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The Rocket Science Of The Global Economy

February 3, 2014 • Michelle Knight

A year ago, at the Davos World Economic Forum, the new governor of the Bank of England,

Mark Carney, was speaking about a time when the major economies would begin to grow sustainably again, without being pulled back into stagnation by low confidence, high debt levels and high unemployment. Carney likened that kind of growth to escape velocity, the moment when an object traveling away from a planet has enough speed not to be pulled back down again by gravity. In the case of Earth, that is about 25,000 miles per hour. With global GDP likely to end 2013 at an annualized 2.8% growth rate, it would seem our thrust has fallen short. In other words, “Houston, we have a problem.”

A Black Hole Of Negative Multipliers Thwarts Escape Velocity

In the wake of the Great Recession, the most powerful financial and market crisis since the Great

Depression, an extremely powerful negative multiplier effect descended upon the developed

world. Unlike other more shallow recessions, the Great Recession forced a massive deleveraging

of consumers and businesses, which in turn has inflicted high unemployment and stagnant wage

growth on the developed world.

Even now, five years into the recovery and deleveraging cycle, consumers and businesses alike are reluctant in their spending, which has perpetuated the weakness of the labor market. For their part, governments have had to increase deficit spending to prevent a return to recession, but high debt levels are pressuring them to engage in their own deleveraging process. The resulting government austerity has only served to further perpetuate this vicious cycle, so that the net result has been a period of prolonged low growth, high deficits and an uncertain consumer and business environment.

Constellation Of Accommodation Tries To Light The Dark Luckily for the financial markets, the not-so-saving grace of deficit spending has also been accompanied by an unprecedented level of accommodative monetary policy in many economies around the world. Indeed, over the past five years, the global stock of dollars, euros and yen has risen by 21%, even as nominal GDP grew only 10% over the same period. The global monetary base has expanded by a remarkable 150%! And many major market averages have soared in response.

In many ways, low interest rates and quantitative easing worked well as policy accommodation

served to stabilize the financial sector, counterbalance fiscal austerity and promote a rebound in

asset prices. But they were certainly not perfect transmission mechanisms.

For one thing, unprecedented policy accommodation has failed to ignite stronger economic growth. One of the great ironies of prolonged easy monetary policy has been that it necessarily dictates a very pessimistic outlook for future economic prospects. Since lending and borrowing are crucially dependent on confidence, borrower motivation has languished, while lenders remain highly discerning in their underwriting standards given how cheaply they have to lend and their outlook for only modest improvements in credit quality.

Second, unbridled policy accommodation may have actually created some long-term harm, or at least the appearance of such. Policy accommodation has driven up prices in stock markets and real estate; that has only served to resurrect concerns about asset bubbles, not to mention future inflation. Acting as a lender of last resort has also undermined the credibility of central bank balance sheets and created a powerful risk of moral hazard.

Finally, the well-acknowledged catalyst of easy money has now turned into a crutch, as the world seems unable to bear the thought of policy normalization. The introduction of even the concept of tapering in 2013 caused a sharp 100 basis point increase in U.S. interest rates that wreaked havoc on the bond market and sparked a painful capital flight from emerging market and resource-oriented nations. Policy overdrive has been our modus operandi for too longso much so that real economic growth, the kind requiring innovation, financing, confidence and end demand, is now alien to us.

The Extent Of Shifting Monetary Policy’s Gravitational Pull In 2014 The normalization of Fed policy is shaping up to be moderate enough in scope to be digestible to the markets and economy, even as Europe and Japan are likely to continue on their current path

of accommodation given still-fledging and fragile growth and their own idiosyncratic risks

(periphery concerns in Europe, consumption tax in Japan). Even though tapering may not be tightening, intermediate- to long-term bond yields are poised to move higher, and that shift will not be without a period of adjustment in both the global equity and fixed-income markets.

While the media and some market pundits will focus on the risks of monetary policy withdrawal

to asset prices, probably the greater risk is that economic escape velocity remains elusive. The

absence of a revival of global demand is the biggest risk we face in 2014 and beyond, especially

as it will come with the harsh reality that monetary and fiscal policy is apparently powerless to restore the global economy to stronger health.

Looking For A Charger

A renewed surge in demand will not happen by itself, but there may be some catalysts on the

horizon strong enough to provide the kind of turbocharge our global economy needs to rocket ahead.

For sure, a sustainable rebound in the housing marketsnot just in prices, but in sales and construction, toowould be a powerful driver of economic demand and its multiplier effects. So, too, would the return of a now-delevered consumer, who for the last five years has provided an uneven support to global economic demand. With reduced debt and higher savings, and supported by the dual wealth effects of housing and stock market appreciation, consumers have the capacity to unleash a powerful catalyst to the global economy that has been lacking thus far except in select pockets like automobiles or housing.

If the housing market and consumer could deliver on their potential, then it is likely they will

catalyze business investment. Companies thus far have used their excess cash for financial engineering (increased dividends and stock buybacks), but should they instead expand in new markets or products, or engage in M&A based on a renewed confidence, then escape velocity

would be at hand. Even more so if such a virtuous cycle prompted bank lending to small businesses that typically deliver the lion’s share of hiring around the globe.

Longer-term, there are other game changers worth noting as well. Domestically, the resurgence in U.S. energy exploration and production holds powerful promise for our country and for the wide array of companies along the energy value chain. Globally, a move to environmental sustainability is sure to give rise to new industries, technologies and methods of consumption that will shape future economic demand. Also driving new sources of demand will be the rise of the middle class, especially in Asia and Africa. The globalization of markets and productivity improvements stemming from technology and innovation will keep inflation low and competition high, ideally to the benefit, not the detriment, of economic growth.

Will 2014 be the year our world transcends the gravity of the Great Recession’s myriad painful legacies? While muddling through should not last forever, all indicators are that the fitful recovery of the last five years will continue, with a confusing blend of good and bad news and a still-uneven economic trajectory.

Michelle Knight is Chief Economist and Managing Director of Fixed Income at Banyan Partners (www.banyanpartners.net), an independent wealth management firm. All investment advisory services are provided by Banyan Partners LLC, a registered investment advisor based in Palm Beach Gardens, Fla.