Global Central Bankers Making Headway (But Only Slightly So)
(June 4, 2009)
Dear Subscribers and Readers,
Yesterday, the Bank of England released its monthly monetary and financial statistics book. A cursory glance suggests that a significant portion of the liquidity created by the Bank of England has gone into foreign accounts during the month of March and April, as overseas investors sold a net £27 billion of gilts during those two months (against the £45 billion of purchases made by the Bank of England). The growth in non-adjusted M4 declined to a low of 2.4% year-over-year, from the long-run average of 7 to 8%. Aside from the fact that no one can really quantify the full (or lack thereof) effects of the Bank of England's “quantitative easing” policy, the UK Telegraph's article also misses (badly) on two important points:
1) First of all, Simon Ward from Henderson New Star (one of the most respected central bank watchers in the UK) points out that credit trends typically lags monetary trends. Historical analysis suggests that money typically leads the economy, while credit lags. Quoting Mr. Ward: “This is why the US Conference Board includes the real M2 money supply in its index of leading indicators, while real commercial and industrial loans and the ratio of consumer credit to personal disposable income are components of its lagging index.” Moreover, Ward's asserted that the “best measure” of the UK broad money supply – that of M4 excluding money holdings of financial intermediaries actually grew by 1.0% in April. Ward estimates that in the first four months of the year, this measure (adjusted M4) rose at an annualized 7.8%, up from just 3.0% in the second half of 2008. Based on these measures, the Bank of England's quantitative easing policy is currently working.
2) Second of all, do not forget that we are still living in a globalized world. However small the Bank of England's purchases are relative to the global monetary supply or GDP, it is still helpful – despite the fact that some of these funds are flowing to foreign accounts. Interestingly, the Pound Sterling has actually been strengthening for most of March and April – suggesting that foreigners may have utilized these proceeds (or more) to purchase other UK assets, aside from Gilts. The point is: To the extent that the Bank of England's asset purchases could stimulate the world economy, the Bank's policies are not impotent, despite the fact that there could be “leakages” from the domestic economy.
That said – given that 1) the Bank of England is not a closed economy, and 2) the small size of the UK economy and the Bank's purchases relative to the global economy – the Bank of England's “quantitative easing” policy could never have succeeded without similar policies from other central banks, especially the Federal Reserve and the European Central Bank. The IMF, in particular, had been instrumental in preventing an all-out economic collapse in Central and Eastern Europe, while the Federal Reserve, with its various policies (including the TALF and the PPIP) and its $1.75 trillion of asset purchase commitment, has been instrumental in “unfreezing” global financial markets and preventing an all-out collapse in the US consumer (although over the long-run, there is no doubt that the US consumer will no longer be the “growth engine” of the global economy). Going forward, other countries to watch are China and India.
Per the latest ECRI Weekly Leading Index (which has been one of the most accurate leading indicators of the US economy), there is a very good chance that the US economy will hit bottom this quarter – with a recovery coming sometime this summer. With the US consumer now permanently disabled – and with no significant productivity enhancing technology on the horizon (such as the automobile in the 1920s, the PC in the 1980s, and the internet in the 1990s) – a sustained economic recovery is still out of reach. In addition – with many asset classes now edging close to the “fair value” stage, and with US commercial real estate just beginning its downward phase – the risks is still weighted towards the downside. While I am still bullish on US equities, we could very well run into significant resistance over the next several months if global central bankers (including the IMF) do not do more to reflate the global economy (i.e. increase their asset purchases or improve the flow of credit).
For now, the Federal Reserve is still on the easing track. This could be seen in the two following charts – the first showing the size of the Federal Reserve's balance sheet and the second showing the annual growth rate of M-2:
After stalling in the early parts of this year (due mostly to the fact that the Federal Reserve did not have to support money market funds anymore), the Fed aggressively stepped up its asset purchases in early March (this coincided with the bottom in stocks). Similarly, the annual growth in M-2 remains robust at about 9%.
While the Fed's asset purchases and the growth in the US money supply remains encouraging, it is notable that they have come off from their highs. With the European Central Bank refusing to step up to the plate (I do not expect the ECB to announce more asset purchases this Thursday, although I do expect them to do so in its next July meeting), and with no more liquidity announcements or interest rate cuts from other major central banks, it is now up to the Federal Reserve to do more. The strains are now starting to show – with the 30-year fixed mortgage rate (which will be the one major mortgage product going forward) now rising back up to their February highs, as shown in the following chart:
Despite tons of liquidity on the sidelines, the strains are also starting to shown in the stock market and the high yield markets. While it is reasonable to experience a “breather” in the stock market after a huge two-month rally, there is no doubt that other factors – such as ongoing jobless claims, weakness in the commercial and residential real estate markets are continuing to be major headwinds. Should mortgage rates remain elevated or should the stock market remain at current levels (or decline) by the next Fed meeting (scheduled to be held on June 23rd to 24th), I expect the Federal Reserve to either increase the size of its liquidity facilities (e.g. the TALF) or announce more asset purchases going forward.
Of course, providing more liquidity could only “go so far” over the longer run, especially since the US consumer can no longer be relied on as the “growth engine” of the global economy. As we mentioned in our mid-week commentary last week, we continue to expect that in the short to intermediate term (6 to 12 months), the economy will show signs of stabilization and renewed growth, even as the commercial and residential real estate markets remain weak. What this does not mean, as we have also pointed out, is an imminent return to 3%+ real GDP growth in the long run. With the US consumer and corporations still actively deleveraging – and with no way to export our way out of a slowdown (unlike the “Asian Tigers” in 1998, Germany, and Japan over the last decade), US real GDP growth would most likely see-saw around 2% for the next 3 to 5 years. As we see it, there are only two possible exceptions that could propel the US economy back to its post World War II trend – neither of which is very likely over the next several years:
- If the Chinese consumer unexpectedly picks up “the slack” of the US consumer sometime in the next few years. While China's purchasing power is formidable, it still pales compared to that of the US consumer. Given the current lack of social safety nets, savings rates in China will remain high. As a result, there is also not much will to utilize much of that spending power. By the years 2013 to 2015, I expect the Chinese consumer to play a significant role in the global economy – but until then, global (and US) consumption will remain subdued.
- Many US and global secular bull markets were driven by certain world-changing events or technologies that captured our collective imagination. Every bull market – no matter how crazy it gets towards the end – has a solid grounding based on fundamentals. Most recently, this came in the form of productivity growth driven by the advent of the PC and internet, and the “opening up” of the formerly communist countries in the 1990s. Unless we could commercialize “cheap” (i.e. lower than grid parity) alternative forms of energy or carbon nanotubes to replace our most common building materials in the next few years, I expect both US and global real GDP growth to remain “challenged” in the next 3 to 5 years.
A sub 2% real GDP growth in the US economy over the next several years isn't necessarily a bad thing. Study after study has shown that having buying more material items after a certain point does not add to individual happiness – and if an individual's tendency is to go into debt to buy more “stuff,” then this could only end in tears over the long run. Sure, consumer credit will be constrained. Many retail stores and restaurants will close. Reading books and having intelligent debates/coffee house conversations will be fashionable again. The finance industry will no longer be the “default” industry for aspiring MBAs. The natural sciences and engineering fields will boom - especially given the Obama administration's renewed emphasis on the sciences as one of the most important growth drivers of the US economy and overall standard of living. For many that are currently working, however, this fundamental “reboot” of the US economy could mean chronic unemployment and unhappiness – especially those who work in the financial and retail industries – arguably the top two industries (aside from technology) that have benefited the most from the boom in US consumption and US bull market over the last 30 years.
Henry To, CFA