Markets have been drifting downwards as we feared. Some investors are going on holiday, whilst those who remain are worried about the slow response in the major economies to the large stimuli applied by governments.
In the UK the big issue is how the government gets out of quantitative easing. This week the Bank of England’s Monetary Policy Committee met, kept interest rates down at 0.5% and said nothing about a possible increase in quantitative easing. They have spent most of the £125 billion they announced. They have the option of spending another £25 billion under their permission from the government. They could also go back to the Chancellor and ask to do some more, on top of the permitted £150 billion.
Prior to the meeting many market participants expected the MPC to say they were going to spend the remaining £25 billion. They probably came to this conclusion because money growth is currently slowing down a bit, and bank credit is still tight for the private sector. The MPC decided to say nothing firm, leaving their options open. There may be divided opinions on the MPC about the issue. There will be general doubt about whether it is working and how much it takes. They will now be able to see how markets respond to a slower rate of spend and to the possibility of no more easing, without having burned their boats.
The Governor thinks the purpose of quantitative easing is to create some more money. That has occurred, although it was also happening prior to the start of the bond buying programme. What also seems to have been happening is a switch of new bank lending from advances to the private sector, to paying for the government’s deficit and bond purchases.
Where the government buys the bonds from the UK private sector, that frees some cash for the private sector to spend or to buy other assets like shares. If the purchasing is from foreigners, it may do the same, or it may lead to weaker sterling if the foreign gilt owner sells the currency as well as the bond. The government may be relaxed about that, as devaluation appears to be part of the strategy to try to curb the balance of payments deficit.
We characterised the strong second quarter rally in shares and commodities worldwide as the quantitative easing rally. The money created on both sides of the Atlantic found its way into these markets, which has helped lift confidence a bit. Markets now need more evidence of improvements in the underlying economies, otherwise the higher prices of shares and commodities will look unsustainable. There is some evidence of more activity and better forward looking orders in Asia, but the outlook remains weak in the US and poor in Europe.
The large imbalances in the world economy remain difficult to handle. We need much more progress on sorting out the trade deficits and surpluses between east and west, which is happening through a mixture of a big decline in western demand and some devaluation. We need to see how the US and UK will wean themselves off colossal budget deficits and quantitative easing. The US and UK are creating new large imbalances to try to deal with past ones.
We have taken a more cautious stance for clients in the third quarter after the rally. We have not gone fully liquid, as we believe the authorities will do some more easing and spending if they fail to see any strengthening of the small and vulnerable green shoots.