We have seen two massive bubbles bursting – the housing bubble and the less visible but even more powerful credit bubble. The global economy has gone into freefall. With overcapacity everywhere, rising unemployment, imploding leverage, a lack of borrowing and lending, a serious retreat by consumers and savings rates on the rise, the depressionary and deflationary side of the ledger looks ominous.
Policymakers have engaged in unprecedented stimuli, collapsing interest rates, enlarging their balance sheets and expanding the monetary base through quantitative easing, yet a lack of sufficient detail and poor execution of policy have left investors feeling short of confidence, confused and fearful. This has led to an extremely stretched technical situation in markets that leaves the outlook for most asset classes rather binary.
If policy is successful and the growth outlook improves, equity markets and other risky assets look very cheap and will enjoy an explosive rally. After all, the world is awash with unencumbered cash. Under this scenario, safe haven assets like government bonds will probably get crushed. If the economy does not respond and the recession proves long and deep, earnings’ estimates will be too high and equities will derate further. We expect markets to alternate between these two outcomes until visibility improves. It will take time to see whether the stimulus will prove adequate, insufficient (deflationary) or excessive (inflationary).
I think one has to assume that if a central bank wants to induce inflation to avoid deflation, it can do so. Aggressively printing money into a low growth environment may do the trick. Central banks want to create inflation or the expectation of inflation for several reasons. First, it will encourage money out of cash and government bonds into productive assets. Second, it should encourage consumers to bring forward spending plans. Third, inflation will reduce long-term debt burdens.
We are maintaining a defensive tilt to our portfolios until visibility on growth and inflation improves. If and when we see evidence that the stimulus is beginning to bite, we will rotate our portfolios accordingly. If markets are no longer in overvalued territory, barring meaningful further hits to earnings, significant upside is possible. Markets can go up as well as down.
Robin McDonald is co-head of multi-manager at Cazenove Capital Management