We first started writing about the credit crunch 3 years ago (see August 2007). Since then, short-term interest rates in the USA, Europe and the UK have collapsed to near zero. Ten year government bond yields across the respective economies have fallen by around two percent. Whilst the fall in interest rates and yields has been a great present for government bond investors, the global economy has been suffering one of its worst recessions since World War II. But enough history. What about the future?
Financial market values at a simple level are driven by two basic themes – long term trend following and shorter term mean-reverting price action. This is also generally true of economies. Looking back over the past 50 years, we have seen a period of strongly upward trending economic growth within which there has been cyclical up and downturns. It has been the job of the modern fund manager from a stock selection point of view to identify if individual stocks and sectors are in a long term trend or mean reverting mode, whilst from the macro point of view they have just had to focus on where the economic cycle is within its permanent uptrend.
The challenge investors now face is to add another dimension to this traditional thinking. What if economic growth is no longer permanently upward trending? What if the trend of growing economies in the developed world is coming to an end?
The credit crunch is now three years old. Where is the upturn in economic growth? On Tuesday the US Federal Open Market Committee (FOMC) acknowledged that we were not there yet and have decided to reinvest the assets they purchased through quantitative easing. This is an acknowledgement that it is still not time to start tightening monetary policy. The FOMC have used up all their bullets in the interest rate armoury by reducing interest rates to near zero percent, encouraged the huge fiscal pump priming undertaken by government (Republicans and Democrats alike), and used unconventional measures of quantitative easing. These policies have been replicated to a lesser or greater degree within the G7 and beyond. And despite all of these extraordinary measures, the global economic recovery remains in doubt. It is fair to say that those central banks around the world that are currently running ultra-easy monetary policy will continue to do so for some time to come.
The interesting question now is whether we are in a long term structural change in economic growth prospects. Maybe we are no longer just in a cyclical downturn. It has been 3 years since the credit crunch began, and the arguments that this is not a normal economic cycle are becoming more compelling. If this is the case, it will be a long term growth environment that the Western world governments, central bankers, and fund managers have never seen before in their working lives. A challenge indeed.