American belt-tightening will tip the global economy into recession in 2012, predicts Charles Dumas, independent economist and chairman of London-based Lombard Street Research.
Over the medium term, however, US equities will prove the most resilient asset class and will be the first to anticipate a recovery.
His analysis is that Washington is going to tighten its belt. Dumas says developed economies need to reduce their debt burdens by 2% of GDP in 2012. This is likely to lead to more drops in financial markets: “A lot of assets remain overvalued vis-à-vis their income streams,” he adds.
Monetary policy is unlikely to help, he adds. Interest rates in the US and Japan are already at virtually zero, and Dumas doubts the efficacy of a third round of ‘quantitative easing’ from the Federal Reserve.
The one policy that Western governments have used to boost their economies is currency devaluation – although in the case of the US/China relationship, the necessary devaluation has largely come through Chinese inflation rather than actual changes to the currency regime.
However, for big developed countries, exports average only 7% of GDP, so gains from trade cannot offset the plunge in domestic demand.
Dumas worries that small changes can have a multiplier effect. Fiscal deflation will have an impact on consumer spending and corporate investment. Already the developed world’s trend growth rate has fallen below 2%, so it won’t take much to tip it into outright recession.
He is more bearish than the consensus market view. The latest fund-manager survey by BoA Merrill Lynch shows that only 9% of US fund managers expect the economy to weaken next year, although a majority of managers expect recession in Europe. Global investors have restored overweight positions to US equities – a move that Dumas may say is warranted but is perhaps premature.
His views may, however, be more in sync with general mutual-fund flows. According to EPFR Global Research, the first two weeks of September have brought a resurgence of investment in global bond funds, US high-yield bond funds and money-market funds. Meanwhile, net outflows occurred from risk-asset products including global equities, energy-sector equities, Asia ex-Japan and Emea equity funds.
Dumas is sceptical that emerging markets, particularly China, will be able to provide the growth necessary to keep the developed world out of recession.
“China is also deflating furiously,” he notes, saying its inflation rate problem is deeper than the market consensus believes. “Investment bankers seem convinced that China’s system [of economic governance] is more effective, but the Chinese aren’t in control.”
He argues that China is losing its export markets, and that the 48% of its GDP comprised of fixed asset investment is destroying value. “Their GDP growth rate is not really that high,” he says.
Chinese consumption and government spending has declined from 62% of GDP to 49% in the past decade, leaving a net savings rate of 51% of GDP.
There is a consensus, symbolised by the Communist Party’s latest five-year plan, to boost consumption. But this requires consumption to grow faster than overall GDP. If consumption is to grow by, say, 7% in 2012, then Dumas believes this means real GDP growth will be lower.
“I don’t see how if the US and Europe are downsizing, that will mean Chinese consumers spend more money,” Dumas says. “If anything they will save even more.”
That will necessitate more government spending from Beijing, which will likely come in the form of fixed-asset investment, and will therefore see much wasted. That suggests China will experience a real fall in GDP growth and slower productivity.
The stimulus required to maintain growth will be inflationary, particularly if Beijing maintains its renminbi peg to the dollar. “China is not disciplining its businesses with a realistic interest rate or currency exchange rate,” Dumas says, “so therefore it will get capital wastage and lower productivity. This could lead to a restructuring of its banks’ assets.”
He recalls Beijing’s efforts in the early 2000s to clean up its banks via a bailout, which succeeded thanks to export-driven growth. “Today, that export opportunity is no longer there. The only way China knows how to grow is through fixed-asset investment.” He says it reminds him of the Soviet Union under Stalin and Khrushchev, whose spending binges on manufacturing also promoted fast economic growth.
Although Dumas is pessimistic about the near future, he is bullish on the United States’ longer-term prospects. The US has won its de-facto currency devaluation thanks to inflation in China and other emerging markets. Assuming a recession also then depresses energy prices, the US will be in the best position to lead a recovery.
And while America may continue to have an enormous current-account deficit with China, growth and de-facto devaluation will ease its debt burden.
A recession will hit resource exporters hard, including Australia and Canada, says Dumas. It will not necessarily unravel the bull run in gold, which is more about a belief in developed-country finances than any affinity for the metal itself. “But the Aussie and Canadian dollar play will reverse, because Treasuries and bunds are the only real safe havens,” Dumas says.
His biggest concern is that a recession in the US could lead to a real depression in southern Europe. This will have serious implications for Germany as well, as its exporters rely heavily on peripheral European markets within the eurozone.
From an asset-allocation perspective, Dumas says over the next 12 months, US equities will likely lose value, but the US and related economies such as Mexico will lead the recovery.
In general he suggests investors avoid exporting nations, unless they are also blessed with big internal economies, such as Brazil and Indonesia.
For bonds, he expects the next 12 months to see yields in Treasuries and bunds enjoy a final rally, but by the end of 2012 the bull market in these assets will finish.