Underground threats to the global economy

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For many months we have argued that the global economy is, despite all the hoopla, actually following a pretty normal course. Yes there are exceptions. The massive fiscal and trade deficits currently experienced by the United States are not normal and represent the tips of a very substantial economic volcano. But investors and financial market operators have grown used to this landscape of peaks and valleys and have come to accept their existence in much the same way that a multi-generational farmer clings to the slopes of, Philippine death trap, Mount Pinatubo. The farmer ekes out a living from the fertile soil aware, at the same time, that at some indeterminate point in the future this livelihood is bound to be swept away in a searing pyroclastic embrace. But for now investment vulcanologists can ease back in their deck chairs. The seismograph chatters quietly in the background, nothing untoward, the economic world is at peace and yet……

Some people are just never happy! In this world of small things monitored so minutely, this world in which the slightest rustle in the hedgerow calls forth a flock of squawking, excitable, pundits babbling hyperbole like a mountain torrent, it can be quite hard properly to discern the true meaning of the almost imperceptible nudges on that same seismograph. They are, however, important and must be recognised as such if this environment in which we inhabit is to be given meaning and context provided for the future.

Consensus: the global economy is slowing

By massive common consensus the global economy is slowing (see chart below). It has taken time for the brakes to start to work, particularly so as economic policy (both fiscal and monetary) has been tightened across the US, eurozone, Japan, China, India, Australia not to mention the UK for a while now.

In part because of and in part exacerbated by, a significant, yet glacial-paced, shift in expenditure patterns this slowdown is causing changes of tectonic proportions beneath the surface, the ripples from which are, however, beginning to show up in market action. Significantly, since the early 1980’s the G7 household sector financial balance has been on a continuous slide from a healthy 6% of global GDP crossing zero in 2001, to a very unhealthy -2% of GDP today. We expect that concerted fiscal and monetary policy tightening will cause this long-term slither to go into reverse, producing a significant squeeze on future consumption patterns.

Over the same period the G7 corporate sector financial balance has been on a shallow upward trend (with the notable exception of the late 1990’s bubble years!) from -2% GDP in 1982 to +0.5% of global GDP in late 2006. There have been a number of good reasons why companies should have wished to have opted for greater financial stability, particularly so in the wake of the creative accounting fuelled late ‘80’s boom and the emergence of pension fund “back holes”. Interestingly perhaps, we see a strong correlation between the steady improvement in company accounting and balance sheet rebuild, the steady demise of volatility and investors’ equally extraordinary creeping acceptance of risk to the point where, in the credit markets, spreads between junk and high grade bond yields have all but disappeared.

The above illustrates something interesting going on too. We have periodically wondered for just how long could companies remain in such control of their wage bills that profit margins can continue to hit new peaks. Perhaps this chart tells us we should start to worry. It reveals that, after several years of extraordinary weakness (the deflation threat years of 2003-2004) in which corporates really held the whip hand in negotiations with employees, the latter have shown signs of fighting back. To some extent this is a reflection of a rising (and pernicious) inflation hedge to wage bargaining but whatever the underlying cause the risk either to future inflation (and monetary policy) or to the sustainability of prevailing profit margins is clear.

Meanwhile back on the markets

The response to the common acceptance that the global economy is following a normal cycle has been to consign the word “risk” to the dustbin of history. The bond yield curve, despite its clear inversion (and thus negative message regarding the economic landscape of the future) is ignored. Relatively low longer dated bond yields have resulted in a historically high equity risk premium (cash today is worth more than cash in the future) and ultra low levels of implied volatility.

The following highly stylised graphic illustrates these financial market inconsistencies and serves as an important frame of reference for what we have already begun to see happening over Q4 2006 and which could, despite the benign macro backdrop, still make for choppy conditions in the equity market.

The diagram, which we reproduce with the kind permission of UBS Warburg attempts to explain a world of macro economic growth, buoyant equity markets and the departure of “risk” from the investor lexicon. The diagram shows that a wide range of hitherto diverse external stimuli have combined, over the past decade, to produce the unusual combination of strong economic growth, wafer thin (skinny) premiums in the credit market, ultra-low volatility and an unusually high equity risk premium (ERP).

The diagram does not explain what might happen in the future but it seems pretty clear to us that any significant change in the external stimuli could produce a marked change in the uneasy equity market status quo. Perhaps the most interesting change is already underway… re-leveraging.

At it’s full year results presentation on Thursday 1st Feb, AstraZeneca lit a fire under its own share price and the Pharmaceutical sector generally by suggesting that the global sector giants should seriously consider gearing up. In fact the process of corporate re-leverage has been going on for a good six months already. The corporate sector is following where the private equity sector has already blazed a trail and already some commentators, such as Standard & Poor’s, identify the growth of leveraged buy-outs as sowing the seed of serious risk for the future.

The return of risk will inevitably give rise to greater volatility, an event which, in our view, should be welcomed by investors as antidote to the duration extension and multiple expansion of the past six months.