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Global Markets Weekly - 23rd February 2009

• Last week revealed further signs of economic weakness spreading to Asia.
  Policy Last week, the reported weakness of the Japanese economy - now contracting at an annualised rate of over 12% - showed how the global slowdown has spread to regions and sectors that are particularly exposed to external sources of demand growth. This is exaggerated by the rapid decline in world trade volumes, where a shortage of trade finance is amplifying the effects of a cyclical slowdown . Positive bank lending data from China held out the prospect that China may be able to buck the trade-driven recession taking hold in Asia. However, commercial bank lending is far more government-directed in China than in any developed economy, so these lending figures are broadly equivalent to quantitative easing (QE) measures in the US: welcome evidence that the authorities are tackling the problem, but not final evidence of their success.
• With inflation rates low and falling fast, the focus has shifted to quantitative easing.
  In the US, CPI inflation for January was precisely flat on the year. Headline inflation rates will probably turn negative in several major economies over the coming quarter. The combination of the worst three-month period for US job losses since October 1945 and headline price deflation means that US interest rates should be negative, according to Taylor Rule estimates . Of course, that isn't possible, so the Federal Reserve has instead turned to unconventional quantitative easing measures in order to lower term rates.
• Interest rates are likely to remain low for longer than normal in the recovery...
  It will be the reversal of these QE measures, not a rise in interest rates, that marks the first stage of future monetary tightening . So, when the recovery eventually comes, interest rates are likely to stay low for longer than in past recoveries. This need not be inflationary, because of the unusually large negative output gap and deflationary impetus accumulated during the recession. That implies a flatter yield curve. The chart over the page shows the flattening of the 5-year minus 2-year (2s/5s) US yield spread since the implementation of QE policy. The UK and German 2s/5s spreads are at very stretched levels and are likely to retreat to their early-2008 levels once the Bank of England and the European Central Bank become more quantitatively proactive.
• ...suggesting longer durations for bond investors.
  To investors who still crave the security of government bond markets, this suggests at least a small extension in duration away from the typical safe haven of 2-year notes.
• In Japan, deflation skewed relative valuation arguments for equities...
  Deflation also poses a challenge to measures of relative equity and bond valuations . The so-called Fed model uses the spread of the equity earnings yield over bond yields. The higher it is, the cheaper equities are relative to bonds. Over recent decades, this has been a useful valuation indicator for major equity markets - apart from Japan. The Fed model shows Japanese equities becoming progressively cheaper throughout the past 20 years. Yet that proved to be a value trap: with a lower trend growth rate and inflation undershooting expectations, past earnings yields were a poor guide to their future levels.
• ...so caution may be warranted now for some developed economies.
  If investors today are concerned about a systemic rise in savings rates reducing trend rates of growth in the US and other indebted countries or about policy-makers' chances of success at fighting debt-deflation, they should also be wary of valuation arguments in favour of any asset class if those arguments rely on the underlying assumption of a stable macro-economic equilibrium.

Indices, Interest rates and Inflation

View the full Global Markets Weekly report (pdf).

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