Markets are becoming very distorted by the quantitative easing policies being pursued by the US and UK authorities. Money is spilling in to the equity and commodity markets, as investors seek better returns than they get on cash and short-term government bonds. It is not rushing into longer-term government bonds as the authorities hope. Instead longer-term interest rates are rising and bond prices falling.
Investors are driving commodity prices higher, and then using this as an argument to worry about inflation. If inflation resumes, they reason, the authorities will have to put interest rates up. Industrial output may remain low, the exports from China, Japan and Germany constrained, yet speculative demand anticipating recovery can still propel metals and oil higher.
The underlying reality is somewhat different from the speculative money go round. Both the US and the UK governments have to sell large quantities of bonds over the next couple of years. At some point they have to stop buying their own bonds by printing money. That is why we have been negative on government bonds for some time. The longer-term growth rates of both the US and the UK are likely to be lower than the past decade. Both economies need to spend less and borrow less, which will lower the growth rates achieved. That in turn makes controlling the public deficits more difficult and more painful.
If we are to avoid anaemic growth or the W shaped recovery some pundits now expect, the running has to be taken up by China and India, by Germany and Japan. Germany seems reluctant to spend, borrow and print more, preferring exports to home consumption. Japan has stretched her public borrowing in the past, and has had limited success with quantitative easing. China tends to try to expand by putting in more infrastructure. She needs now to allow Chinese workers to earn more so they can buy more. India is already near capacity and quite inflation prone.
On income grounds the US equity market is no longer cheap. The UK still faces a painful adjustment, which has been deferred by current policy. Present share values and commodity prices reflect easier money and low interest rates. We still prefer Asian to western equity, but think as the markets rise so do the risks that the recovery will disappoint.
In Eastern Europe the position of the Baltic countries remains very strained. This is a problem both for the architects of the Euro and for the banks that have lent substantial sums there.