Global Growth Accelerating

In yet another indication that the global economic recovery is gaining momentum, the International Monetary Fund (IMF) has again raised its projections (see our January 28 blog). On April 21 the organization bumped its 2010 global GDP forecast from 3.9% to 4.2% and reiterated its prediction of 4.3% in 2011

The IMF continues to emphasize that the expansion will be lead by the leading emerging economies of China, India and Brazil with growth increases of 10.0%, 8.8%, and 5.5% respectively. The IMF also continues to anticipate sluggish growth in the Euro Area (1.0%) and Japan (1.9%) but they are becoming more optimistic regarding the U.S. with GDP growth raised from 2.7% to 3.1%.

The IMF forecast is supported by a consensus of economists that the latest monthly polling by The Economist foresees modest 2010 GDP growth in the Euro Area (1.2%) and Japan (1.9%), slightly higher growth in the U.S. (3.1%) and robust growth in China (9.7%), India (7.7%) and Brazil (5.5%). Worth noting is that these economists anticipate a broad-based as well as a multiyear expansion. The consensus expects positive 2010 growth in 38 of the 42 countries included in the survey (negative growth is projected for Greece, Spain, Hungry and Venezuela) and additional gains in 2011 for 40 of the 42 (Greece and Venezuela are the exceptions).

Review of the First Quarter 2010

Global stock markets in the U.S. and abroad weathered a temporary setback in January and early February and then rallied to extend beyond one year the new bull market. In its best 1st quarter since 1999, the Standard and Poor’s 500 Index rose 4.9%. This marked the 4th consecutive positive quarter without a correction in excess of 10% and increased to 72.9% the advance dating back to March 9 of last year. Despite fears of inflation and central bank tightening in China, India, and Brazil, the ishares Emerging Markets ETF (EEM) rose 1.5%, which increased its advance from last March to 111.0%. Although Europe was plagued with sluggish growth and a sovereign debt crisis, the ishares Developed Countries ETF (EFA) was up 1.3% for an overall gain of 76.6%.

The catalysts for the early quarter’s correction, which amounted to declines of -8.1% for the S&P 500 Index, -12.9% for the EFA, and -14.7% for the EEM, originated in China and Greece. In January, the Chinese government, concerned that strong economic growth would accelerate rising prices for real estate and food, introduced curbs on excessive bank lending. Alarmist speculation from some China watchers that the Chinese policy makers were about to prick a bubble economy triggered profit taking. The inflation contagion spread quickly to the Indian and Brazilian markets, where fears mounted that interest rate hikes by their central banks might choke economic growth. The storm passed quickly and all three markets recovered, but inflation clouds were still visible on the horizon as the quarter came to a close.

If the problem in China, India, and Brazil was that their economies were too healthy, the problem in Greece, Portugal, and Spain was that their economies were too sick. Many of the Euro area governments resorted to huge budget deficits to fight the recession, but national debts measured as a per cent of GDP were most worrisome in these countries. Although there was widespread agreement that a Greek default was unacceptable, the crisis was exacerbated by fierce worker resistance to belt tightening measures proposed by the Greek government and ugly bickering among Euro area governments as to who would finance a solution to the problem. As European stock markets trembled and the euro dropped like a stone, government leaders, the European Central Bank (ECB), and the International Monetary Fund (IMF) finally worked out a compromise. By the end of March, European stock markets recovered and the euro stabilized, but the potential for debt headaches down the road persisted.

Despite high unemployment, anemic consumer spending, a weak housing market, humongous federal deficit projections, and unseemly, vicious partisan squabbling in Congress, U.S. stock investors focused on positive developments. Driving optimism in the U.S. stock market upward were fresh data showing economic recovery, strong and above-expectation 4th quarter corporate profit reports, and comforting statements by the Federal Reserve that inflation was under control and an accommodative policy would be maintained for “an extended period.” An indication of investors’ confidence was that the best performing S&P 500 industry sector was consumer discretion (+11.8%) followed by industrials (+9.3%). On the bottom rungs of the ladder were the relatively conservative telecommunications (-2.5%) and utilities (-2.9%). In their optimism, investors preferred low-quality stocks, and their appetite for many of the big blue-chip stocks was meager: suffering declines were Exxon Mobil (-1.8%), Microsoft (-3.9%), AT&T (-7.8%), Pfizer (-5.7%) and Coca-Cola (-3.5%).

An interesting and noteworthy development in the 1st quarter was that the gain in the U.S. stock market was accompanied by a rise in the dollar. Since early 2008, the dollar and stock prices had exhibited a pronounced inverse relationship, and for both to move up together was seen by many investors as a positive sign that recession fears had subsided. Commodity prices usually fall when the dollar rises, and the CRB Commodity Index declined 3.5% during the quarter. On the other hand, gold gained $15.50/ounce to $1115.50/ounce and oil rose from $79.36/barrel to $83.76/barrel.

The bond market was relatively calm during the quarter: the yield on the benchmark 10-year U.S. Treasury note started the quarter at 3.84%, never rose above 3.88% nor fell below 3.56%, and ended the quarter at 3.83%. Thirsty for yield, individual investors continued to pour money into investment-grade and high-yield bond mutual funds despite the huge borrowing needs of the government and expectations that the Federal Reserve will push interest rates higher later in the year. As a result, the spread between U.S. Treasury notes and corporate bonds narrowed to levels not seen since late 2007. An ominous development in March was that both investment-grade and high-yield “junk” corporate bond issuers increased significantly their issuance of new bonds, thereby indicating their view that yields will most likely rise (and prices fall) in the future.

Good Reading: Lords of Finance

Good reading: Lords of Finance: The Bankers Who Broke The World by Liaquat Ahamed (Penguin Press, 2009), 505 pp.

For investors tracking the ongoing efforts of governments and central banks to battle recessionary pressures and engineer a global economic recovery, we recommend strongly Ahamed’s informed and captivating Lords of Finance. The book focuses on the largely successful efforts of the central bankers of the U.S., England, France and Germany to restore economic and currency stability following the chaos of World War I and their subsequent policy mistakes that helped bring on the Great Depression. These bankers were men of sharply divergent backgrounds and personalities, and they were committed to the sometimes conflicting interests of their respective countries. Nevertheless, they managed at critical moments in the 1920s to coordinate policies, overcome the obstacles thrown in their path by the politicians, and weather one crisis after another. The glue that held them together was a near-religious faith in the gold standard, which they managed to restore after World War I and to maintain for a tumultuous decade. Ironically, the author argues that it was their slavish adherence to this inflexible gold standard that ultimately triggered the Depression and in the process tragically ruined their careers and reputations. For the author, who is no fan of the gold standard, the heroes of the book are John Maynard Keynes, the brilliant and controversial English critic of these central bankers, and Franklin Roosevelt, who rejected the insistent advice of his economic advisors and took the U.S. off the gold standard at the depths of the Depression in 1933.

Readers will enjoy and profit from Lords of Finance even if they are not sophisticated in economics or historians of the Great Depression. Ahamed, whose background includes a stint at the World Bank, patiently and expertly explains the formation of the Federal Reserve and its inner workings through the 1920s and 1930s. He also provides a clear explanation of the gold standard with its benefits and limitations, and places the economic and currency crises within a broader political and social historical context. Readers will also appreciate the ability of the author to paint personality portraits of the major protagonists. The book is a useful antidote to the currently fashionable thesis that seismic economic events, such as the Great Depression, are the consequence of largely impersonal and unavoidable political, social and demographic trends.

In a very instructive epilogue, Ahamed compares the Great Depression with the 2008-2009 global economic and financial crisis. Although he acknowledges the two events share many of the same characteristics, he concludes that the differences outweigh the similarities. His major point is that The Depression was the consequence of the misguided policies of politicians and central bankers; modern policy makers, enlightened by the errors of their predecessors, are now pursuing a contrary set of policies that will result in a more favorable conclusion.

The book deserves its accolade as the Financial Times and Goldman Sachs 2009 business book of the year.