Friday, 2 September 2011
Will it ever get better?
So the economic slowdown is upon us. Everybody is busy revising estimates for economic growth and company earnings downwards. And the talk of the town is: will we end in a recession? That question is probably misleading. There is not a huge difference between a growth rate of 0.1% and one of -0.1%. Neither will feel good and neither will generate jobs or an investment boom.
The financial markets have (finally) adjusted. As far back as in mid-July, the stock markets were still humming along, convinced that company earnings could only continue to grow linearly. Bond markets were as usual negative and yields had reached new low levels that were only compatible with – recession. Corporate bonds were firmly in the camp of the stock markets.
Now, six weeks later, the bond market again proved right. Stocks and corporate bonds have fallen off a cliff, and nobody can apparently find any good news that will turn the market mood around. It will probably take some weeks before this can happen, and weeks are an eternity in market time.
It is my conviction that markets react stronger to surprises than to anything else. Most market participants feel good about being part of the great big market consensus, and it is only when this consensus is disturbed that something has to change.
Forecasts are coming down, and in all experience it will mean that we will soon have a situation where market consensus undershoots the economic development. My guess is that by mid-September this process will have run its course. The markets will by then be ready to be taken by positive surprises.
In the current gloomy mood, nobody can see what would create growth. However, there are several elements that could turn positive. First, we have negative real interest rates. Former chairman of the US Council of Economic Advisors, Christina Romer, in academic works showed how low interest rates eventually end up by supporting the housing market. Negative real interest rates also push capital out of cash and short-term bonds, lowering the price of capital for companies. Consumers who have postponed purchases of cars and other durable goods will have a pent-up demand. Similarly, companies will have a greater need for investment after a long period of no investments. Inventories will have been brought down or written off.
And finally, austerity measures will be if not postponed, then at least delayed. Reality is finally about to win over ideological arguments that deficits will have to be cut dramatically here and now. It is slowly becoming clear that austerity will hamper growth.
So if – and that is still a BIG if – nothing goes wrong in the European banking sector, we are setting the scene for the stock markets to be positively surprised, even if economic growth will remain weak for a while.
At Origo, our work with market risk indicators has led us to precisely track the gap between economic downturn and unfounded optimism in the stock markets. We will report back here when the opposite scenario begins to unfold.