Posted by:
Andrew Bell

23 August 2010

On August 20^th, the UK commemorated the 70^th anniversary of the Battle of Britain, with BBC radio (minus Alvar Lidell) playing a long extract of Winston Churchill’s stirring speech to the House of Commons in 1940, in which he praised the heroism of the RAF pilots who had fought off the Luftwaffe, with the memorable tribute “Never in the field of human conflict was so much owed by so many to so few”. It took a further five years before the war was over but the air victory ensured that the risk of a collapse of resistance to Hitler was prevented.

More recently, governments have been conducting an economic campaign to contain the after-effects of the bursting of the credit bubble. We are approaching the second anniversary of the Battle of Banking (the riot point after Lehman Brothers filed for bankruptcy) when the financial system came close to collapse and had to be bailed out by governments worldwide. If the banks had collapsed, the ramifications would have made the recession we have endured look like a tea party, so it was certainly in the common interest to recapitalise the banks and give them state guarantees while they recovered. This marked the point at which the danger of economic implosion was contained. Nonetheless, a (politically-fanned) impression lingered that, in an inversion of 1940’s selfless heroism, a small population of well-to-do bankers had been rescued from the consequences of their errors by the resources of the general population. Never in the field of human commerce was so much owed by so few to so many.

Investors have become restive this year because what had been prematurely celebrated as victory over the recession in 2009 now looks interim rather than final. It is more like a step in a long haul to rebalance the world economy, while we work off the debts accumulated by the private sector in the credit bubble and by the public sector in an effort to mitigate the consequences of the ensuing credit crunch.

The angst may be overdone. Although this is scarcely an age of carefree economic prosperity, the processes of repair appear well underway. Bank capital ratios are higher than before the recession, economic growth is positive (though anaemic), low interest rates help borrowers manage (or reduce) their debts and banks have started to loosen lending criteria from the wincingly tight levels in force a year ago. The danger is not so much that the economic picture is worse than early 2009 (which it clearly is not) but that complacency over monetary and fiscal policies could allow a softening in economic growth to mutate into a self-fuelling collapse of confidence that causes the credit system to break down again.

The central banks appear alive to this risk. The US Federal Reserve has recommenced buying government bonds to boost the money supply and may well discuss further initiatives at its annual conference this month at Jackson Hole. The Bank of England entertains the option of further quantitative easing (particularly if the onset of the fiscal squeeze endangers the recovery) and the European Central Bank has purchased the bonds of governments under pressure from the market and deferred an exit from current loose policies until 2011.  Emerging markets that were tightening policy earlier in the year have turned to more neutral policies. The period of exceptionally low interest rates is likely to be prolonged as a result, with direct beneficial effects for borrowers, as well as positive pricing implications for higher risk financial assets. If investors come to trust the profit and dividend forecasts for equities, either prices are too low or interest rate forecasts will have to be revised up.

Although economic growth may slow in the second half of the year, it looks likely to prove less volatile than equity markets, which currently appear to view every sign of slowdown as threatening a renewed recession. If consensus forecasts of maintained, or faster, economic growth in 2011 are met, equities seem oversold. Corporate management seems less nervous than investors, with a surge in merger and takeover activity in August, which is generally a dormant month for transactions. This suggests that companies are less defensive in their attitude to hoarding cash and that they view acquisition of other companies as cheaper than building new capacity. Although this is less beneficial for economic growth than new investment, pricing existing capacity more realistically is an important sign of economic confidence. A rise in asset prices helps the economy by reducing the cost of capital, the size of pension fund deficits and through wealth effects on shareholders.

There are clearly risks to the course of the global economy, with policy makers steering a narrow recovery channel between the Scylla of resurgent inflation and the Charybdis of deflationary collapse. Recent signs that policy makers have tilted back to being more responsive to growth risks are being ignored by equity and bond investors alike. Only a moderate improvement in economic confidence could easily add ½% or more to 10 year bond yields (which have fallen 1% this year), creating losses for latecomers or overstayers at the bond party. Such a climate could see equities recover their April highs, as confidence rebuilt in resilient or growing earnings in 2011. According to Homer, Odysseus opted to go closer to Scylla and lose a limited number of sailors to her many teeth, rather than risk the whole ship foundering in the whirlpool of Charybdis. Given what appears to be policy makers’ similar preference for moderate inflation rather than deflation, it is not hard to imagine a market environment in which the 25% outperformance by long gilts versus equities since April is reversed.

On that happy (or plaintive) note of [equity] optimism, I hope you enjoy the final leg of the summer holiday period, whether topping up your tan abroad or growing a coat of mildew in Britain.

Comments or feedback are always welcome at theblog@witan.co.uk 

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