Markets need more than rate cuts, QE and talk

In the latest twist, markets have been rallying on hopes that central banks will ease. That's odd. After all, it was only last month that investors took fright at the Fed's dovish no-hike decision.

Still, with expectations growing for central banks in Japan, Europe, China, India, and elsewhere to loosen soon, investors are feeling more cheerful. And we shouldn't be surprised if risk assets rallied on these hopes, given the extent of their two-month swoon. But if market sentiment depends on central banks alone, this rally will peter out. Much more is required to sustainably restore investor confidence.

The reason is simple—the world suffers from not enough growth. And central banks, while not powerless, are unlikely to lift growth much. Partly, that's because their tools—interest rate cuts, quantitative easing and jawboning—are clearly subject to diminishing returns. Central banks are also very unlikely to deploy policies that would work, such as financing fiscal expansions or taxing cash.

The root of what ails markets is not monetary. It is structural growth deficiencies which are demand- as well as supply-driven. One well-known impediment is excessive debt, ever present in the Anglo-Saxon household sector, pronounced in the public sector and increasingly worrisome in some emerging economies.

Less well-recognized is the pernicious nature of weaker trend growth and excess supply. That's why low inflation, which otherwise lifts purchasing power of households, is not translating into robust demand as predicted by conventional models.

The diagnosis for what ails global growth is found, oddly, in two opposing schools of thought—Keynesian economics and real business cycle theory (RBCT).

Traders work on the floor of the New York Stock Exchange.
Lucas Jackson | Reuters
Traders work on the floor of the New York Stock Exchange.

The Keynesian perspective is straightforward. Persistent low inflation reflects chronic demand deficiency. Accordingly, it signals a collapse in the return on capital. Monetary policy is ineffectual, given that demand, not the real rate of interest, is decisive for investment decisions. Slowing trend global growth due to faltering productivity and poor demographics only compounds matters. The net result is sluggish investment and weaker-than-expected consumption, leading to uneven growth.

Real business cycle theory—a branch of macroeconomics out of favour since the late 1980s—also has something to say. According to RBCT, recessions are preceded by episodes of over-investment. That rings true for many energy and commodity producers. It also strikes a chord in various industries, including China's bloated state-owned business sector.

The risk is that the combination of Keynesian demand deficiency and RBCT excess capacity results in a stalled global economy. Recessions, which in the past followed periods of monetary restraint or the bursting of bubbles, might now occur following much more modest shocks. For the first time a convulsion in emerging economies could tip the world into recession.

No wonder investors are antsy. Even worse, if the diagnosis is correct, the remedies are harder to see. They involve politically challenging structural adjustments to reduce excess capacity, improve productivity, and benignly reduce imbalances (for example in China). Small steps—supply adjustments in the US energy sector or the recently announced Trans Pacific Partnership (TPP) agreement—are visible, but much more is required.

So how should investors play it? The market turmoil unleashed in August represents a key inflection point. It marks the end of the long rally in risk assets that began in 2009, as well as the return of volatility. Accordingly, Sharpe ratios have collapsed. Robust portfolio construction becomes paramount. Yet the traditional way of doing so—pairing weakly correlated assets—is famously difficult to achieve, much less sustain. Investors must therefore generate returns not tied to overall market performance. We've entered a period when smart is not beta, rather good old-fashioned investor acumen.

Larry Hatheway is group chief economist at GAM.