Archive for February, 2011
On 17 December last year, a 26-year-old Tunisian street vendor set himself on fire after local officials made it impossible for him to do business. A little more than two months later, and the series of events set off by this incident has seen the governments of Tunisia and Egypt fall, Libya beset by civil war, and almost every other Arab regime throwing money at its people to forfend a similar fate. Never has the phrase “chaos effect” seemed more appropriate.
It is too early to tell which Arab governments will survive, let alone what exactly might replace the ones which fall. Perhaps there will be a flourishing of constitutional democracy, with free elections, separation of powers, bills of rights – the complete apparatus of western liberty. Or perhaps the stage is set for a narrow, repressive theocracy which will see the pyramids destroyed for being un-Islamic.
So what has all this geopolitical uncertainty meant for markets?
Equities have mostly enjoyed a solid start to the year, especially in Europe (the exception being here in the UK). Bond markets have not done so well, with yields higher pretty much everywhere. While the political situation has made them nervous, therefore, these markets as a whole have reflected the continued entrenchment of the global economic recovery.
The commodity space has been impacted more directly and dramatically. Oil in particular is up, with the near Brent future almost $20 higher year to date. Governments, mindful that food price inflation was one cause of the Arab uprisings, have stocked up on wheat and rice, driving prices up for a time, but they have just fallen back again on fears that more expensive oil will dampen growth and demand in key markets.
By and large, however, financial markets are looking through the political turmoil. The butterfly effect has yet to play itself out in north Africa and the Middle East, but elsewhere the bulls and bears remain in control.
It was one of Mr Bernanke’s predecessors at the Fed who said that his role in setting monetary policy was “to take away the punch bowl just as the party gets going”. The current Fed chairman appears determined to wait until festivities are in full swing, but he will have to start taking away that punch at some point, and there are worries that this will leave equity markets with a sore head.
We have already seen that higher rates need not necessarily mean lower stocks when it comes to developing economies. But how has the US market reacted to post-recessionary policy tightening in the past?
In the early 1980s a hawkish Fed pushed interest rates to 20% in an effort to contain inflation. It succeeded – at the expense of a recession that saw rates fall all the way to 8.5% by December 1982. The Fed stayed its hand for a while before tightening again in May the following year to a peak of 11.75% by August 1984.
At the bottom of this cycle – from the beginning of December 1982 to the end of May 1983 – the S&P 500 returned 19.9%. And by the time rates peaked – from end May ’83 to end August ’84 – it had returned another 8.6%.
Moving on to the post-recessionary tightening cycle of the 1990s, rates bottomed at 3% (Sep ’92), began to rise in Feb ’94 and peaked at 6% in Feb ’95. And the S&P returned 17.6% while rates were held low and a further 7.4% during the period of tightening.
Finally, while the US economy didn’t experience a technical recession in the wake of the TMT / dotcom crash, it did contract in the first and third quarters of 2001 and the Fed eased policy accordingly. This time rates didn’t bottom out until June ’03 (at 1%); they stayed there until June ’04 before rising to a peak of 5.25% in June ’05.
While rates were at the bottom that time the S&P returned 20.6%, and a further 15.5% during the period of tightening.
Time for some provisos!
- The UK had a mini tightening cycle from Feb 1994 to Feb 1995 too: the stock market returned -11% over the period.
- The US equity market has already returned 50% since the Fed funds rate bottomed in December 2008.
- The 1980s and 1990s were periods of exceptionally high returns for equity markets for many reasons besides the level of interest rates.
The one conclusion that it is safe to draw from all this is that investors should not necessarily expect stocks to respond to monetary tightening in a one-dimensional way. Taking away the punch doesn’t always ruin the party.
The policy response to inflation has become a hot topic for equities this year. Emerging markets, whose governments are doing terribly unfashionable things such as running positive real interest rates and trying to balance the budget, have been hit especially hard. If fighting for stable prices is to be punished rather than rewarded, perhaps those who advocate inflation as a cure for government debt are being proved right.
Their argument is simple. If a government finds itself with a debt burden that is beginning to prove cumbersome to service, it can stir up a bit of inflation. The nominal value of its debt will not change, but its revenues will increase in nominal terms, making the debt easier to pay off.
It’s a beguiling idea – but dangerously wrong. While the nominal value of debt will not change, the cost of servicing it certainly can, and for a heavily indebted nation this could easily be punitive.
Take the case of Japan. There is about ¥870trn of government debt outstanding (about £6.5trn, and not far off twice Japanese GDP). Of this debt the biggest chunk comprises short dated liabilities – money market bills and short maturity bonds – with some ¥233trn to be refinanced this year. The rate of interest the government has to pay in the 1-2 year area is about 0.25% at present, putting the cash cost of the refinancing at a manageable ¥0.6trn.
Now let’s turn to the “inflation cure”. Japan runs a budget deficit of some 7.5%, so to use inflation to reduce the level of debt to GDP would require quite a high figure. Let’s assume the Japanese government succeeds in creating price inflation of 10% and real GDP rises by 2%.
On the naive view, the ratio of debt to GDP would start the year at 200:100 and finish it at 207.5:112 – a reduction in debt as a proportion of GDP of 15%. Nine years of this and Japan’s debt burden would fall from 200% of GDP to 100%.
Allowing for an increase in the cost of debt servicing, however, transforms the story. Assuming that real borrowing costs remain unchanged – in this example therefore that they rise by 10% in cash terms – the cost of refinancing Japan’s 2011 borrowing would increase from ¥0.6trn to ¥24trn – about 5% of GDP. This would push the budget deficit from 7.5% to 12.5%, more than eroding the impact of higher nominal growth in GDP and condemning the country to a higher debt burden.
And this ignores the likely increase in the real cost of borrowing, and the need to refinance larger sums of outstanding debt with each passing year (as principal payments on longer maturity bonds fall due). Take these factors into account and Japan becomes Zimbabwe.
The story is similar in the US, where the budget deficit is 8.6% and there is $2.5trn of borrowing to be refinanced this year (of a c. $9trn total). Increase inflation to 10% and assume a similar increase in the cost of borrowing and the deficit would rise to 10.4%.
The situation is not quite so extreme in the UK as a far lesser proportion of our borrowing falls due over the next couple of years, but the same logic applies. For countries with lots of debt, inflation is no alternative to paying it off.