We have made no changes in our portfolios this month. The swing in sentiment towards a more favourable view of prospects for the global economy is encouraging, and has been reflected in the recovery in equity prices. We have therefore decided to maintain our holdings in Euro & US equities. We continue to retain our 10% holding in cash deposits as a contingency measure. The sovereign debt crisis remains a very serious threat, thus we have zero exposure to bonds.
World Growth
There has been much talk in recent weeks of a ‘double- dip’ recession, as some weak figures have come out. However wobbles of this type are fairly typical in a recovery from a severe recession. In our view the recovery remains in line with the path we have laid out before. This was for a world recovery that would be restrained by raw material shortages, which would put constant upward pressure on their prices. So we see world growth this year at around the 4.5% rate, well below the 5.5% figure being registered at the height of the boom; notice that the world is not ‘catching up’ the lost output of 2009, rather it is reverting to a slower growth path from the lower output base. Even with this pattern raw material prices have been very strong, with oil for example near the $80 a barrel mark. The rises in these prices forced China and India to tighten policy and restrain their fast recoveries to prevent inflation. Even now in India inflation is not yet under control, having reached 13.9% in May, and policy will need to tighten further. On a lesser scale inflation has become threatening in a number of emerging market countries. So what we are seeing is that the fast-recovering countries mainly in East Asia are having to restrain their growth. Meanwhile in the OECD countries where inflation remains muted … or in the case of Japan deflation remains entrenched; growth is much weaker than in East Asia. The reason for the disparity of growth lies in the disparity of productivity growth.
In East Asia the movement of people out of low- productivity agriculture into high-productivity manufacturing using the technology imported from advanced countries implies huge productivity growth. In advanced OECD countries productivity growth is dependent on innovation, a much slower process. So we observe a world in which productivity and so GDP growth is restrained generally by tight raw material supplies and in which the OECD countries growth relatively more slowly also. This adds up to a weak recovery in OECD countries, which is what we observe. The picture is not likely to change. It will take time for new technologies and discoveries to shift the shortage of raw materials; there are parallels here with the 1970s and 1980s when it took until the end of the 1980s to ease the acute shortages built up in the earlier decades. By 1990 for example oil per unit of real world GDP had roughly halved from the mid-1970s and oil prices fell to low levels. Nevertheless this does not mean that employment growth need be weak or unemployment remains high.
Labour market flexibility … i.e. real wages falling relative to general productivity and willingness to adopt new practices … can encourage substitution of more labour for capital and raw materials. This is most obvious in service industries where there is plenty of scope for higher labour-intensiveness. Furthermore, service industries themselves can grow faster when labour is more flexible.
So could this weakness turn into a double-dip recession in the OECD? It might seem so if growth there is restrained by tight raw materials and if also governments are pursuing fiscal tightening; the only way might seem to be downward pressure on growth. But this is to leave out the role of monetary policy. In the OECD inflation targeting has been the unsung hero of macro policy; inflation has stayed down in the recovery and deflation kept at bay during the 2009 recession.
The reason lies in the effectiveness of inflation targeting in anchoring expectations. Surprisingly also, many inflation expectations mirrored in wage settlements and bond yields have remained around the 2% mark, reflecting the inflation targets set by most OECD central banks or governments. But it should not be a surprise; the targets have reflected a popular change in overall policy, towards outlawing high and variable inflation. We had it, people did not like it, and policy changed to stop it during the 1980s or at latest by the early 1990s. In the debate over recession and public debt the idea that inflation should be used to tackle either problem has barely been discussed, let alone advocated in any serious way.
What this has meant is that monetary policy has been quite unhampered by the fear of inflation in its aim to keep recovery on track. With OECD banking systems mostly in difficulties credit growth has been held down — in most countries it is hardly positive. So monetary policy has had to use unconventional means to encourage investment and consumption. Interest rates on official lending have been kept close to zero and central banks have aggressively bought financial assets from the public, with the effect that the yields on these assets have been reduced.
These purchase programmes have now been stopped. But if recovery looks threatened they can be restarted and will again have a powerful effect through these asset markets.
Two decades ago such programmes would have raised inflation expectations. Today they are given the benefit of the doubt. Some people argue that they are quite safe because bank credit and broad money therefore are hardly growing; however, one cannot be sure that other financial channels are not replacing banks while they are so weak.
The truth seems to be that firms and people who need finance are mostly able to obtain it on quite cheap terms, so banks are being bypassed to a substantial degree. But inflation is not expected to result because it is widely (and correctly) believed that if inflation were to start rising monetary policy would be tightened. This belief does free central banks to take aggressive action to prop up the economy if it falters. In short we think that the recovery will continue much along the current lines because from above it is held down by raw material shortages while from below it is held up by potentially aggressive monetary policy, with the power to more than offset the dampening from fiscal retrenchment.
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