Making sense of the markets
In an age of quantitative easing, negative interest rates, low oil prices and limited spending, many investors could be forgiven for finding the global economy increasingly difficult to understand. We look at some of the driving forces and consider how best to respond to a frequently puzzling picture.
John Nugée, Laburnum Consulting
Compounding the general sense of unease is a widespread feeling that the global economy has become not just slower and more fragile but markedly more difficult to understand and make sense of. Consider, for example, one of the key features of markets at the start of the year: the weakness in the price of oil, which led to weakness in equity markets, which in turn fed back to renewed weakness in oil.
For anyone who remembers oil price rises of the past — not least during the miserable decade of the 1970s, when OPEC, the oil exporters’ cartel, inflicted so much pain on Western consumer societies — this is bizarre. If a rise in the oil price is bad news for consumers, which in general it is, then surely a rapid fall in the oil price should be good news and positive for the economy as we all rush off to the shops to spend the money we have saved at the pumps.
The first reason why this is not necessarily so is that the global economy is now much more balanced between developed and developing nations and between oil exporters and oil consumers. In the 1970s 80% of world GDP was accounted for by the West — in other words, developed and mostly oil-importing countries — so a rapid rise in the oil price was unequivocally bad news for world consumption and GDP growth. Now developing and emerging economies, including oil exporters, have a much larger share of world GDP — by some measures over 50% — and a fall in the oil price creates real difficulties in places like Saudi Arabia, Brazil, Nigeria, Russia and other countries that comprise a far more significant share of the world economy than they did 40 years ago. Forced sales from the sovereign funds of oil-rich countries have been among the main causes of stock-market weakness since the peaks of April 2015, and there is little sign of this selling easing off.
Another major difference between this and earlier periods of oil-price weakness is that consumers may have been benefiting at the pumps but have hardly been rushing out to spend their gains. Levels of indebtedness, both public and private, were very high as we entered 2016, and governments and consumers alike appear to be nervous of loosening the purse strings just yet. Austerity remains the watchword, and for most people the emphasis remains on reducing debt and rebuilding personal balance sheets rather than increasing spending.
And so, with China and the developing world slowing down, oil producers feeling the pinch and consumers in the developed world unwilling to pick up the slack and spend, the global economy faces an overall deficit of demand. Along with sales of assets from oil-exporting countries’ sovereign wealth funds, this is for many commentators the main underlying cause of the current market weakness.
The response of more and more central banks is to rely on unorthodox policies. Both the Bank of Japan and the European Central Bank (ECB) have increased their quantitative easing, and negative official interest rates are now in place in a growing number of economies — the latter phenomenon itself another of those “markedly more difficult to understand and make sense of” events mentioned earlier. Such moves are put forward as “supporting economies” and “encouraging demand”, but the reality is rather simpler: they are part of a widespread — though so far mostly covert — drive towards lower exchange rates.
We have not quite reached the stage of overt currency wars, in which central banks actively and openly engage in competitive devaluation, but we are well into the “phoney war” stage. There is no doubt that governments and central banks — the ECB, the Bank of Japan and the Bank of England included — are far from unhappy when their currency shows signs of weakness. It is as if policymakers have despaired of actually increasing global demand and global economic activity and have instead decided to concentrate on grabbing for themselves and their economy as large a share of the remaining activity as they can.
What is the prudent long-term investor to make of all this? Perhaps the first observation is that there are good reasons for some of the market nervousness. Central banks’ increasing use of unorthodox policies such as extended quantitative easing and negative interest rates does take the world into uncharted territory, and there are few — if any — historical precedents we can draw on for understanding how economies work in such circumstances and equally few roadmaps to take us back to more normal levels.
Moreover, central banks have neither the remit nor the power to abolish global slowdowns and recessions. Indeed, some commentators have argued that central banks have been trying too hard to boost economic activity in the past five years: they were right to pull out all the stops in 2009-2010 to avoid a rerun of the Great Depression, but since then they have been taking ever more aggressive (and distorting) measures to achieve ever less success.
Crucially, those who have the patience to bide their time may be able to take advantage of lower prices later in the year. It might be difficult to believe as prices are falling and confidence is thin, but this is when the real bargains can be found!
To take advantage of lower prices, though, investors do need to be able to ride out the storm. As the old market maxim has it:
Optimism means expecting the best.
Realism means accepting that the best may not happen.
Confidence means knowing that you will survive even so.
Generating in clients the confidence that their portfolios will survive market volatility is a key goal for any asset manager. The Rathbones team will undoubtedly have this at the top of their priorities as 2016 continues its uncertain path.
John Nugée is an independent commentator on financial, economic and political issues (www.laburnum-consulting.co.uk). The major part of his career was spent at the Bank of England, where his last post was as Chief Manager of the Reserves.
This article first appeared in Rathbones Review Summer 2016