There isn’t a lot of Christmas cheer when it comes to economic forecasts at Hermes, with the fund manager’s chief economist Neil Williams predicting the current gloom besetting the world economy will not lift in 2012, and may even get worse.
Williams says the broad ranging de-risking that has dominated investment thinking in the second half of 2011 will continue, with investors more concerned about capital preservation than chasing returns.
“The underlying thesis currently prevailing in markets is that investors are chasing the return of their money, not the return on their money,” Williams says.
Hermes has identified five macro themes it believes will shape the economic outlook for next year.
• The realisation that policy-makers are out of effective tools and that the world is set for next-to-zero policy rates and probably low bond yields.
• More quantitative easing (QE) is on the way, and the question is whether this will backfire leading to cost rather than demand-led inflation. If QE is to work, it will be based on the “heroic” assumption that institutions will give up their treasuries and gilts to invest in risk-assets.
• Whether big economies continue to step closer to “becoming Japan”. Despite concerted government efforts to drive interest rates down, consumer spending is yet to revive.
• Europe will remain a “dark cloud” over the world economy. The question of whether Europe will engage in outright monetisation will depend on the capitulation of a German government, which is yet to fear recession and deflation.
• China to loosen monetary policy and move decisively to support growth as policy makers strive to maintain the status quo ahead of a once-in-10-years leadership change.
In his latest economic outlook for the first quarter of 2012, Williams says that there will be little “growth payback”, and the continued pressure on consumers, banks and governments to repair balance sheets means “downbeat assessments and warnings of a re-run of the 2008 crisis are looking increasingly realistic”.
“One of the big difference between now and anytime since the crisis is that it has become clearer that low bond yields have become one of the few tools left in the box and not as a reflection of economic data.”
Central banks and governments simply won’t tolerate aggressive shifts upwards in bond yields until the economic fog lifts, and it is unlikely this fog will lift in 2012,” he says.
Williams says this makes more QE inevitable to maintain inflation expectations, which suggests that there is still value for investors in selected inflation-linked bonds.
However, Williams questions if these latest rounds of QE will have the desired effect, arguing they may actually hinder growth by hitting already fragile consumer demand.
“QE done in the same way as QE back in 2009 could backfire,” he says.
“We know QE does stoke inflation, but it has been the wrong kind of inflation, it has been cost inflation rather than demand-led inflation. This tends to hit us [consumers] in pockets rather than help us out through increases in energy prices and through asset prices in general, including oil.”
Williams also argues that the regulatory pressure on banks to beef up their balance sheets will also hamper QE’s aim of encouraging investors to invest in risk assets.
Despite uncertainty about the outlook for the world economy, Williams says that there may be some opportunities in risk assets for investors willing to look beyond the current prevailing mindset of capital preservation.
“De-risking will undoubtedly continue and there may be pockets of light. If policy is perceived to be loose for even longer than expected then, of course, cheap cash will need a home,” he says.
“One of the beneficiaries of that could be growth assets, as it was in 2009. So, it is not in itself a gloomy outlook for equities or necessarily for other growth assets, such as commodities. But the driver there is much more cheap money looking for a home rather than a significant pickup in fundamentals.”
Williams argues that due to the effect of the previous bouts of QE, the true QE-adjusted policy rate is, in fact, much lower than the headline figure.
Using US Federal Reserve chairman Ben Bernanke’s own analysis that the $600 billion part of QE2 was equivalent to 75 basis points off the funds target rate, Williams extrapolates what is the “true” QE-adjusted policy rate for the US.
Given that the cumulative value of all QE so far is $2.6 trillion, Williams estimates this has been the equivalent of slicing some 325bp off the funds target rate.
“The US is running an effective nominal policy rate of not 0.25 per cent but -3 per cent, or -5 per cent in real terms.
Williams predicts that when rate-tightening cycles finally do come they will be “abnormally shallow”.
Hermes’ Policy Looseness Analysis suggests a “neutral” US Fed funds target no higher than 3 per cent, versus a 7.5 per cent long-term average. In the UK its analysis points to a policy rate of 2.75 per cent versus a long-term average of 5 per cent.
Williams says that with interest rates likely to stay at very low levels through 2012, it is now apparent that the US and UK have be running ultra-loose policy for the fifth year running.
“The hope is that more QE doesn’t end up throwing out the [growth] baby with the bath water,” he says.