DABERIAM LXXVII

June 2013

ADHD or Attention Deficit Hyperactivity Disorder is the phrase that comes to mind to describe the markets in general.  For some time it must have been clear to most relatively well informed investment managers that Central Bank QE, which has largely been a euphemism for funding government deficits, would have to slow down and at some point cease.  The amount of government debt that the Bank of England, the ECB and the Federal Reserve has been buying is a hockey stick graph that could not persist.  In the US, Bernanke has for most of the year been periodically making noises about thinking about this problem.  Every time Bernanke whispered that he was considering it, the market worried and earlier this month his warning again virtually panicked the market.

New York’s tail-spin after surviving the “sell in May” syndrome is doubly interesting as the underlying figures for the health of the American economy remain fundamentally good.  Unemployment is slowly declining in spite of a very considerable number of government employees coming on to the market as a result of “sequestration”.  (Since the end of 2010 US government employee numbers have gone from approx. 23 m to 21.8 m.)

The Bank of England is making the same indications with the same effect; unfortunately in the UK case the economy is not nearly as robust as the US.  The reduction in government expenditure and the recapitalisation of the banking industry has been very much slower.  Also the UK is more vulnerable to the crises in Europe.  The ECB, however, has in fact been tightening, in reality more so than the US and the UK, and never was liberal with its provision of liquidity owing to constraints from Germany.  The ECB task is also much more complicated as it is dealing with twenty-three countries that use the Euro and their separate banking systems which, since the start of the crisis, have virtually ceased to operate across country borders.

In Europe it is individual country’s banks that the ECB has had to provide liquidity to, which in turn has primarily been used to buy their respective national debts.  This is a situation that leaves Europe still open to a major banking crisis, as at some point interest rates will rise and this will have a devastating effect on bank balance sheets.

The impact on rising interest rates from their current exceptionally low level is likely to have some dangerous consequences in the financial community.  General trade and industry is more affected by the availability of bank credit and not hugely affected by interest rates at the current or foreseeable level.  The insurance and banking industry, however, have in the last few years accumulated enormous amounts of their respective government debt, greatly encouraged by “the regulators”.  The accumulation of historically very low yielding “safe debt” is a major worry.  Years ago, an old friend of mine, an expert in the junk bond market, commented that the most unsafe of debt instruments were AAA rated bonds.  There is an absolute correlation between the market value of a bond and its coupon, but this seems to have been generally forgotten in recent years as interest rates have declined.  When interest rates double, the value of the bond halves.

The cage-rattling by western Central Banks has been compounded by China’s Central Bank putting out a warning that they too were going to restrain liquidity to pre-empt the bubble that is growing in their property market and secondary banking industry.  The People’s Bank of China and the Chinese government work as one.  China’s political leaders are trying to manage, by and large successfully, a change of direction in the Chinese economy from an export led industrialisation growth strategy to a more rounded and domestic consumption pattern.  A hugely complex task, bearing in mind the often forgotten size and complexity of China’s population and the only limited control that the central government has over the state governments.

State governments in China have funded enormous increases in primary industry.  China today produces nearly half of the world’s steel and aluminium and, I read somewhere the other day, half of all pigs on earth live in China!  Whatever the difficulties and the dislocations that are going to arise from the change of direction in Chinese policies, one can be reasonably confident that they will succeed in the longer term, but it could be a rocky road.

The wild card in the world economy is Europe.  One can be more sanguine about China as they have huge resource in both financial and, more importantly, senior government intellectual competence.   The greatest worry for the rest of the year, and well into next year, will be the European experiment.  Youth unemployment in southern Europe, in many areas reaching 50% and more, is a personal and social catastrophe of appalling proportions.  It is also extraordinarily dangerous to a democratic state, and even the concept of orderly democratic government.  Most worrying, however, is the apparent lack of any concern in Brussels.  It is difficult to conceive of how the EU will address these core problems and the creation of a centralised banking and economic system, particularly as the economic difficulties of individual countries fragment any feeling of cohesion between the twenty-seven states.

In many areas, at the very local level, business is at least stabilising and companies seem to be getting used to the norm of marginally negative growth, but stability at current levels is not in the long term a sustainable prospect.

To revert to China, the Asian area is, in spite of China’s restructuring efforts, doing well and has a regional life of its own.  America is also well into the recovery trend.  Five and a bit years after the great financial crisis, one can be optimistic while keeping an eye on a couple of black, or perhaps grey, swans.  Powder kegs would be an appropriate phrase; we will need a few blow ups to generate the political will to deal with some of the outstanding misalignments in Europe.

As in the case of a rise in interest rates, it’s not difficult to project what is likely to happen, but it is impossible to say when.  The complexities of the problems that need to be resolved are of Balkan proportions.