It seems that there are still plenty of things for investors to worry about: a double dip in the global economy; high private and public sector debt in key countries; policy tightening; a resurgent US dollar; and a possible China collapse among them. Fortunately, most of these are not as worrying as they appear.
More broadly though, it is actually a sign of a healthy market when there is still so much scepticism and fear around. It indicates there are still plenty of buyers sitting on the sidelines that will help push share markets higher over time.
It is in the nature of humans to worry about what may go wrong. Maybe it has something to do with our evolution in the Pleistocene era when the trick was to avoid being attacked by a woolly mammoth or saber-toothed tiger.
In relation to this it is frequently said that shares climb a “wall of worry”, in that when shares are rising it is often when there seems to be lots to worry about.
The logic is simple – if everyone is worried then it is quiet easy for events to unfold better than feared. Below is a current list of worries doing the rounds – why some may not be worth worrying about and why others are worth keeping an eye on. Addressing the main worries in turn:
The US/global economic recovery is not self-sustaining and will double dip once the stimulus is over
A double dip back into recession would be bad news. This is less of a direct issue in Australia and Asia where employment growth has recovered underpinning private sector spending and so re-starting the flywheel of demand growth.
However, the risk cannot be ignored in most advanced countries. In the case of the US, the housing sector has yet to start recovering and we may see more house price declines and employment is yet to improve.
However, worries about a double dip are common during the very early stages of recoveries when the recovery is yet to fully find its legs and the fear is that “once the policy stimulus wears off growth will collapse anew”.
More fundamentally though, there are signs that the US recovery is on its way to becoming self-sustaining. Retail sales in the US have picked up and more significantly a range of forward-looking indicators suggest that US employment will soon start to grow again. Thanks to strong productivity growth and a rebound in profits, US companies are now generating record cashflows and if history is any guide this will show up partly as higher capital spending and employment. If this is the case, as seems likely, then it will support future consumer spending and take over from stimulus measures in driving the recovery going forward.
Some have raised concerns that leading economic indicators are showing signs of rolling over. But short of them rising to infinity this is inevitable.
Overall we would see the risk of a global double dip as being low – with around a 25% probability.
A lack of credit will prevent a sustainable recovery
A common concern is that the recovery can’t become sustainable with private sector credit still falling in the US.
Even in Australia credit growth is still very soft. This of course is related to double dip worries. However, there are several points to note. First, consumers are in fact increasing their spending – even retail sales in the US have been picking up with growth of 3.9% over the year to February and US auto sales are trending higher.
Second, the experience in Australia and the US post the early 1990s recession highlights that debt de-leveraging won’t necessarily stop a recovery in the economy and sharemarket. In fact, it is the acceleration or deceleration in the change in debt that affects growth. Sure a rise in the saving rate will detract from growth but once the savings rate is at a new higher level (and debt is still falling) spending can then rise in line with income and so the continuing reduction in debt doesn’t stop growth from resuming.
So while we see high levels of private debt being a longer-term growth constraint in the US, UK and Australia, we don’t see it as a barrier to a continuation of the recovery.
Premature tightening will trigger a double dip
Taking a lead from the experience of the US in the 1930s and Japan in the 1990s, it is feared that moves to wind back the fiscal stimulus and/or tighten monetary policy will trigger a renewed global downturn.
However, the general impression from policy makers is that they will only move to tighten once it a clear recovery is self-sustaining. This explains why Australia and some other Asian countries have started to tighten as growth is looking self-sustaining here, but in the US, Europe and Japan tightening is still some way off. Witness the Fed’s continuing commitment to keep interest rates low for an “extended period”. We rate the risk of premature policy tightening as low.
A fiscal crisis in key advanced countries is imminent
Moves to deal with high public debt levels in the US, Europe and Japan by raising taxes and cutting government spending will constrain growth over the long-term. The concern however, is that investor impatience at the lack of action to cut deficits in the short-term will create a “fiscal crisis”, much as has recently occurred in Greece, forcing key advanced countries into a fiscal tightening before the economic recovery has become entrenched.
However, for now at least the risk of a fiscal crisis seems low: contagion from Greece seems to have been averted by the “pledge” of support from the European Union; there is little competition for funds from the private sector; inflation is low; and there are lots of buyers of bonds (eg. banks). That said this is the most serious worry on the worry list right now and is definitely worth keeping an eye on. Watch long term bond yields for signs it is becoming a real concern.
Easy money will push the US to hyperinflation
Some still seem to see a surge in inflation as inevitable. But until US credit starts to pick up (rather than sitting in bank reserves) and spending returns to normal levels inflation will not be an issue. And by then central banks are likely to have wound down their stimulus. It’s that simple. Talk of hyperinflation remains nonsense.
The US dollar will surge making life harder for US companies, commodities and emerging markets
Last year there was much concern that the US dollar was about to collapse as central banks diversified their reserves away from US dollars. This year the concern seems to have swung full circle to the US dollar staging a comeback, which is seen as being bad for US shares (as many have overseas exposure) and bad for commodity prices and emerging country share markets.
However, just as it was hard to see the US dollar collapsing (as the alternatives were no better) it is hard to see it taking off big time either (as it still has plenty of problems of its own). Rather what seems to be occurring is the US dollar going in different directions against currencies from different regions – up modestly against the euro (reflecting Europe’s weaker short-term growth prospects and issues with Greece) but potentially down against stronger Asian currencies (maybe helped by an eventual Renminbi revaluation) and commodity currencies like the Australian dollar. So the outlook for the US dollar is probably a lot less definitive than many claim and big moves are unlikely. As such, we see it as a low risk to the investment outlook.
Financial re-regulation will stop the recovery
Yes, it could slow it, but as we are seeing with financial reregulation in the US right now the path will likely be slow and potentially faltering. Secondly, some might argue that economic growth was actually stronger in the 1950s and 1960s (when post Depression financial regulations were in force) rather than in the financially de-regulated 1980s, 90s and 2000s.
China is a bubble that will burst in response to policies to slow inflation
Many fear that China has overinvested and its assets are in a bubble that will soon burst as policy is tightened further to head off inflation, removing a key leg of the global recovery and undermining commodity prices. However, while such a scenario cannot be ruled out it is unlikely.
At a national level there is no evidence that China has overinvested, there is little evidence of a bubble beyond a few cities and its inflation problem is overstated – with most of the rise in inflation due to higher food prices. Yes, further tightening in China is likely as inflation continues to rise to around 5 or 6% around mid-year as last year’s deflation drops out.
However, an aggressive tightening is unlikely and 10% or so economic growth is likely for this year. This all points to worries about China remaining in the next few months, but fading through the second half of the year. In fact from a six to 12 month perspective the China outlook is low risk.
US/China trade tensions are likely to escalate
Economic tensions between China and the US seem to be intensifying with Chinese Premier Wen Jiabao rejecting calls for a Renminbi revaluation and some in the US intensifying their calls for some form of retaliation. Never mind that China’s trade surplus has been shrinking and that the US may not benefit from a Renminbi revaluation anyway. This could become more of an issue, but trade tensions between the two have been around for years and both countries have too much at stake to allow the issue to cause fundamental damage. Judged low risk.
The table below shows our view as to the risk posed by the worries discussed above with respect to the outlook for the global economy and shares for the next 12 months.
Many of the worries doing the rounds are overblown and are not enough to prevent solid gains in shares over the year ahead, notwithstanding they may lead to bouts of volatility. A public debt crisis in key advanced countries is unlikely in the shor-term but it is the risk worth keeping an eye on. Fortunately, it’s not directly an issue for Australia and emerging countries.
More fundamentally, the fact that there is still so much caution with respect to the outlook is actually a positive thing because it makes it easier for events to pleasantly surprise and it suggests there are still plenty of investors sitting on the sidelines.
Dr Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors.
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