Economic Commentaries

26

Since the beginning of this year global equity markets have risen steadily while sovereign fixed income markets have held roughly steady. This is despite the fact that if anything global economic growth is shaping up as weaker than generally expected while inflation is collapsing worldwide.

The reality of subdued growth and negligible inflation has led global Central Banks to aggressively ease credit, flooding the world with liquidity. We think the out performance of equities reflects this liquidity infusion and a seeming blind faith on the part of investors that central banks will indeed succeed in reviving the global economy. This faith is reflected in consensus economic forecasts which are for a meaningful reacceleration of economic growth in the year's second half.

Whether or not this faith is justified or the piper will be paid with a sharp equity correction and interest rate drop remains to be seen. But no matter the outcome at least one thing seems pretty certain to us and that is that inflation is cooked and commodity markets will continue losing appeal.

An intense debate about the second half outlook is undoubtedly underway within the confines of the Federal Reserve as it contemplates the future of its currently aggressive asset purchase program. This is evident from the minutes of the latest FOMC meeting and it was evident in Fed Chairman Bernanke's congressional testimony this past week.

While acknowledging some bright spots in the economy such as the recovery in residential real estate, the Fed Chairman was quick to remind everyone of intense fiscal drag, weakness in Europe and Asia, and the knock on effects of continued worldwide deleveraging. The Chairman for the first time explicitly pointed to collapsing inflation as a factor that offers the Fed more latitude.

From his past writings and uncountable speeches as Fed Chairman our read is that Mr. Bernanke fears a repeat of the policy mistakes made in the U.S. in 1936-1937 and in Japan over the past twenty years. Thus, we think the Fed Chairman will opt to err on the side of being late rather than early to alter its current policy course.

Fortunately or unfortunately we still do not see convincing evidence that the economy is anywhere close to shaking off the blues and reaching the escape velocity that everyone is hoping for. We think the economy will run at best at about a 3% nominal GDP rate in the second half. This will make it hard for companies to achieve top line growth although at least the lack of inflation suggests that the quality of earnings such as they are will be enhanced. If we are right the Fed can be expected to continue its current policy without undue risk, but investor expectations may not be realized.

Like the Fed Chairman we admit that this is a very difficult forecasting environment and like the Fed Chairman we will be monitoring economic data very closely over the next several months, hoping to reach a firm conclusion before the markets do.

Posted in: General