Ignacio de la Torre. Professor. IE Business School
23 October 2013
Falling bond prices, rising stock exchange rates, Europe’s exit from the recession, and the end of the raw material super cycle are all things that we can expect to see in the near future.
One of my favorite and oft-used quotes is by Galbraith: “The only function of economic forecasting is to make astrology look respectable”. Given that I’m an economist, it could be that the predictions I make in this article make even the non-existent astrology section in the newspaper I am honored to write for look more scientific than the theory I am going to set out below, but seeing as I always did like to provoke debate and I don’t believe in astrology, here are my ideas.
First: The US economy hinges on solid bases provided by a) the creation of wealth in households through rises in house and share prices - US households have never been as rich as they are today, b) an increase in loans made by banks and c) job creation. These bases provide economic growth which directly or indirectly generates a rise in interest rates in the long term which has already started, is inexorable, and will have dramatic consequences for fixed-income markets. The US bond (along with the German bond) was recently at its highest price level (low profit levels) since 1790. One could expect that in the face of such high prices the market would react by selling, but in fact the opposite happened, causing one of the biggest bubbles in history: that of government bonds. This bubble has now started to deflate, that there have been drops in the price of bonds since bubble levels were reached is obvious. I would expect profit levels of the ten-year US bond will stand at 3% around the end of the year.
The consequences are: a) a fall in the price of other government bonds b) a fall in the price of investment grade bonds, given that today the rate of interest says a lot more about its future value than the credit spread, c) a fall in the price of high-yield bonds, which are currently actually low-yield bonds, d) a fall in the price of real estate investment trusts, e) a fall in the price of bond proxy stocks (electricity, motorways…), and f) an improvement in the stock exchange performance, where rises in the rates of interest from very low levels (up to 4-5%) usually occur in lockstep with rises in the multiple when there is greater economic growth, which means that the PER of the stock exchange will rise and the risk premium spread will drop against the low risk bond ( and yes, the oxymoron was intentional).
Second: signs of a slowdown in China are still evident: electricity consumption is up by only 4%, extremely weak imports (showing up lethargic investment), weak export activity, industrial price index in negative descent for several months, a sure sign of excess capacity… many analysts relied on the government carrying out greater injections of credit, but data for May shows quite the opposite, social financing is down by 30% and the total loan is growing much less than anyone expected. In other words the Communist Party is more concerned about preventing a “Minsky moment” (a credit implosion like the one that occurred in Spain, as Yosi Truzman commented last Monday) than about kickstarting the economy using more debt ( which would be a bit like giving someone with a hangover alcohol to them buck up). Has it come too late? I think the risk is significant given that the country has already injected 30 points of GDP in only three years in the form of credit, and it’s difficult to avoid an asset bubble and financial crisis with a precedent like that. The consequences will be: i) Growth of Chinese GDP will not accelerate from the 7.7% registered for the first quarter, but rather it will grow even less during the second quarter, ii) the supercycle of raw materials is now sluggish, China’s weakness will lead to lower prices in raw materials, and this in turn will cause weakness in geographic regions whose boom depended on the mass export of raw materials bonanza (Australia, Nueva Zealand, Canada, Latin America, Africa); in some of the these areas lower external demand will coincide with the end of their real estate bubbles. In Brazil the situation will be made worse by the massive loss of competitiveness due to salary levels. As a whole, growth spreads between developed and emerging countries will become gradually smaller.
Third: The situation in Europe is gradually improving, and the enormous economic differences between countries in Northern and Southern Europe is beginning to close in terms of advanced indicators. The consequences will be i) Europe will exit the recession during the third quarter; ii) said exit will particularly benefit the countries in Southern Europe which have become the new “export tigers”; iii) in Spain the data for last month give reason for optimism (the advanced indicator of the economy, the PMI, is at 47, up from 44, France is currently at 44), that is to say that Spain’s future looks more promising than that of our Gallic neighbor (courtesy of reforms), and iv) still on its way out of the recession, Europe will not attain growth rates like those of the US (greater than 2%, growth levels required reduce unemployment, the millstone round Europe’s neck and our greatest collective failure) until its tragic-comic financial system has been resolved. Said solution lies with the banking union, with the mass opening of bond markets for mid-sized companies and with the capitalization of zombie banks.
Place your bets…