What a week. August 2011 starts off confirming its reputation as a month not to plan too much relaxing vacation, as yet again panic sets into global financial markets. This day 4 years ago was when the first severe credit crisis rumblings really set in. And this weekend, it partially feels as though we are back where we were – with great uncertainties and waiting for a policy response. What makes it so tricky is that in those intervening four years, a lot of conventional policy responses have been used.
From a market perspective, everything is once again very globally connected. From a macro economic perspective, this August feels as though there are three distinct macro issues bothering markets – all three of which are big and complex. I shall discuss these before turning to the markets.
The three issues are: (1) the US economy and economic policies, (2) the European Monetary Union, and (3) China. Of the three, the one that is trickiest to resolve and probably the one of greatest concern to markets is the EMU. I shall discuss the other two first.
China is perhaps the least pertinent issue to global markets in the short term, but given China’s crucial importance in offering some domestic demand support for the challenged Western economies, ultimately I believe it is extremely important. I touched on this last week, but the internal Chinese debate about the ramifications of the high speed train crash continues. David Pilling in the FT on Thursday, August 4th touched on all the key issues in a piece entitled “China crashes into a middle class revolt”. As I mentioned last week, the aftermath of the crash has led to strong internal protests, with no signs of calming down. It is possible that this incident heralds a moment where central policymakers are going to have to be more accountable to the rising middle classes, which has its own set of risks. Moreover, it highlights that the pursuit of GDP for the sake of GDP, especially through government investment spending, may have reached its limits. It adds to my belief that China might grow closer to the 7 pct assumption in coming years, as estimated in their latest 5 year plan. Given that half of 2011 GDP has been reported, there is little chance of growth slowing to this level for this year, but I suspect that real GDP in China is going to be lower than the consensus think in the next couple of years. As I also said last week, ultimately, slower growth in China will likely be a positive thing, especially if domestic consumption rises as a share of GDP as planned and desired. But there, if markets expect GDP growth between 9-10 pct to continue, the adjustment might be tricky. This would be especially so for heavy commodities where Chinese investment spending has been so important.
We will start to see all of China’s usual monthly data releases this coming week, and within them, the CPI and PPI releases will be the most important. Signs of a peak in inflation will be much sought after by those of us that believe in the optimistic path for Chinese domestic demand. For the Chinese consumer to get stronger, a turn in inflation is necessary.
THE US AND THE S&P DOWNGRADE.
So the immediate question from S&P’s move is: does it matter? While both Fitch and Moody’s reaffirmed the AAA status following the debt ceiling extension, S&P’s move to downgrade was largely expected. Given that (a) it was expected, (b) there seems to be some serious dispute about the mathematics assumed by S&P, which adds to questions about their usefulness, and (c) US bond markets continued to benefit from global investor risk aversion during last week’s panic, I am not sure that this news is really that important in the short term. Symbolically, it is. It is certainly a blow to the prestige of the US and, almost definitely at the margin, is likely to lead to a further shift away from G7 assets for diversification. But, will this move cause problems for US bonds? I doubt it.
What is more important is what is really going on with the near term cycle, the underlying trend rate of growth, and whether the US can and should implement significant fiscal tightening given the economic headwinds.
At the margin, the late week’s news flow was marginally positive about the state of the cycle, with both weekly job claims and the July employment report stronger than expected. Following the rather alarming weakness reported in the manufacturing ISM at the start of the week, this was a relief. It also seems as though auto sales are starting to recover through Q3 as many as hoped, so some sort of bounce from the weak first half is still distinctly possible.
As evidenced in the downward GDP forecasts from the GS Economics team on Friday, however, there is something wrong with the economy.
I find myself starting to doubt whether the underlying trend rate of growth of the US economy is indeed as robust as I had persuaded myself this past 12-18 months. How else can you explain the repeated soft patches that re-appear as the economy tries to recover from the crisis? And, in some ways more intriguingly, how can you explain the ease at which core inflation has risen this year? To me, this is the more interesting issue than the S&P ratings move, not least because it adds to the challenges facing policymakers, including the Fed. Many people are assuming that the Fed will move towards a new bout of quantitative easing at the forthcoming FOMC meeting, and while I suspect there is a bias that way, it is not clear to me that the Fed can do much.
EUROPE AND EMU.
In my view, this is the biggest of the three problems. I have been arguing all year that the Euro Area sovereign debt crisis is not a true debt crisis, but more of a crisis about the EMU. In the past 3 weeks, it has taken on a much bigger dimension, with both Italy and Spain coming under significant pressure in the markets. France is now also receiving some attention. Spain’s economy is twice the combined size of Greece, Portugal and Ireland, and Italy is about four times their combined size. As is well known, it has the third highest $ or Euro value of sovereign debt in the world after Japan and the US. Italy facing severe financial strain is an issue for us all.
This weekend, the Italian PM and his team is placing great emphasis on a stronger set of structural reforms and stronger fiscal discipline. This is likely to be a key issue Monday morning, as what they present to the world will have the most immediate impact on sentiment. More importantly, it will determine whether the ECB is to further risk its precious reputation by adding Italian bonds to the growing list of those that it is prepared to support.
I have written repeatedly that the fundamental problem in the EMU is that the markets now realize it was floored. Too many countries were allowed to join. They have found it difficult to adjust to the competitive environment under the straightjacket of a monetary union, and furthermore, there has been no fiscal discipline really applied according to the Growth and Stability Pact. The only way to keep the EMU alive is to go deeper into a stronger union, with more fiscal union and a true genuine Euro denominated bond. EU Commissioner Rehn hinted on Friday that the EU will suggest just that as a goal in the Autumn. However, as policymakers must know, once markets become as unsettled as they currently are, long term solutions have to be brought forward, and something needs to be done to stabilize Italian and Spanish debt – and with this, the broad European banking industry – very quickly, and possibly next week.
To add to the challenge, key European policymakers continue to squabble publicly with Thursday and Friday seeing the EU’s Barroso being rebuked by the Head of the German CDU when asking for quicker ratification of the recent proposed support packages. Germany holds all the keys to the ultimate path for the EMU, as it is their credit rating that will be needed to resurrect a stronger and more stable EMU. So watching words from Berlin and around Germany is critical.
In the meantime, it seems to me that the ECB is going to have to support the European financial markets, especially Italian and Spanish debt, until the politicians finally agree on something more substantive.
Last week saw a major breakdown in equities, and it would seem as though that momentum may continue without a lasting solution on the European policy front especially. Many bears are heralding the beginning of a fresh bear market and/or the rally since 2009 was simply a long counter-trend rally. While there is no denying the loss of global economic momentum, and it is possible that the bull move since early 2009 is over, I still doubt it. A fresh bull market move is likely to start when Chinese inflation has clearly peaked and their policymakers can move away from tightening policy. As I have talked about repeatedly in the past, it is China, along with the other Growth Market countries that will control the world economy and its markets’ destiny in the years ahead. Meanwhile, the local challenges in the US, and especially Europe, will feel bad and weigh on us all.
The foreign exchange market is now becoming really interesting. Last week, both the Swiss National Bank (SNB) and the Bank of Japan (BOJ) decided that they couldn’t cope any more with the responsibilities of expensive safe havens. Both of their individual moves have been generally regarded as inadequate and insufficient to reverse their currencies, and in view of the S&P news after the Friday market close, this may be the correct judgment. But it does seem to me that both currencies are now ludicrously overvalued, and especially in the case of the Yen, very hard to square with a market that is focused on sovereign debt. Some Yen bulls will allude to Japan’s current account surplus and lack of foreign ownership of JGBs, and will therefore conclude that there is no risk of foreigners pulling out. But, there are growing signs of less marginal purchases by big local Japanese investors. If you were one of those, would you prefer 10 year Italy at 6.10 pct or 10 year Japan at 1.00?
I am completely unsure as to where things will move next week or through the remainder of what could be a treacherous August. But looking into the Autumn and beyond, I suspect that you wouldn’t want to have stayed long either the Swiss Franc or the Yen.
Chairman, Goldman Sachs Asset Management