A shot across the bows

It is now eleven years since the first indications of the looming financial crisis began appearing on our radar screens. In the summer of 2007, banks began to curtail redemptions from funds which were heavily invested in collateralised debt obligations and subprime bonds. This set in train a series of events that culminated in the bankruptcy of Lehman’s in September 2008, which triggered the biggest economic and financial crash in 80 years. A decade on, and we are only now beginning to see indications that the scars inflicted upon the industrialised world are healing.

The IMF’s World Economic Outlook, released today, points to a further pickup in global growth in 2018 to 3.9% which is the fastest since 2011. The regional composition also increasingly looks more balanced, with slower growth in China and clear signs of recovery in the euro zone. But weak productivity growth and wage inflation in the industrialised world mean that workers may not immediately feel the benefit. Moreover, as the IMF pointed out, even though the global economy is looking stronger, a combination of weak productivity and adverse demographics means that the long-term potential growth rate in the industrialised world will be far slower than in the years prior to 2008 (the same also holds for China which is increasingly an ageing society thanks to the one child policy introduced in 1979 though subsequently abolished in 2013).

This obviously poses a problem for central banks, which wish to take back some of the monetary easing in place for the last nine years, and although the Federal Reserve has begun the tightening process, weaker potential growth will mean there are limits as to how far it can raise rates. But the Fed’s actions – and perhaps more importantly, its rhetoric – have contributed to taking some of the edge off the market rally with equity indices still some way below their end-January highs. My recommendation at the start of the year to reduce the degree of risk exposure in investor portfolios has thus been borne out by recent events. Recall, too, that I expressed concerns regarding the reliance of the US equity rally in 2017 on tech stocks, and the sharp collapse in this sector over the past month affirms my belief that now is not the time for rational investors to be taking risks.

However, I am less sure of my prediction that equities have 5-10% upside compared to end-2017 levels. Aside from the fact that all the good news is already in the price, the trade dispute between the US and China has changed the landscape somewhat and raised uncertainty levels. The actions of central banks are also increasingly a complicating factor.

Whilst the Bank of England looks set to raise interest rates next month, taking them above 0.5% for the first time since 2009, the weakness of inflation and the prospect of a loss of momentum in the real economy suggests that the case for further tightening is weaker than a few weeks ago. Meanwhile, the ECB continues to keep its foot to the floor and its asset purchase programme is likely to continue for another six months. The prospect of a monetary tightening in the euro zone any time soon is remote. But as I have noted previously, there is an argument for more aggressive tightening on this side of the Atlantic. Forget about inflation – the strength of economic activity alone suggests that we no longer need monetary policy on a setting designed to cope with the problems of 2009.

But as one investor asked me today, will this not lead to an undesirable slowdown in activity? It might, but there is a good case for using fiscal instruments to offset some of the pain. After all, monetary policy has done much of the heavy lifting over the past decade, and as the IMF pointed out “all countries have room for structural reforms and fiscal policies that raise productivity.” If we do not see some form of monetary normalisation, central banks will not have much conventional ammunition left to cope with the next downturn. As the IMF’s chief economist Maurice Obstfeld wrote, “global growth is on an upswing, but favourable conditions will not last forever, and now is the moment to get ready for leaner times. Readiness requires not only cautious and forward-looking management of monetary and fiscal policies, but also careful attention to financial stability.”

Markets may not like this prescription, but they have had a good run since 2009 and now it is time to put monetary policy on a sounder footing. European central banks take note.