Rajinder Sabherwal: Which way is the global recovery shaping up?

Financial contagion in the eurozone and slow job creation in the US, combined with policy deficits in coping with global tensions, do not augur well

Doubts whether the global recovery will continue has become the central question following the events of the past six weeks. We have had financial contagion-type developments in the eurozone. There have been fears of a China slowdown consequent to the crackdown on the housing market. Economic data in the US has hit a soft patch, and the pace of job creation is disappointing. An overload of unusual events and headlines has undermined confidence. Political and social tensions are on the rise globally and there appears to be a leadership and a policy deficit in coping with them.

Paradoxically, the things that create the most doubts about near-term growth — the eurozone’s earlier than expected forced austerity and China’s aggressive response to a growing housing bubble — also enhance the sustainability of the global recovery.

 

Where does that leave us?
Earlier, I expected a global recovery despite the broad range of potential macroeconomic outcomes as the world emerges from a credit-induced collapse. Historically unprecedented activism by governments had increased the concentration of debt in the public sector to potentially unsustainable levels. Debt in developed countries along with potential for policy errors, in my view, were the two biggest factors that could result in a double dip in the US and Europe and derail a broad global recovery.

I had pegged the chances of a global double dip at 10 per cent (defined as less than 2 per cent global growth). Since March this year, there has been a significant deterioration in the quality of the global recovery. Does that change the probabilities of potential outcomes?

The straight answer is, not yet. The risks of an adverse outcome have risen and the next six months will determine which way the global recovery is headed. Confidence is fragile, but recovery from a near-collapse is underway, driven by balance sheet and liquidity improvements — the exact opposite of the situation that prevailed in 2008.

Four positive factors are at work. First, some key global economic indicators are signalling an improvement — world trade volume, world industrial production, US and Euro area capital goods orders and Japanese machinery orders. Chinese exports expanded 48 per cent y-o-y for the most recently reported trade numbers. The Fed’s recently released Beige Book — a timely and detailed account of what is happening at the grass roots level across regions and sectors — was surprisingly strong. Japanese machinery orders have now nearly regained their 2008 peak and Euro area capital goods orders are 12.5 per cent above their trough levels and steadily climbing.

Second, while the sovereign crisis exposed the fault lines in the single currency structure and the dysfunctionality in the political and governing process, it has forced fiscal austerity much earlier than expected. Past evidence of fiscal consolidation in OECD countries has been positive for equities, especially when coupled with a depreciating currency, as we see with the euro. The weak euro will benefit all eurozone countries by boosting exports and improve the competitive position of the PIIGS countries (Portugal, Italy, Ireland, Greece and Spain), which is at the heart of the problem in the Euro area. Germany and France in particular are well positioned to benefit. It is estimated that the depreciation in the euro will boost eurozone GDP by 1 per cent in 2011.

Third, corporate profits and valuations remain robust with upward profit revisions. Valuations for equities are in the buying range. Consensus bottoms up S&P 500 earnings estimates are 82 and 96 for 2010 and 2011 respectively, implying forward P/E ratios of 13.4 and 11.4. Top down earnings estimates of investment strategists are about 10 per cent lower, but even with that valuations are reasonable. Equities in Europe and Japan are even cheaper than in the US. Undistributed profits are at a high; this should lead to hiring or capex (which provide an economic boost) or dividends and M&A (which boosts markets). Even as return on capital is at its zenith, the cost of capital is at a nadir.

Finally, the absence of inflation in developed countries gives central banks in the US, the Euro area and Japan the leeway to keep monetary policy accommodative for an extended period of time. Even China and other emerging countries are likely to push back plans for policy tightening given the fragility in financial markets. These accommodative policies are likely to be favourable for emerging market assets and commodities in particular.

However, there are also two risk factors. First, the extent of funding required in the public and corporate sector needs to happen at reasonable interest rates that don’t cause a debt spiral. That depends on the credibility of the sovereigns and the confidence of bond investors. That credibility and confidence has taken a hit in the past couple of months. We are entering the era where developed-country debt may require higher interest rates to fund than similarly rated corporate debt.

Second, the sustainability of US demand depends on income, employment, credit and asset values. All of these are question marks, even though retail sales in the US have shown improvement. The weak employment picture more than a year into the recovery is the single biggest cause for concern. A rebound in labour share of GDP in the US will give a big boost to the economy and sustainability of the recovery. Income and recent spending has come from a combination of transfers, tax breaks and reduced savings that are not sustainable. House prices may fall further and global equity markets have fallen about 15 per cent, jarring confidence and sentiment. Because confidence is weak and uncertainty high, it has given rise to very high volatility in markets. Market confidence in our leaders is low, fraying investor confidence in the past few months.

The question is whether the world is entering a period of unusual tensions and upheaval between countries over trade and resources, and between interest groups, that will make governance difficult and policy mistakes more likely.

The writer is CEO and chief investment officer, Magister Ludi Capital Management, LLC., a New York-based global macro fund (raj_sabherwal@hotmail.com)