January Update
ALL THE LIQUIDITY IN THE WORLD CANNOT CREATE REAL ECONOMIC GROWTH
Risky assets rallied sharply in January, which comes as great relief after a dreadful 2011, and a nice reward to those who took advantage of recent volatility. According to U.K.-based risk consultant CheckRisk, ECB efforts to add liquidity to European sovereign bond markets are having the desired effect. European banks are able to borrow from the ECB at 1% and buy Italian bonds at more than 6. So the risk trade is back on, but what are the risks?
Low volumes and large price movements suggest this rally is driven by liquidity and likely lacks institutional investors, who were generally bearish at year-end. A total meltdown has been averted and Germany’s economy is performing very well. The euro is down substantially against the RMB thus acting to spur German exports, the one European bright spot. But, as Lombard Street Research notes, peripheral countries like Greece and Portugal are effectively insolvent without meaningful economic growth. Some sort of Eurozone break-up is therefore still in the cards.
CheckRisk suggests the bigger risk, perhaps, is rapidly declining global GDP growth or, effectively, a lack of aggregate demand. All the liquidity in the world cannot create real economic growth, just perhaps help to avert debt deflation. In the U.S., fiscal tightening will reduce growth to a minimum, despite recent improvement. According to Lombard Street, accelerated capital spending pushed up GDP as various tax credits expired. In Europe, austerity has set up recession. Chinese monetary easing has effectively revived markets there but half the economy is investment spending. The challenge is whether this massive investment is productive.
Set against these worries, the scope for emerging country development, especially Chinese, is truly vast. The trick is for investors to build-in sufficient margin of safety or an effective hedge. Given the risks, we believe investors should enjoy these rallies but also perhaps be careful about buying them.
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