But the key problem is Europe. Here the cyclical outlook is most risky because suicidally-low levels of ECB liquidity have likely already pushed the region to the brink of recession. This is dangerous, since any recession in the core economies of France and Germany will disrupt the desperately needed flow of bail-out capital to the periphery. The only feasible solutions for the eurozone must involve an ideological change at the ECB towards printing money. The bottom line is that the euro looks set to fall more.
There is an inevitability about this path. It worryingly echoes the 1930s and more recently post-bubble Japan. These periods suffered pervasive very low inflation, even outright deflation. Traditional asset models are simply not built for these times and end up recommending too high allocations to equities. Tactically, equities look attractive, but much like Japan’s experience since 1990, strategically they do not.
Three things characterised economic policy in the 1930s:
- attempts to reduce debt by cutting spending;
- competitive devaluations and the erection of trade barriers;
- QE policies, highlighted by the 140% jump in the size of the Federal Reserve’s balance sheet between 1933 and 1939.
The net results of these policies were remarkably similar to our later experiences:
- sluggish economic recovery featuring persistent unemployment;
- volatile paper currencies;
- low high street inflation (often deflation) but strong commodity price increases.
We have warned before that these policy results must raise the scale of international tensions simply because resources, and particularly access to oil, are not evenly distributed.
In our view:
- Gold will test $3,000/oz before this debt crisis is over. Using a gold/oil ratio of 14x this ultimately means over $200/bbl oil;
- Emerging markets will double their per capita incomes over the next 15 years, making the West feel poor;
- Western currencies will devalue against their Asian counterparts. The renminbi will be the axis for the next set of international monetary arrangements;
- Western risk-asset markets will suffer a decline in valuations until structural deflation is reversed. Japan and 1930s America showed us how tough this can be;
- The next banking crisis is some way off (pace Europe) and most likely will hit by 2016 to complete its normal nine to ten-year pattern;
- Nearer-term the world avoids recession, but the eurozone does not;
- Another QE3 lies ahead. This will underpin risk assets and cause yield curves and bond yields to rise;
- Drastic policy action is needed in the eurozone. This likely will mean greater liquidity injections and much weaker euro;
- Over the next six months risk assets will perform well. We favour emerging markets (where policy easing is coming) and commodities. Once the ECB acts, buy German shares hedged into dollars.
