The only way is not up, it's sideways

Equity markets have probably stopped falling, but that doesn't mean they are now on an upward trajectory. They were pricing in Armageddon, which hasn't materialised, so the rally brings markets back in line with fundamentals, which are weak. However, it is fair to say that we have seen the lows of this bear market, since a further severe decline in fundamentals would be required to push prices to new lows.

From an economics standpoint, the fall in output has caught up with the fall in demand, which should prevent further deterioration in industrial production. Indeed, whilst retrospective indicators show no sign of improvement, current sentiment & demand indicators such as US & UK Manufacturing PMIs show signs of improvement, as the chart below demonstrates.

Indeed, Fed Chairman, Ben Bernanke, commented this week that:

"Recently we have seen tentative signs that the sharp decline in economic activity may be slowing, for example, in data on home sales, home building and consumer spending, including sales of new motor vehicles... A levelling out of economic activity is the first step toward recovery... [However,] we will not have a sustainable recovery without a stabilisation of our financial system and credit markets"

However, this is not cause for celebration as it is unlikely there will be a substantial bull market or significant economic recovery, merely a period of low growth punctuated with large fluctuations in asset prices, both up and down, for the foreseeable future. Indeed, this was the case in Japan, where, despite having peaked in December 1989 and falling 75% to March 2009, the TOPIX had a number of very large bear market rallies over the period (see chart below).


In fact, Barclays Capital noted this week that:

"US data have surprised to the upside to some extent over the past month or so. But sooner or later, the recovery in risky asset prices is unlikely to be sustained if some of the more important economies do not show convincing signs of recovery."

So, failing a sustained improvement above expectations, the current 25%+ rally in world equities may yet turn out to be another in a series of bear market rallies to come.


Therefore, expect interest rates to be kept low for the foreseeable future and inflation to remain subdued whilst growth remains stagnant. Moreover, given the amount of monetary stimulus that will eventually have to be removed, there is a high margin for policy error, increasing inflationary risks on a longer term perspective.

Interesting FT story on Germany's perspective on the possible economic aftermath

Germany warns on 'crisis after crisis'
By Bertrand Benoit in Berlin, 12 Apr 2009 10:57pm

The world could face high inflation and a "crisis after the crisis" when the global economy recovers, Peer Steinbrück, German finance minister, has warned.

The comments, in a weekend interview, are the latest sign of concern from Germany at the extra-loose monetary policies conducted by central banks around the world and the ever-larger fiscal stimuli being unveiled by governments.

"I am concerned that the countermeasures we are seeing around the world, financed by enormous amounts of debts, could be paving the road to the next crisis," Mr Steinbrück told Bild, a tabloid daily.

"So much money is being pumped into the market that capital markets could easily become overwhelmed, resulting in a global period of inflation in the recovery.

Mr Steinbrück's warning comes after Angela Merkel, chancellor, told the Financial Times last month that pumping too much money into reviving global growth would create an unstable recovery.

German officials fear the liquidity being injected into financial markets could prove difficult to reabsorb, creating long-term inflationary pressure and, possibly, new asset price bubbles. "We do not have a short-term inflation problem," Mr Steinbrück said. "But in the medium term we must start thinking about how to pull the billions we are pumping into our economies out of the system again. This will be a special challenge for the central banks, including for the European Central Bank."

Because of its strong reliance on exports, the German economy has been one of the worst affected in Europe by the global economic downturn. It is set to shrink by 4.5-7 per cent this year and statistics published last week showed Germany had its lowest inflation in 11 years.

Peter Bofinger, one of the five top academics who advise the government on economic policy and, like Mr Steinbrück, a member of the Social Democratic party, said that Berlin's concerns about inflation were unwarranted. "Germany faces no risk of inflation for the foreseeable future. On the contrary, I see a clear danger of deflation," he told the Handelsblatt.com website.

Rising unemployment in the coming months would put wages under pressure, said Prof Bofinger, creating a potential downward spiral in wages and prices. Asked about how to fight the crisis, Mr Steinbrück conceded that there were "no intelligent alternatives" to higher public investments programmes. Unlike in the US, he said, there were no signs yet the German economy had turned the corner. "We are not through yet. Nobody can say if the worst is behind us."

China, what credit crunch?

Chinese data released over the weekend showed that banks had continued to lend for new investment projects with record new loans of $277bn in March. China's latest trade numbers revealed signs of stabilisation for both exports and imports over the past year to March. The news, together with the record surge in bank lending and money supply last month, fuelled hopes of an early economic recovery in the country and boosted Chinese equities. The Shanghai Composite gained 2.8 per cent to reach its highest level in eight months as turnover ballooned to Rmb187.3bn, the highest for nearly a year.

UK CPI: one swallow doesn't make a summer

UK CPI (February YoY) came in ahead of expectations at +3.2% versus consensus of +2.6%. The 10 year Gilt yield rose to 3.37%, up 24 basis points. Mervyn King commented this morning on the higher than expected inflation number in an open letter to the Chancellor:

"Since last summer, world commodity prices have fallen sharply and that has helped drive a fall in overall CPI inflation from 5.2% in September to 3.2% in February. But the effect on UK consumer prices of decreases in world prices has been dampened by the depreciation of sterling. Since my December letter, the sterling effective exchange rate has depreciated by about 5%, bringing the total depreciation to 28% since the summer of 2007. February's inflation out turn is somewhat higher than expected. That could reflect pass-through of the exchange rate depreciation to consumer prices since much of the strength in the out turn appears to be concentrated in components where a large share of goods is imported."

Later, when questioned by the Treasury Committee about the implications about the implications for the Bank's QE programme, Mervyn King commented:

"We might need to do less on QE than £75 billion if it works... the target is to complete something in the order of £75 billion in QE over the next three months"

However, one swallow doesn't make a summer and it is still premature to say whether monetary policy is working or if it is stoking inflation. Indeed, Mervyn King noted in a statement to the Treasury Committee this morning that inflation is likely to fall in the medium term:

"Inflation in the UK is currently still above target. CPI data released this morning show that inflation was 3.2% in February, triggering another open letter from me to the Chancellor. At its next meeting, the Committee will want to consider further the implications of this inflation out turn. But the sharp slowdown in spending is likely to generate a significant margin of spare capacity in the economy, which, in turn, will bear down on inflation in the medium term. So the key question for the MPC is how to ensure nominal demand returns to a level that is consistent with meeting the inflation target."