Monday, February 02, 2004
A year of returning normality
Posted by David Smith at 10:58 AM
Category: David Smith' s magazine articles

How unusual have the past three or four years been for the economy and financial markets? And what are the prospects of something like a return to normality in 2004?

For equity investors, the most unusual feature of recent years was the unusually long bear market. That came to an end in 2003, the first year the market has risen this century, although some have not yet been prepared to let it go. So one question is whether the equity market upturn is sustainable and another is where it might end up.

For economic policy-watchers, something rather strange has been happening to monetary policy. Central banks have been applying a degree of monetary stimulus that not so long ago would have been regarded as irresponsible. All the major central banks have presided over the lowest interest rates since the 1950s.

Not only that but governments have also felt it necessary to boost their economies by fiscal means. Allowing budget deficits to rise during a period of slower economic growth is known by economists as allowing the “automatic stabilisers” to operate. In many cases, led by America, governments have gone further by cutting taxes and boosting government spending.

What kind of economy have we had? The world has been through a recession, although it was relatively mild (in spite of September 11 2001 and the war with Iraq) and it is starting to fade rapidly in the memory, at least in the case of America, first into the downturn and first out of it. At time of writing the latest US growth figures were those for the third quarter, and they were spectacular – an annualised rate of 8.2%.

Britain endured a period of slower growth but, unusually, no recession. Again, there is now firm evidence of stronger growth – the 0.7% rise in GDP in the third quarter (not annualised) was at or slightly above trend. The euro area is also easing itself into stronger growth, albeit in a recovery that appears dependent on exports rather than domestic demand.

The world recession and its aftermath coincided with a reappraisal of the balance of global economic power. While Japan has finally shrugged of its prolonged period of stagnation, the performances of China and India have really captured the eye. In a way that was not apparent even a couple of years ago, these are now seen as the emerging economic giants.

If that is where were have been, where are we headed? Let me make a few predictions. First, the markets. The recovery in equity markets is in my view real and has further to go. Last year I predicted a 20% rise for equities. This year I think we will see between 10% and 15%, on the back of stronger economic growth and rising profits, and I don’t think the recovery will end there. Bond market prospects are less bright, for reasons I’ll explain in a moment.

Second, monetary policy. The Bank of England led the way among the big central banks by raising rates from 3.5% to 3.75% in November. The Bank’s monetary policy is engaged in the task of returning rates to normal or “neutral” levels of 4.5% to 5%. We should reach the lower end of that range by the end of the year. What about other central banks? The European Central Bank is constrained by slow growth, the Federal Reserve by the presidential election (although it would never admit as much), the Bank of Japan by fears of renewed stagnation, although inflation has just turned positive again.

Even so, I would expect all to either have moved to tighten monetary policy – raise interest rates – by the end of the year, or at least signalled their intention of doing so.

Third, governments will talk about maintaining fiscal responsibility but are unlikely to do much about it. Elections and austerity do not make compatible bedfellows, In America George W Bush is unlikely to raise taxes or rein back government spending in an election year. Indeed, the opposite is more likely to be true. In Britain an election is also looming, probably in the summer of 2005. Taxes will surely rise after that but Gordon Brown will move heaven and earth to avoid doing so beforehand.

In Europe, where France and Germany have managed to avoid sanctions under the terms of the stability and growth pact by getting it suspended, neither country is about to submit voluntarily to tax hikes or spending cuts. Germany, in fact, has just introduced income tax cuts. What this means, in summary, is that 2004 will not be year of fiscal retrenchment. That won’t come until 2005 at the earliest, implying additional pressure on monetary policy (higher interest rates than would otherwise be the case) and a relatively poor outlook for bond markets.

Fourth, the economic outlook. The White House has thrown everything at ensuring a strong election-year economy, and America will be the growth-leader among leading economies, with perhaps a 4% to 5% growth rate. Britain should manage 3%, Japan something similar. Euroland will do well to grow by 2% but overall this is a return to something like normal growth among the G7 economies. But I still think we will be looking in wonderment at China and India.

What could get in the way of this return to normality? Terrorism is the usual reason, though that is a little glib. We have got used to living with a certain level of terrorism. It is a question of degree.

Closer to home, although this also applies to America, some fear a day of reckoning arising from high house prices and record levels of household debt. I don’t but I would concede that it would be hard for Britain to enjoy a normal recovery alongside tumbling house prices. I think the Bank of England can steer the housing market towards a soft landing. Let’s hope I’m right.

From Professional Investor, February 2004