Investment: The summer of risk

Global equity markets have almost exactly doubled since the darkest days of early 2009. Even subprime bonds, the culprit for the greatest economic crash in living memory, have enjoyed spectacular gains. All this has come against a gloomy backdrop of high unemployment, record levels of government debt, and emergency action by many central banks. Why has this happened, and can it continue?

In retrospect, the reason for this dramatic recovery in asset prices is straightforward. The emergency action taken by policy makers has “worked,” if only in the narrow sense that it has stopped the economic situation from getting worse. In the darkest hours of 2009, many financial assets were priced at levels consistent not just with the worst recession since the war, but with a repeat of the outright depression seen in the 1930s. This has now been avoided, and the markets have breathed a huge sigh of relief.

Investment managers sometimes remark that “the easy gains for the current cycle have already been made.” The behaviour of markets always seems much easier to interpret in retrospect than it does in real time. But there is some truth in this statement on this occasion. As it became clear that the rescue operation was restoring confidence to the financial sector, the pricing of risk assets proved far too depressed to persist. But that is no longer the case. One popular benchmark measure of value in global stockmarkets is the price/earnings ratio on US equities. Based on Robert Shiller’s method, this now stands at 23.8, compared to its long-term average of 16.4. In other words, American shares are now somewhat expensive compared to their long-term history. The same is true in Britain. In order to justify these ratings, the global economy must continue to grow quite rapidly.

Fortunately, that seems probable. The world economy is improving for two main reasons. First, in the emerging economies there was no credit crunch, banking collapse or explosion of public debt. These fast-growing markets, which now account for 47 per cent of the world’s gross domestic product, were barely dented and have quickly resumed their extraordinary growth of the previous decade.

Some still see this as a bubble waiting to burst. It is much more likely that we are in the midst of the most extraordinary surge of economic growth since the industrial revolution. Now that China, India and many others have achieved economic takeoff, they are repeating the experience of earlier miracle economies such as Japan and Korea but on a vastly greater scale. Standing all the traditional truths of the global economy on their head, the emerging world now has better debt ratios and stronger balance sheets than the developed world. Far from waiting for the west to lead them out of recession, the exact opposite is happening. That does not mean that emerging nations are automatically the right places to invest since their equity markets now look fairly expensive. But it does mean that a strong source of growth in overall global demand will remain in place.

The second reason for recovery may prove less robust. This is the gradual normalisation of business and consumer behaviour which is under way in the US and much of Europe. (I exclude the chronically troubled economies of Greece and Ireland, but they are not large enough to matter, except to their own citizens). Across the developed world, the shock experienced by the private sector in 2008 was so great that people and businesses took quite extraordinary measures to postpone non-essential spending and to avoid long-term commitments. As a result, they raised their savings rates and began to pay down debt.

Such was the collapse in the private sector’s spending relative to its income that balance sheets had already started to improve by spring 2009. Since then, the private sector has relaxed a little, continuing to pay down debt, but not quite as much as before. With some money left over to allocate to consumer spending and capital investment, economies have started to grow again.

In the aftermath of some earlier crises—for example, those in Scandinavia and Britain in the mid-1990s—economies have improved for many years as this healing process has continued. In other cases, such as Japan, they have become mired in a deflationary trap from which they have never really emerged. Still others, such as the US in the 1930s, enjoyed a strong early recovery, which led policymakers to tighten fiscal and monetary policy too rapidly, choking off growth before unemployment could return to normal. The premature tightening of macroeconomic policy in the US in 1937 still haunts policymakers over there. Or, if it does not, it should. On that occasion, it took the rearmament programme of the early 1940s to end the depression.

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The future for asset prices will be determined by which of these templates is followed. Will the healing process remain on track? Or will Japanese-style deflation take hold? Will policymakers tighten too soon, as in the 1930s? Or, worst of all, will they tighten too late, leading to a fiscal crisis or rapidly rising inflation—the endgame after many earlier episodes when government debt has ballooned. This represents an alarming list of very different outcomes, with no clear lessons from history to rely upon.

In the first of these scenarios, investors should prefer equities and commodities to bonds. In the second and third, they should prefer government bonds to any form of risky asset, housing included. And in the final, inflationary scenario, there will be no hiding place, except possibly index-linked bonds and some commodities such as gold.

It is a critical choice, but I am sceptical whether anyone can see the future clearly enough to make a prediction that will hold for long. Flexibility of mind, and of asset allocation, may well be needed. Here are some tentative thoughts.

The inflationary outcome seems to me the least likely. Contrary to the cynicism that many express, central banks have not forgotten the lessons of the 1970s and will not permit inflation to take hold. There may be painful episodes, driven by commodity shocks like the one we see today, but this does not mean that we face a dose of double-digit inflation.

Nor will there be a general collapse in confidence in government debt. Private savings are so high that, with some extreme exceptions, governments can finance their deficits. And countries like Britain are doing their utmost to steer away from this appalling endgame. No, the likely choice is between continuing economic recovery, possibly spluttering at times, and a renewed Japanese-style slide towards deflation as economies fail to cope with the tightening in fiscal policy that has now started.

I am cautiously optimistic about the outcome. Central banks can keep policy easy to aid recovery, and so far they have been ready to do this.

Capitalism did not (quite) meet its maker in 2008. There is life in the old dog yet.