt from the private to the public sector.

But as recent events in southern Europe have highlighted, markets will not tolerate rising public debt levels forever. In turn, the fear of peripheral euro sovereign defaults has triggered renewed concerns over the solvency of European banks, whose balance sheets remain thinly capitalised and notoriously opaque by global standards. It has also precipitated a raft of austerity packages across Europe including the UK. The primary economic concern is that such austerity will not just dampen growth but given existing fragilities tip the region back into recession. What is more, if fiscal tightening is simultaneously aggressive across countries the risks rise further still.

Governments across the developed world face a considerable policy challenge: tighten aggressively and risk recession; delay tightening and risk a solvency confidence crisis. As Mohamed El-Erian of Pimco has rightly highlighted, this is a somewhat false debate: “countries need to adopt both fiscal adjustment and higher medium-term growth as twin policy goals”[1]. This is easier said than done.

American funk: Several recent data releases have provided the bears on the US economy with renewed confidence: housing and construction remain very depressed and unemployment painfully high. Evidence of a peak in growth of various leading indicators (ECRI, Conference Board) has fuelled concerns that the hand-off from government stimulus-led rebound to private sector sustainability will not be achieved successfully. Already elevated US public debt levels and zero interest rates suggest the bullets are mostly spent should more policy firepower be required. A return to quantitative easing would be the likely next resort.

China’s bubbles & policy risks: Fears of a property bubble, mounting local government debt and the effectiveness of Chinese policy tightening have been a concern for some time now, as the performance of local stock markets would suggest. Housing transactions have slowed abruptly following policy measures, leading to concerns that overall growth will slow and worries over rising bad debts resulting from poor lending decisions during the stimulus program.

If not exhaustive (we have not mentioned regulation or weak credit growth, for example), these are the main concerns. How then do we approach asset allocation at the current juncture?

All investors must recognise the considerable degree of uncertainty when it comes to forecasting the future. With that in mind, when the market consensus appears to herd around one particular view there is often money to be made by being contrarian. We recognise that there are downside risks to prospective economic growth, but we believe the market consensus is overly pessimistic at present.

This, in fact, is common at the early stages of recoveries. As Robert Shiller recently highlighted, with the “depression scare still fresh in our minds, sensitivity to the possibility of another downturn remains high”[2]. Accordingly, the market consensus is ignoring much of the good news, in our view: (i) emerging markets are growing robustly, including China which is tackling its problems early; (ii) corporate profits are rebounding and balance sheets improving; (iii) US companies have started hiring and increasing capital investment; (iv) Europe’s actions reduce the risk of sovereign default for at least the next couple of years; (v) monetary policy is staying looser for longer in the West.

In our view, sentiment towards equities is depressed resulting largely from the concerns outlined above. Forward-looking PE multiples are low globally by historic standards and the cost of downside protection in options markets elevated. The implied equity risk premium has risen to levels that suggest equities are likely to deliver healthy returns over the next decade.

As risky assets have weakened, perceived “safe” government bonds such as German bunds, US treasuries or even UK gilts have delivered strong returns of late. While inflation globally is likely to remain low for some time in our view, the yields now on offer in these bond markets are unattractive on a medium-term view. Since we believe the recent rise in risk aversion is likely to be temporary we maintain a low bond duration currently.

Changing perspectives in the investment world are mirrored on the cricket field. In an age when even 50-over internationals are deemed to be too slow in favour of the hurly burly of 20/20 cricket, the qualities so long admired of Test cricket – most of all patience – are scarcer than ever.

So too in the investment world. Perhaps more than ever, patience will be required over the coming months. It is impossible to forecast a catalyst that will suddenly turn the game in favour of the optimists. More likely, in our view, just as the obdurate Test batsman builds an innings a steady accumulation of supportive corporate and economic data will restore confidence in the economic outlook and support higher values for risky assets.

Tristan Hanson, Ashburton Investment Strategist