Weak plaster will not heal the wound
Equities and economies continue to struggle. While central banks are reluctant to inject more liquidity to ease the troubled balance sheets, they must consider other, more enduring measures.
Stockmarkets suffered falls of up to 15% in May as uncertainty about global growth increased. Europe is the focus as commentators and investors worry about the viability of the currency and depression in the southern countries.
What seems to be preventing a larger fall in the perceived haven markets in America, Britain and Germany is the hope that central banks will pump more liquidity into the system to boost asset prices.
Besides the argument that this action makes the battle against high debt and low growth worse in the long term, central bank liquidity is having less effect each time it occurs.
The chart shows the MSCI World Equity index and the combined balance sheets of the Federal Reserve, the European Central Bank (ECB) and the Bank of England. It shows market corrections in the past three years have only occurred when central banks are not providing stimulus.
Each period of liquidity is shorter than the previous one. This is perhaps not surprising as despite these injections of liquidity and historically low interest rates, the global economy is barely growing and Europe is in recession. (Strategy continues below)
When quantitative easing (QE) was first suggested, it was hoped it would be the saviour of a spluttering world economy. However, QE1 and the subsequent programmes of QE2 and the long-term refinancing operation (LTRO), far from being the cure, could be the medicine making the patient sicker. Smaller doses are being administered.
In Europe, the situation is dire. Southern European countries are in depression and the stronger Northern countries, with Germany at the head, are in recession. Many in the market hoped Mario Draghi, the head of the ECB, would remain ’dovish’ in the post-ECB press conference in May.
However, he was quite ’hawkish’, stating that the most recent economic indicators, although weak, “are not enough to change our baseline scenario, which foresees a gradual recovery in the course of the year”. Stockmarkets have fallen since, and need the injection of liquidity to rise.
In America, the economy is growing but not strongly enough to get excited about that growth driving the stockmarket higher.
”Once the tap is turned off, stocks have to be valued on their own merit”
On the other hand, the growth is not bad enough to force the Federal Reserve to stimulate via more QE.
Ben Bernanke, the chairman of the Fed, continues to sit on the fence. He, and other key members of the Fed, say that all choices including further easing remain open to them if the economy should worsen. It remains to be seen whether the trigger for any action is a serious drop in the equity market.
Bernanke is on record as saying rises in stockmarkets improve the “animal spirits” and help all asset prices to rise, which leads to consumers spending and companies investing.
Therefore, it is possible that something as economically arbitrary as stock prices may force the Fed into action. There may be a point below which any market fall is unacceptable.
Earlier in May, Mervyn King, the governor of the Bank of England, reaffirmed the committee’s view that it was pausing the money printing presses at £325 billion and would prefer to see how the economy behaved before printing more. Equity markets have since suffered.
We could be in a self-defeating cycle of equity markets being driven down to the point where central banks consider they have no choice but to print money and inject liquidity. Banks across the world are going through deleveraging, meaning they are rebuilding their balance sheets.
When the stimulus is pumped in, they will either deposit the funds with the central bank or it will find its way into equities and commodities. However, once the tap is turned off, stocks have to be valued on their own merit. One unintended consequence of this is the lack of trust investors will have in equities. Investors are quick to sell, which increases the volatility of equities and exaggerates the problem.
The central bank-ers in America, Britain and Europe say they have done their bit. They will not do any more unless the system looks as if it is about to collapse. So they will not be stimulating soon and equity markets have to stand on their own feet.
But the evidence of the past three years is that they are unable to do so. With little choice left, central banks will have to press the money printing button as economies deteriorate. This will start the cycle all over again.
Europe is at serious risk of an economic meltdown, America is muddling through at best, with low growth of sub-2% expected in 2012, and Asia is slowing down. Recent history shows that when central banks stop stimulating, equity markets fall over. Therefore, it seems almost certain there will be further stimulus.
Central banks have few weapons available and printing money can provide a short-term fillip. But it has to be married to fiscal and taxation policies aimed at growth so that the kick-start does not peter out, as it has in the past. Equities and economies face a continued tough time.
Stewart Richardson is the chief investment officer of RMG Wealth.
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