We may be seeing some green shoots of recovery, propagated by Chinese policy... Over the past month, there have been some encouraging initial signs that the global economy may be stabilising after lurching down again after the collapse of Lehman brothers last September. In recent weeks, copper prices have moved higher, oil has made a three-month high, and Baltic freight rates have more than doubled from historically low levels. More importantly, beyond these market data points, some of the economic activity numbers are showing initial signs of stabilising – critically the US and Chinese purchasing managers’ indices, but also the German Ifo survey of business confidence as well as US housing starts. The rise in the copper prices and freight rates, along with the Chinese purchasing managers’ index, probably reflects actions taken by the Chinese authorities to reflate their economy. As a still largely command economy, China can implement fiscal measures quickly and mandate its banks to lend. Western democracies have to engage in the slower process of consensus building and political debate.
...and by a move to quantitative easing in the US and the UK. Nevertheless, Western policy-makers have also stepped up their efforts to combat deflationary forces . The Bank of England cut rates (from 1.0% to 0.5%) for what will almost certainly prove to be the last time in this cycle and started the process of creating money to buy Gilts. In recent days, the US Federal Reserve (Fed) has followed the Bank of England’s lead and announced plans to purchase Treasuries. The impact of these moves has been to push bond yields down sharply. Although the European Central Bank (ECB) has cut rates again over the past month (from 2.0% to 1.5%) and is likely to cut again, it is yet to start purchasing government bonds. But, now that the Fed has joined the Bank of England in buying bonds, it is only a matter of time before the ECB follows suit. We continue to anticipate further falls in bond yields as the market prices in the realities of an extended period of low policy rates and continued government purchases. ,
This is helping monetary policy to function more effectively. With central banks creating money to purchase bonds, it’s tempting to ring the inflation alarm bell . Yet, given the powerful deflationary forces at work, inflation is a more legitimate concern for next year than this. In the near term, what the buying of bonds does is help to fix the monetary transmission mechanism and improve the outlook for economic growth. After these new initiatives, the transmission mechanism looks as if it is functioning at around 80% efficiency, up from some 65%.
If more signs of stabilisation emerge, the equity rally could have further to run. Disappointment about the lack of detail in the Financial Stability Plan announced by US Treasury Secretary Tim Geithner on 10th February drove equity markets down by around 20% over the following four weeks . They have since retraced half of that fall in response to signs that the global economy many be stabilising and hopes that a resolution to the bank solvency crisis is growing nearer. At present, this looks like just another bear market rally. But, if markets start to believe that this is a severe recession and not a depression, it will have further potential. Key to that will be the outcome of the stress tests being carried out on the 19 most systemically important US financial institutions and details of how much capital private-sector investors are willing to put up to join the US Treasury’s public-private partnership to buy up troubled assets. If the sums involved prove to be large enough to fill the gaping hole in balance sheets, the probability would shift further in favour of a long recession rather than a depression, and riskier assets would benefit.
