period of adjustment
June 3rd, 2011
John Greenwood, group chief economist at Invesco Perpetual, considers a range of issues including inflation, quantitative easing, fixed income and the emerging markets and argues investors are going to have to rein in their growth expectations
Will there be a double-dip recession in the UK?
The deep recession was caused by people being overleveraged, followed by a panic in the financial markets and a sudden freeze on credit, spending and so forth. I see no prospect of going back to that. Monetary policy is now as accommodative as it could possibly be and, although fiscal policy is going to be restrained and tightening progressively, there are very few cases in history where fiscal tightening has overwhelmed monetary easing.
Has the UK Spending Review gone too far in shrinking the public sector?
At the rate the public sector was growing, it was completely unsustainable. It is not the state that generates wealth but the private sector – whether the money comes from borrowing or taxation, the private sector carries the burden. These cutbacks will gradually be compensated by spending in the private sector, but have no doubt – we are going to have a period of relatively slow growth, which is a consequence of the problems we got into and the balance-sheet over-leveraging across the household and financial sectors.
With UK economic growth now looking better, is there a need for further quantitative easing (QE)?
A major reason why the Bank of England did not do a further round of QE was because it was worried about the inflation figures and because growth was starting to look a bit better. Frankly, however, we may well see those growth figures revised downwards and we certainly should not expect a continuing growth rate of 3%. My advice would be to keep QE at the ready because it may be needed again.
Does QE2 in the US signal things are so bad it could perversely result in less consumer spending?
The US is not significantly worse than the UK. It is true house prices have fallen there, but the leverage in the household sector is much less. We have a situation where house prices have fallen less, but most people here are on variable mortgage rates and the pound has fallen more, so the economy is recovering a bit better. Broadly, QE needs to be done from time to time during this period of balance-sheet adjustment, but we should not expect a miracle from it. Basically, money and credit are not going to grow while people are repaying debt. That means growth is going to come mainly from incomes – not from supplementing incomes with additional credit – and that means we are in for a period of rather sub-par growth for the next year or two.
What is your view on inflation and its impact on interest rates?
Inflation is fundamentally, as Milton Friedman always said, a monetary phenomenon. You have to remember that, in Britain, we had a much higher rate of growth of money and credit, for much longer – in fact, it is not much more than a year since money and credit started to slow down abruptly and it is too early to expect our inflation rate to come down to the sort of rates we see currently in the US or the eurozone. However, that will happen over the next year or two. With very low rates of growth of money and credit, we are going to have a much lower rate of inflation but it is also about the composition of inflation. With weaker sterling and higher commodity prices, some prices – imported prices particularly – are rising, but that simply changes the mix, not the overall rate of inflation. With higher commodity and energy prices, we are going to see much weaker growth of wages in real terms. We are also going to see weaker prices for services because, if we have to spend more money on high-priced imports, we will have less money left to spend on domestic goods and services. There will, then, be downward pressure on inflation. During the last decade, we essentially had very low goods prices and higher service prices but we are going to see much closer concordance of goods-price inflation and service-price inflation in the years ahead.
You said in 2010 we would be surprised at the low level of inflation – what are your thoughts on 2011?
The reinstitution of VAT and the stronger rise of commodity prices, given the background of weak sterling, are coming through more strongly than I had thought, but those factors are not sustainable – they are one-off events. I still hold my view, then, that inflation will be on a downward track – it is just taking a little longer. I do not think interest rates will rise for a long time – at least not in 2011 – but the perception inflation is a lot weaker than most people expect will become apparent, and we may have to have more episodes of QE, which will reverse things because people will again fear it. In Japan, however, they did QE for five years. Does Japan have inflation? On the contrary – it has deflation. QE therefore does not equal inflation.
Are the western economies actively devaluing their currencies in an attempt to lessen their burden?
A weaker currency is clearly one way out of the hole countries have got themselves into, albeit the prospects for export growth are rather limited going forward. The real problem, however, is that, with policy interest rates at virtually zero and deposit interest rates at close to zero in most major countries, we have lost our anchor for relative valuation of currencies. We are, then, seeing a rather short-term, random movement of hot money between different currencies as the stories and the headlines change. What is important, then, is for people to get their asset allocation right between bonds, equities and other assets because the real earnings generated by companies are often unrelated to those short-term currency movements, and they also do not reflect the currency of denomination. For example, AstraZeneca is listed in the UK but has only 5% or so of its sales there. The fact you have a sterling-denominated asset does not mean you are buying a stream of sterling earnings – you are buying a global stream of earnings, which will be reflected in the results of the company.
How can Portugal and Ireland become internationally competitive again?
The key problem for the crisis countries in Europe is they are members of a currency union and cannot individually devalue. However, if they cannot devalue – in other words, effect an external lowering of their price levels – what they can do is lower their internal price levels. While there is a lot of resistance to that, if you look at countries such as Hong Kong after 1998, which had several years of internal deflation, or, interestingly, the Baltic economies of Lithuania, Latvia and Estonia, they have all just returned to growth and current-account surpluses, and they did all that by slashing wages and government expenditure, within a two-year timeframe. It is therefore possible to adjust prices internally. It may be painful, but if you choose to be a member of a currency union, that is part of the price you pay.
Where does this leave the euro in the long term?
The euro will weaken further over time but I do not think it is going to collapse. There are questions over the ability of the centre to control the budgets of the periphery and they clearly have to do more to control that. As long as they have not solved that problem, there will continue to be doubts over the future and value of the euro.
How do you see the sovereign-debt problems in Europe playing out?
Some form of restructuring is required – whether it be delays in the repayment of debt or the postponement of interest payments on existing debt. The euro was set up on the rather optimistic premises that nobody could leave, nobody would default and no country would need to support any other one. Clearly, those have been seen to have failed but a country leaving the euro would be a very drastic move and unlikely to occur.
Why has the gold price been so strong?
Three reasons – people distrust the banks, distrust government debt and fear inflation. The banks have been largely rescued and supported. Government debt will continue to grow, as budget deficits continue but, over the next four to five years, those debt-to-GDP ratios will peak out and gradually start to come down. So, mainly, fear of inflation is driving the price of gold. As I have said, money and credit growth in the developed world is close to zero. Inflation fears are going to be realised, which means, as and when that sense becomes pervasive and/or interest rates start to rise, the gold price will come under downward, not upward, pressure.
What is your view on the timing of a bond-market reversal?
I do not believe bonds are in a bubble. As I say, inflation is not on the cards, given the monetary background in the developed economies and the lack of any appetite to borrow and of any willingness of commercial banks to expand their balance sheets. That means we are going to have these very low rates of inflation, which, in turn, are keeping bond yields very low. That is what has been behind the whole bond rally. We are going to have extraordinarily low rates of inflation for the next couple of years in the US and in the eurozone – and the UK will not be so very different. That in turn means government bond yields will stay low, so we are not going to see a dramatic reversal during that two-year time horizon. Beyond that, if we see a strong recovery and the banks start taking a lot more risks, we may see an interest-rate hike, which would end the bond rally, but for the moment and for the next couple of years, I do not think we are in danger of that kind of collapse.
A number of large-cap equities yield more than their corporate bonds – what is your view on that?
It relates to the previous question. Bond yields are being driven down by very low inflation rates, the flight to quality and the support of bond markets from central banks. On the equity side, essentially, we are seeing that dividends of a number of companies have been maintained, as well as a strong bounce-back in earnings over the past year. That earnings recovery and the ability to pay dividends at rates substantially higher than bond yields is probably going to be sustained, as long as these very low inflation rates and bond yields continue – but we should not count on the same sort of rate of growth of dividends we have seen in the past. With that sort of scenario, we are going to have very low nominal GDP growth rates, which, in turn, mean sales and dividend growth and so forth will be rather slow. From an investment point of view, the key point is these premium dividend yields will be very attractive to investors.
Given the outlook for growth is quite uncertain, why are equity markets as strong as they are?
With very low interest rates likely to continue, equity prices should be supported at these levels – and maybe move even higher – but we just have to be careful because the underlying earnings growth will not be of the kind we saw in the 1980s, 1990s or 2000s, where nominal GDP growth was very strong and people were leveraging up. The growth expectations going forward should be much more cautious – at least for the developed economies – although the emerging markets are a different story.
Is growth in the emerging economies sustainable at current levels?
Emerging economies can grow at a rapid rate for long periods of time. Look at the case of Japan from 1949 to 1974 – for 25 years, the Japanese economy grew at an average 9.5% a year. Many other Asian economies have done the same and we are now seeing that pattern spread more widely and, of course, China is now growing at that sort of rate. There is, then, no reason why these economies should not grow at a rapid rate for several decades while they are catching up. That said, with the developed markets weak, we are seeing a relatively slower rate of growth. Take China – during the boom years of 2006 to 2008, the Chinese economy was growing at 12% a year but, today, it is growing at something more like 9% or 10%. That difference is due to the slower growth of exports to the western developed economies. The emerging economies can, then, grow rapidly at their own domestic rate, but there will not be that extra increment they had before the bubble burst.