Monthly Archives: December 2013

As we enter 2014, the five-year bull market in developed market equities remains in full swing. Recently, I argued that equities now look overvalued, but not egregiously so, and that the future of the bull market could depend on when the level of global GDP started to bump up against supply side constraints, forcing a genuine tightening in global monetary conditions.

Today, this blog offers a year end assessment of three crucial issues that relate to this: the supply side in the US; China’s attempt to control its credit bubble; and the ECB’s belief that there is no deflation threat in the euro area. At least one of these questions is likely to be the defining macro issue of 2014 and beyond. 

The long farewell to quantitative easing, one of the most remarkable experiments in the history of macroeconomic policy, starts now. In the wake of the strong US employment data in recent months, the Federal Reserve finally announced that it will taper its asset purchases from January onwards. The Fed’s balance sheet will stabilise in 2014, but will not begin to decline for several more years.

Variously described as the saviour of the global economy, totally irrelevant, a drug for the financial system or the harbinger of future inflation, QE is still controversial and insufficiently understood. Macro-economists are destined to be studying its effects for decades to come. Here are some early reflections. 

For all type of investors, one question for 2014 dominates all others: can the great bull market in risk assets, especially in US equities, continue for another year? John Authers points out that there is an unusually strong consensus in analysts’ forecasts for next year, with almost everyone expecting stronger global GDP growth, dovish central banks and further rises in equity markets. As John says, this “cozy consensus” borders on complacency.

Investor psychology usually reflects the recent past. The year just ending has seen the best performance by US equities in the past four decades, with the single exception of the calendar year 1995. The word “best” in this case does not refer to the highest absolute return, but to the highest Sharpe ratio, which measures the risk-adjusted return.

Strongly positive returns, with very low volatility, is a dream scenario for investors, especially since the stellar performance of 2013 comes on top of several previous years in which equities also rose markedly, though with much greater volatility than seen this year. So is all this simply too good to last? 

In recent months, inflation has again reared its head as a problem in the developed economies. But this is not because it is too high. In most countries, headline CPI inflation has been falling significantly since the end of 2011, and it has now dropped to less than 1 per cent in both the US and the euro area.

Furthermore, the pervasive decline in headline inflation has been accompanied by a similar decline in core inflation rates, which are also hovering at worryingly low levels in most countries. In fact, out of the 25 developed economies that publish regular data on Haver Analytics, only Iceland is currently experiencing an inflation rate that could be considered markedly too high by any of these measures. 

When George Osborne, the UK chancellor of the exchequer, stands up to deliver his Autumn Statement on Thursday, he will be able to talk about good economic news for the first time since 2010. The speed of recovery in the economy in the past six months has been little short of astonishing. This will certainly have persuaded the Office for Budget Responsibility to increase its gross domestic product growth forecast for 2014, causing an automatic reduction in government deficit and debt projections.

The vicious circle linking low growth and high budget deficits, so prominent in Mr Osborne’s first three years, has been transformed into a virtuous circle — for now, at least. It will take a Herculean effort of self-control for Mr Osborne to resist claiming: “Austerity works”.

The acceleration in UK GDP growth during 2013 has far out-stripped that in any other leading economy, following a period of several successive years in which the opposite was the case. According to “nowcasts” for economic activity (see graph below), UK growth has been running at above 5 per cent annualised for several months, compared to about 1.5 per cent at the start of the year. For a while, sceptics argued that these nowcasts were being over-influenced by buoyant survey data, but there is now evidence from hard economic data that the take-off in activity is genuine. 

International investors often complain that they have a hard time understanding the actions of the People’s Bank of China. The PBOC still seems to pride itself on the inscrutable nature of its policy pronouncements, rather in the style of the Fed until the mid 1990s. In order to judge what the Chinese monetary authorities are doing, it is necessary to watch their actions more than their words, and even then there is plenty of room for misinterpretation. As in other areas of Chinese public administration, power resides in secrecy.

The fact that Chinese monetary policy can seem obscure to outside observers does nothing to diminish its importance. In fact, the ongoing attempt to deflate the 2010-13 credit bubble in China is more important for the global economy than the Fed’s tapering plan, or the ECB’s thinking on negative deposit rates. A collision is developing between a progressive tightening in monetary conditions, and the inflationary psychology of the housing and land markets. No-one can be certain how this will end.