Weak Economy, Strong Markets: A Paradox That Might End in Tears
The disconnection between (stock and bond) markets and fundamentals is due to abundant macro-liquidity and repeated central bank (CB) intervention. After years of complacency, data signal risks ahead: across the world, growth is slowing; leading indicators point to a mild global recession, driven by an EM slowdown; volatility and financial stress are rising and macro-liquidity is not translating into consistent market-liquidity. Policy interventions are unlikely to be effective. In this context, CBs risk making policy mistakes and, eventually, losing credibility. The recent episode of market volatility was an early-warning: when CBs start tightening, a bear-market correction will ensue and asset prices will decline to match fundamentals. Capital preservation via a defensive asset allocation is priority. Yet, unusual portfolios – less liquid and more volatile – are likely to perform better than conventional ones.
A.The world’s economy and stock markets are reaching an unstable equilibrium. In nominal terms, since the 2008 crisis the global economy grew by 22.7 percent and the global equity markets by 118.9 percent (Endnote 2, Table 3). Over the years, the disconnect between economic fundamentals and financial asset prices has widened. The result is an unstable equilibrium (imagine a large sphere on top of a hill), where a small disturbance can produce momentous changes. Over the same period, bonds rose by 26.3 percent, slightly above fundamentals, while commodities rose by only 2.1 percent, signaling lower growth ahead.
- The paradox: most economies are weak … Since the crisis, the recovery has been weaker than expected. In real terms, the world economy has grown at a compound annual growth rate (CAGR) of 3.3 percent; developed markets (DMs) at 0.9 percent and emerging markets (EMs) at 5.2 percent (Endnote 3, Table 4). Year after year, growth fell short of expectations. Despite improvements in the labor markets, inflation is still below CBs targets
- … but stock markets are strong. Between March 1, 2009 and September 30, 2015, despite the ongoing market turmoil, the equity markets rose at a significantly higher rate than the real economy: the Dow Jones Global Index grew – without a correction for about 128 weeks (2.5 years) – at a CAGR of 12.6 percent. In the bond markets, the JPM Global Aggregate Bond Index grew at a CAGR of 3.6 percent, with no significant correction. Commodities were stagnant: the Rogers International Commodity Index (RICI) benchmark registered a CAGR of 0.3 percent, without significant correction (Endnote 3, Table 4)³.
- Financial asset prices are well above fundamentals. As a result, current valuations are significantly above historical levels. According to Deutsche Bank, global markets (stocks, bonds, and residential housing) are above their pre-crisis (2007) price levels and close to an all-time peak. At end-September 2015, the price-to-earnings ratio (PE) on the S&P Global 1200 index was 16.4, 82.2 percent above the pre-crisis average of 9.0 (1997-2007 period). Due to large CBs purchases of government bonds and low inflation, bonds’ yields are at multi-century lows.
B. Financial markets and fundamentals got disconnected, complacency is hindering growth. Across the world, CB-liquidity injections upheld economic performance by creating a “low-growth equilibrium”, but boosted financial markets. Yet, in the real economy, liquidity-induced complacency hampered reform-efforts and delayed investments.
- In a context of abundant macro-liquidity … To counter the 2008 crisis, an unprecedented amount of money – about 25.6 trillion (tn) of US Dollar (USD), or 33.2 percent of the world’s Gross Domestic Product (GDP) – was thrown at the global economy. At once, DM and EM governments provided fiscal stimuli by increasing spending. Since 2007, DMs’ average debt-to-GDP ratio has risen by about 50 percent; in Britain and Spain it has nearly doubled. To date, total fiscal stimuli amount to at least USD 17.7tn, or 23.0 percent of world GDP. Over the same period, the world’s main CBs slashed interest rates and supported the financial system by almost doubling – from USD 10.1 to USD 17.9tn – their combined balance sheets. To date, the total amount of monetary stimuli is about USD 7.8tn, or 10.2 percent of world GDP. As the economic recovery consistently proved weaker than expected, governments shelved fiscal consolidation and CBs repeatedly postponed tightening.
- … when there is trouble, CBs to the rescue! Between March 2009 and September 2015, market capitalization (a proxy of financial markets’ liquidity) more-than-doubled: from USD 11.3tn to USD 23.3tn. The financial markets got used to prompt CBs intervention, aimed at encouraging risk-taking whenever the macroeconomic outlook deteriorated and after each shock – be it an ‘earlier-than-expected’ US Federal Reserve (Fed) exit, the sharp drop in oil prices, the Greek crisis or China’s devaluation. Short- and long-term interest rates were kept low (and even negative in some cases, such as in Europe and Japan) and quantitative easing (QE) widely practiced.
- The status quo is convenient … Over and over, the arrangement worked – and it still works. CBs create short-term macro liquidity to contain volatility and avert further price deterioration; immediately, equity markets rise and bond yields decline. Since 2009, the prices of all asset classes rose, almost in sync: equities, fixed-income private-and-public-sector bonds and commodities (Endnote 1, Table 3) – but also real estate. Over time, CBs liquidity fed price bubbles and market prices decoupled from economic fundamentals. Only recently commodity prices dropped, in line with fundamentals[i].
- 4.… but liquidity has created complacency, which hampers long-term growth prospects. In both DMs and EMs, cheap money created a culture of complacency. Abundant liquidly – putting creative destruction on hold – kept governments, banks and companies afloat but brought about zombie-entities, which deliver low growth[ii]. Today, policy makers can afford delaying structural reforms, entrepreneurs borrow to re-finance their debts and back their own shares, not to invest in the real economy. Markets suffer from risk-myopia, i.e. financial agents ride “[beta](https://en.wikipedia.org/wiki/Beta_(finance%29)” with full leverage and without significant hedges, taking excessive risks for relatively low returns.
C. Across the world, growth is slowing. The global economy is fragile, still recovering from the 2008 financial crisis. In 2014, world retail sales increased by a meager 2.3 percent yoy. In 1H-2015, global economic output expanded by barely 2 percent (the weakest two-quarter period since mid-2009); lower demand for commodities depressed (real) prices and contributed to reducing global inflation; world trade growth turned negative (‑0.7 percent). In 2016, the globe will enter a mild recession35, mostly driven by EM weakness