With this we could be talking ultimately about the contractionary forces of deflation, i.e., something very similar to that which afflicted Japan and for which that economy still pays.
The other is the inflationary impulse from the developing world. Here we’re talking about the emerging economies whose comparatively fast growth and imposing demand for energy, raw materials and food stuffs is sustaining the upward pressure on commodity prices shown in the chart and, in doing so, ‘exporting’ inflation to the developed world.
Crucially, we’re also talking about the aggressive pursuit of a policy of long term growth by an emerging economy whose population exceeds that of the economies that led the post war expansion, i.e., the United States and Canada, Western Europe, the UK and Japan. China’s overwhelming load on world commodity markets and its appreciating currency have a lot to do with why the developed world is on the receiving end of an inflationary impulse.
These countervailing forces are chief among the challenges facing central banks and their response to date reflects how they have chosen to balance the associated risks.
For its part, the Federal Reserve is gearing monetary policy to the risks implicit in the first, i.e., the disinflationary and contractionary influence of the credit crisis. The Federal Funds rate is likely to fall another 100 basis points - to the 2 percent -before the Fed puts policy on hold.
The Bank of England, by virtue of its narrower mandate, is attempting to balance the risk that ‘a sharp slowing in activity pull(s) inflation below target against the risk that elevated inflation expectations keep inflation above target.’ The MPC is cutting interest rates but more slowly than the Fed and base rates are likely to reach 4.75 percent by the summer. The ECB remains preoccupied with inflation and is keeping policy on hold - for now.
These countervailing pressures create the downside for the developed economies but the upside is the contribution from the developing economies to global growth.
At a time when growth in the developed economies is slowing rapidly the shift in economic leadership towards the faster growing regions of the world is positive for the developed economies, as we tried to illustrate recently in Where to for the FTSE 100 – 5000 or less or 6000 and beyond? 18th February 2008. China’s equity market may not have decoupled from Wall Street, but its economy appears to have decoupled. Economic growth this decade has been driven primarily by domestic demand, not exports.
The chart of the OECD’s leading economic indicators below shows that the prospects for the global economy look very different in the absence of the contribution from the major developing economies - China in particular. The issue here is less about decoupling and more about a coupling of the developed economies with the developing. UK plc is especially well placed to gain from this through its exposure to the faster growing developing economies.
This exposure is not great, being somewhere in the region of 11.5 percent by sales according to industry estimates, but this is still large enough to help companies across a wide range of sectors grow their earnings at a time when the earnings derived in the developed economies are under pressure.
Chemicals, Mining, Aerospace and Defence, Electronic and Electrical Equipment, Food Producers, Beverages, Tobacco, Mobile Telecoms, Banks and Technology, which comprise over 40 percent of the FTSE All Share Index, are among the sectors exposed to the emerging economies. A little more than half of this exposure is through emerging Asia, which is growing faster than anywhere else. This has got to be a plus for the UK equity market.
So, have equity markets left their January lows behind or, having rebounded, is this a ‘now or never’ opportunity to exit from what might prove to be a protracted bear market.
Our position - from which we haven’t budged - has been that there are few difficulties an assertive relaxation of monetary policy, such as the Fed’s, can’t resolve and hence, that the set back in equity markets presents a long term buying opportunity.
To focus on the FTSE 100 and to repeat the comment in a recent note (see Improving tone for the UK equity market! 19th February 2008), the tone of the equity market has been improving and the banks could help clinch a sustainable recovery. The results thus far from the bigger banks have been satisfactory and, on the face of it, suggest that the valuations attached to them are not merited.
A barrier of resistance exists on the FTSE 100 in between 6000 and 6200 and clearing it could be a bit of a job. But overcoming it could also trigger a rapid move by the FTSE 100 back up to the area around 6500 or, indeed, higher if the banks get their re-rating and, of course, if we get more help from Wall Street, which we should with lower interest rates.
