As the summer doldrums drag on in the markets, more people are asking serious questions about the US and UK recovery. The two governments have hurled everything at the problem, belatedly. They have printed money, buying government bonds. They have swelled the public deficits, announced new spending programmes. They have devalued their currencies.
By the end of this year, when we come up to the anniversary of the deep interest rate cuts of 2008, we should see some end to the economic collapse. Some of the figures will start to look better, if only because they will be comparisons with dire figures from a year earlier. Lower currency levels allied to restrained demand will have some favourable impact on balance of payments deficits. There are limits to how much destocking companies can do.
Despite this, markets are more inclined to ask the difficult questions. How do they get away from quantitative easing? How do they start to curb the massive public deficits? How can we expect much of a consumer recovery, when unemployment is still rising and cuts in earnings are commonplace?
In the last few days the UK market has been uneasy partly because the Bank of England is experimenting with the idea that maybe it will not commit to more quantitative easing than the £125 billion announced. Naturally market participants are concerned that government bond prices will have to fall and their yields rise to fund the massive government deficit. The US market has been adjusting to the slow pace of recovery in the US economy, and realising that the Obama effect and his stimulus package have not had an immediate and positive impact in the way people hoped. Discussion of a second package has not helped. It has reaffirmed the view that the first one is not working, and reminded investors of the high price of the first package and its impact on the deficit.
The problem with stimulus packages is they may not stimulate. If they are paid for out of taxes, some part of the increase in activity is offset by the spending forgone by those paying the taxes. If the package is paid for out of borrowing, there is always the danger that the market will remember borrowing is tax deferred, and will put up interest rates to allow for the extra borrowing. A well judged and popular stimulus package can help, but the law of diminishing returns can set in in conditions where a government is very highly borrowed and where it lacks credibility.
So what should investors do? They should wait patiently if they are in cash and corporate bonds. They should cut their risks to western equity and to UK government debt, and look for opportunities to go east. The Asian economies are better placed than the west. The US and UK may not be in a similar position to Japan circa 1992, but the twin deficits leave plenty of risk on the table.