
A friendly client reminded us recently of a statement we had made in the aftermath of China's monetary response to its 2005 yuan appreciation. In order to make sure that a potential export slowdown (which never materialised) did not derail growth, China flooded its economy with money. M2 money supply growth jumped from 14% year-on-year in early 2005 to more than 18% year-on-year in the months following the revaluation. Our comment afterwards was that “we did not foresee how willing the Chinese would be to inflate their system.”
- Central banks, led by the US Fed, begin to exit asset purchase programmes. Equity markets immediately relapse and treasuries rally.
- Credit spreads begin to widen in mortgage-backed securities and municipal debt. Risk aversion increases in all credit markets. Emerging-market debt sells off.
- Volatility in markets increases with 2009’s leading asset classes the most vulnerable. Consensus has already bet heavily on continued appreciation of commodities and emerging markets as well as a further fall in the dollar. These are correlated bets. Rising risk aversion equates to a strengthening dollar and a reversal for consensus.
- Problems that have been pushed to the background while cash has been abundant will re-emerge. Residential mortgage defaults will continue to rise, Fannie Mae and Freddie Mac will re-enter crisis. Commercial property defaults in the U.S. will grow to crisis proportions. Eastern Europe currency pegs will come under increased pressure and eventually break. Defaults associated with the shipping industry will increase.
- Gold will increasingly be viewed as a safe haven and a store of value. Despite no emergence of consumer price inflation it will rally hard as physical demand increases and subjective valuations rise. The current system of central banking is fatally flawed and gold is one of the few acceptable prospects as an anchor for a new world financial system.
- Over the next few months, before the financial crisis reasserts itself in a meaningful way, regulators will be busy enforcing costly new prudential regulations and restrictions on banks and financial services companies. Along with the removal of easy money injections these will weigh heavily on bank profitability. Expect a sector de-rating.
- Global growth will disappoint as the private sector in developed and emerging countries does not recover as expected. The weakest link in the demand chain will not be the consumer (who will be subdued) but business investment. Interest-rate signals are too confusing, capacity too plentiful and the outlook too uncertain (both in terms of demand and taxation) for capital spending to revive.
- Unemployment in the U.S. and Europe will continue to rise with the headline rate exceeding 11% by end 2010 in the U.S. Consumer demand in the global economy has reset to much lower levels than pre-crisis.
- Monetary inflation in China will cause major problems in overcapacity and asset prices. Generalised consumer price increases in non-tradable goods and services will rise sharply in 2010. A crackdown in monetary expansion will lead to the re-emergence of recessionary signals in the near term.
- By the end of 2010 world growth will again be contracting as the credit contraction in Western economies intensifies and the Asian domestic demand story disappears. Only India truly has a domestic demand-led economy in the region. Commodity prices (industrial metals in particular) and commodity currencies will be in general retreat as a result.