Global Markets: Managing Low Growth and Return Expectations in a More Volatile World

HIGHLIGHTS

• Growth is settling in at a sub-par rate and downside risks dominate
• Quantitative easing is possible but doubts about its effectiveness make it unlikely now
• Interest rates will likely be kept lower for longer to facilitate structural adjustment
• Growth and return expectations should be kept low and reasonable
• And with many downside economic and financial risks lurking beneath the surface...
• Financial volatility is likely to be high and range bound making strategic investment decisions difficult to embrace
• The publication also includes quarterly interest rate and exchange rate forecasts for the U.S., Canada, U.K., Australia, and New Zealand, and also offers additional exchange rate forecasts for the Japanese yen, the euro, the U.K. pound, and the Swiss franc.

Downside growth risks opening-up

The global economy is at a sensitive point in the cycle as it transitions from policy driven expansion to sustained private demand. Global purchasing manager's surveys peaked in May, and the growth tailwind from the inventory rebuild is blowing with less force. We are at that point in the recovery where data surprises are no longer all to the upside, and significant variation in growth forecasts is distributed about the globe adding to forecast uncertainty.

Since the last edition of Global Markets, surprises have been to the downside, and the G20 has signed-up to short-term, growth depressing, fiscal austerity. Market based measures of inflation expectations have fallen in response, and US ten year yields have declined about 50 basis points to about 3.00% pulling-down interest rates everywhere.

Yet, getting traction from lower interest rates is difficult with the world's banking system still in a state of disrepair and incomplete recovery, as monetary policy is partially disconnected from both households and small and medium sized business. Faith and confidence in sustained economic recovery is weak, and an unwelcome uncertainty has returned to risk asset markets, uncertainty that will be slow to dissipate.

We have made much of the distinction between risk and uncertainty, where the latter prevents investors from making well calibrated investment decisions. So, even as interest rates declined, risk asset markets have struggled to hold onto their start-of-the-year levels. This uncertainty has been reflected in much higher volatility.

European mismanagement of the Greek fiscal challenge transformed a containable problem into an incipient banking system crisis. A negative confluence of uncertainty flowed to gut risk assets and raise fear of economic downside just at the time when the global industrial production recovery was peaking.

Guarding against downside risk means more quantitative easing

With bank credit barely available, debt market issuance unimpressive, and risk assets trading in a volatile range, concern about the durability of the global recovery has put pressure on central banks to once again enjoin with quantitative easing, QE, potentially adding another measure of cash to what is already abundant global liquidity.

The bar to delivering more QE at the Fed, the ECB and the BoE is fairly high, both analytically and politically. QE is not a near-term risk in the absence of another negative shock, as there are significant reservations about how effective a renewed round of QE would be either to keep faith in the recovery alive, or to effectively boost demand in response to any downside shock.

Casting doubt on the effectiveness of more quantitative easing

Why doubt QE's effectiveness? First, commercial banks in the most effected countries - the US and the UK - have essentially hoarded the cash pushed into their balance sheets by the Fed and the BoE, and higher reserve holdings have defied our understanding of how the supply of money creates deposits and loans. Large reserves have not stimulated renewed and strong loan growth. The desire to hold more cash is shared by the financial and non-financial sectors alike after the 2008 crisis temporarily disabled the banking system, and holdings of cash seem in excess of precautionary needs.

QE should depress benchmark government rates, making spreads to risky assets more attractive, and by lowering interest rates, entice precautionary savings to shift towards current spending. But instead, we continue to see excessive hoarding of cash that will not aid economic activity until it is put fully to use.

The desire by commercial banks to hold big reserves at the central bank seemed understandable when tightening bank capital requirements and regulatory demands for more liquidity were at their height after the 2008 crisis, but this seems less pressing today as credit standards have broadly ceased to tighten.

Nonetheless, global regulators seem set on much higher capital requirements, lower leverage ratios, and high liquidity requirements all of which constrain top line credit creation at a time when the economy needs access to credit in order to grow. Structural headwinds remain intense, and central banks and regulators appear not to have managed well the conflict between achieving structural stability and facilitating strong near-term growth.

Secondly, QE also works through non-bank financial players, especially institutional investors. QE was expected to induce a change in investor behaviour. Risk-free assets - essentially government bonds -- taken onto the central bank's balance sheet are paid for by creating reserves leaving investors with cash.

The spring of 2009 was the ideal time to execute quantitative easing and push cash into institutional investors, as the preconditions to success were highly favourable. Long-run measures of equity value, and other risk assets, such as priceearnings ratios and price-to-book, showed unambiguous value signalling that the risk of loss was likely to be low.

Given that the returns to cash are deeply negative in real terms, this creates a push out of cash into risky assets in the search for returns that are closer to investment hurdle rates some distance from current cash rates, which in turn helps shape an environment of rising confidence through capital gains and recovery of lost wealth. This push is powerful when value is good, inflation is expected to be positive, and risk of loss is low. It is not so powerful when value is not so good, and where expectations of deflation create a positive real return to cash should price changes turn south. The risk of loss from exposure to risk assets is now comparatively large, undermining the likelihood QE will be as effective.

But if QE's in the cards do it swiftly and do a lot

While it may be less effective than before, the asymmetric risk of deflation argues that QE might best be used sooner rather than later and more rather than less in the hope that it changes perceptions of the balance of risks and is transmitted through the financial and real economy through the expectations channel. Quantifying how to proceed is hard to calibrate precisely when the transmission mechanism is so vague, so any action has to be decisive and impressive. No central bank seems willing to take on this commitment now.

If a period of deflation settles-in, real interest rates rise deterministically increasing the incentive to hold cash over risky assets, sapping an economy's growth momentum. This fear could potentially rise as the pace of economic growth decelerates in the second half of 2010 and deflation risks slip into uncertain macro forecasts.

We believe QE will find it harder to leverage the push from cash today, and it is not clear that pushing asset prices excessively higher to compensate for a poorly performing banking system justifies the risks of a renewed asset price bubble. Moreover, neither private nor public actors have the ability to absorb another negative shock.

Making liquidity abundant in the face of crisis was what QE was designed to do, and it did so to great effect in secondary debt markets, which at the end of 2008 had ceased to function. Corporate debt spreads were much wider than the spread consistent with a reasonable probability of default, even in an environment of considerable economic and financial distress, so the big issue was eliminating the illiquidity premium.

The bank lending market and secondary debt markets are not substitutes: they are complements, so abundant bank liquidity was a necessary condition to achieve relief in secondary debt markets. The Fed's acquisition of mortgage backed securities introduced massive amounts of needed liquidity into the system and kick-started the mortgage market and brought mortgage spreads down.

Interest rate relief translated into household and corporate cash-flow relief as mortgages and loans were re-priced, facilitating debt reduction or renewed expenditures. This was very helpful in stabilizing the level of prices and output.

However, the circumstances that allowed unconventional monetary policy to get solid traction in the spring of 2009 are now absent. Equity markets are close to long-run fair value, suggesting that risk of loss is higher than it was in March 2009 - as the 12% Q2 decline in the S&P made clear. The push from cash is now much weaker.

With the initial conditions for QE less conducive, it is not clear that a renewed round of QE can really help, so we will just have to wait for the banking system to become sufficiently capitalized before we should expect a higher rate of economic expansion and a sustained take up of spare capacity.

A slow growth world is a low return world

Recoveries from financial crisis are half-speed recoveries precisely because the demand for credit is slow, and the financial system's ability to supply credit is constrained. So, we should expect recovery to be slow, disinflationary slack to remain, and interest rates to remain low. The post-war policy power to reduce economic pain in the face of economic distress is all but tapped-out, and expectations that central banks and QE can provide a quick fix are too high.

There are a few key risk events to clear over the summer months, not least of which is the European bank stress test. To earn some market credibility, some banks will be found to be insolvent, and so the next hurdle will be how to resolve identified insolvency: recapitalization or liquidation. Either way, there will be some renewed financial burden for already over-burdened states. And, with fiscal drag just around the corner, more unemployment could mean more bank losses and more insolvency.

The round of credit rating agency downgrades is likely not over, and the Euro remains sensitive to more bad fiscal news. Moreover, the ECB continues to deny the Eurozone's liquidity needs, and the drag from peripheral Europe - which needs a private sector offset to harsh fiscal contraction - has barely got going. Meanwhile, significant outperformance by the German economy relative to peripheral Europe will raise the hurdle for intervention to stave off disinflationary or even deflationary risks for parts of the Eurozone. There are more negative surprises ahead.

And what about our hopes that Asia can sustain global demand to backstop structural drag from the developed world? Don't bet on it. Asia's development plan has devoted capital to meeting the import needs of the developed world, and while developing Asia acknowledges that it needs to absorb more of its own output, it cannot redirect productive capacity to home markets overnight. Any attempt to do so would inevitably lead to slower global growth as resources were redirected. Enterprises can disappear overnight, but it takes time for their replacements to emerge.

Correspondingly, investor return expectations likely remain too high in a low inflation world when real interest rates need to remain abnormally low to achieve recovery. The returns to risk will also likely be low, and given that the system's capacity to absorb shocks is small at a vulnerable time, volatility should remain higher than we have been used to.

When volatility is trading to the bottom end of recent higher ranges, it remains time to buy insurance rather than take on more exposure to squeeze-out a bit more return. Risk asset markets are likely to remain highly tactical in the months ahead - and navigating a period of slow economic growth for those conditioned to high growth is going to be a challenge.

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