In the Eye of the Storm

October 31, 2013

Could it be that this is the eye of a market storm?  To the rear lies the worst accident to GDP and employment growth since the 1930s, an event from which advanced economies never fully recovered.  Lately, emerging nations like India seem under the weather, but economic prospects for the most part appear constructive.  Assumptions in the Bank of Japan’s semi-annual report released today capture the pulse of what many market analysts are saying.

While overseas economies have been somewhat weaker than anticipated at the time of the Outlook for Economic Activity and Prices (Outlook Report) in April 2013, they are expected to pick up gradually — particularly the advanced economies — on the assumption that global financial markets remain generally stable.

In spite of the recent U.S. default scare and omni-present worries about Europe’s banking system and the size of Japanese debt, the financial world has passed through a comparatively peaceful half-year.  Compared to April 30, Ten-year sovereign debt yields have climbed between 73 and 93 basis points on balance in the United States, Britain, and Canada and by a lesser 45 bps in Germany and 31 bps in Switzerland.  The JGB is actually 2 basis points lower in spite of a roughly 4% annualized rise of Japanese real GDP in the first half of 2013.  The five Euro area members constantly on debt watch — Portugal, Italy, Ireland, Greece and Spain — have seen their 10-year spreads versus the German bund drop in four instances, including declines of 285 bps for Greece, 55 bps for Spain and 52 bps in the case of Ireland.  The Portuguese-German spread went up merely six bps and remains far narrower than frequently seen in the first half of 2012.  Yield curves remain positively sloped and far from the inverted shape that often precedes economic trouble.

Other market developments are consistent with the gradual economic upswing.  Share prices have had a good run these past six months.  U.S. gains are above 10%, and the Japanese and European indices are up to a lesser degree.  WTI crude oil is about 3.5% higher on balance but importantly is trading under $100 per barrel.  The price of gold, which generally thrives in tumultuous financial markets and when confidence in paper currencies is compromised, tumbled 10.6%.

The dollar has been boring to watch.  While trading in high-low ranges of 10-12% against the yen, Swiss franc, sterling, and kiwi, net movement in none of those dollar pairs exceeded 3.5% and was marginally less than 1% in the yen.  The euro fluctuated in an 8.5% band, rising just 3.2%.  The loonie had an even tighter range and fell 3.5% net.  China’s managed yuan appreciated at an annualized pace of just 2.4% over the six months.  At least the Australian dollar offered excitement, ranging between USD 1.0384 and USD 0.8849 and losing 8.8% for the period.  Emerging market currencies also saw livelier action.

The widely held presumption of a continuing gradual recuperation from financial apocalypse doesn’t have to be how the future plays out.  Be warned that procrastinators from the private sector and governments as a habit almost never predict recessions before their onset, so the typically sanitized baseline forecast ought to provide scant comfort and shouldn’t be interpreted as an indicated lack of downside risk.  Any time that growth is soft, upturns are vulnerable against unforeseen stress and could decline past the stall-speed threshold.  Three pieces of favorable news are

  • The absence of strains like excessively high energy prices or accelerating inflation.
  • The presence of synchronized accommodative monetary policies.  It seems very unlikely that the Fed will tighten before March.  Japan is locked into aggressive stimulus for at least another 18 months, and both it and the ECB have a continuing bias toward ease over the coming six months.
  • Governments better understand that aggressive fiscal restraint without a growth strategy is counterproductive.

Given a great enough shock, however, calm conditions can change in an instant.  The world continues to live with unrest in North Africa and the Middle East, but that stress is not on the same plane as others like the 9/11 attacks, assassination of President Kennedy 50 years ago, the invasion of Kuwait in 1990, the subprime mortgage debt chain reaction of August 2007, the mishandled Lehman Brothers failure thirteen months later, or the revelation that Greek fiscal debt and deficits were much bigger than admitted previously. 

An actual U.S. debt default would be just as traumatic, if not more so, as the above examples.  I’ve heard of one advisor with a U.S. money center bank telling a depositor that it might be prudent to withdraw all money for the next six months as a precaution against a sequence of a default draining the FDIC resources.  Worst of all could be a crisis so different in nature that it’s not even included on lists of what might go wrong.  Former Defense Secretary Rumsfeld called such events unknown unknowns.  One can hope that nothing of the kind happens during the coming six months, but it’s probably too much to expect that the improved and generally stable market conditions of the past six months will persist forever.  Sooner or later, currency market plates are going to shift.  They always have.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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