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Fragile state

Despite plenty of economic reasons to worry, investors still feel, for the time being, more compelled to buy rather than sell. Somewhat at odds with the increasing chorus of optimism in markets today, we continue to believe that the global economy and, by extension, equity and bond markets are currently very fragile. In our opinion, all three are in need of tremendous quantities of unconventional government intervention and support merely to sustain their current levels.

Particularly in the West, governments are compromising their long-term credit-worthiness in the hope of short-term economic gain.

It is now widely understood that from 2000-07, monetary policy in the euro area, while perhaps appropriate for a relatively sluggish German economy, stimulated bubbles in a number of smaller, fastergrowing economies (Spain, Ireland, Greece, etc). The resulting bust has come at a great cost to the region – a reminder that bubbles are ultimately very dama-ging. A period of austerity now looms for big parts of Europe, meaning growth is liable to stay sluggish for some time. We believe this episode has further to run and in the meantime we remain underweight in European assets.

Whereas the Europeans have so far sought austerity in their route towards macro stability (and eventual growth), the US has chosen to continue accumulating debt in the hope of stimulating growth in its quest for macro stability. A recent statistic courtesy of Simon Hunt is that for every one unit of nominal GDP, the US required 2.8 units of debt in 1990 but 8.3 units last year. For the time being, fiscal consolidation remains a medium-term aspiration at best. Time will tell which policy course proves most effective.

Parallels are now more frequently being drawn between the experiences of Europe over the last decade and what is now under way in emerging Asia. After all, the eurozone is not the only fixed (or, in this instance, quasi-fixed) exchange rate regime that exists in markets today. In the same way that German interest rates ultimately proved inappropriate for Spain, we believe that US monetary policy is proving wholly inappropriate for China and indeed much of emerging Asia, which continues to maintain a currency union with the US.

In an effort to maintain its crawling peg with the dollar, in spite of robust growth, the Chinese economy maintains negative real interest rates and a deeply under-valued exchange rate. This mispricing of capital is leading to speculative activity in the region, with over-investment evident in real estate and manufacturing.

In 2009, China grew its domestic money supply by 40 per cent of 2008’s GDP. So far this year, domestic money supply in China has swelled by a further 30 per cent of 2009’s GDP. The country’s monetary base stands at $2.4tn v $2.0tn in the US. Its M2 is $10.1tn v $8.6tn in the US. This, for an economy that is still only one-third of the size of the US’s. Is it any wonder that inflationary pressures are building?

Robin McDonald is co-manager of the Cazenove Capital multi-manager funds

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