In my last column I argued that while market participants around the world were looking for a recovery, they were going to get hit by a global equity crash. I argued that the driver of this coming equity crash would be the combination of, on the one hand, the adoption of a less accommodating monetary policy by the US Federal Reserve in the face of a weakening dollar and rising inflation and, on the other, continuing, disappointing economic news.
Lesson number one is that markets hate policy conflict and that is what they are being offered. Inflation is up. Economic growth is fuelled by credit creation and, outside of India at least, the banks are in no position to create credit. The business models of US banks have been shot through. US and European banks are short of capital. They are about to be regulated further and their risk appetite is low.
It would appear that that the conditions for this coming equity crash are falling into place. Last Thursday, Federal Reserve Chairman Bernanke, highlighted the dollar as a cause for concern for the first time. On Friday, the US May Labour Market Report showed a jump in the unemployment rate from 5.0% to 5.5% and non-farm payrolls slipped for the fifth month in a row. US equity markets paid me the courtesy of responding with crash-like signs.
It is fool-hardy enough to try and forecast an event, so I am not going to forecast its timing as well. But you have been warned. The equity crash is coming. I don?t know when exactly but you could do a lot worse than being in cash or certificates of deposit from good quality companies for the next couple of months. Take the time to look for those value points you aim to exploit on your return to the market. Sit out the exciting M&A news coming out of India and recall that all the empirical evidence is that M&A is almost always a value destroyer.
If you are still yearning for action, then consider the currency markets where there is always something going up. There will be important differences in the way global policy makers respond to the policy conflict and this will lead to significant foreign exchange volatility. One of the best guides to how central banks will respond when faced with conflicting objectives is not what they say, or how they say it, but demographics. That is lesson number two.
This is useful because demographics are one of the few things we can forecast with any degree of certainty. I can forecast how many 40 year-olds there are going to be in India in 20 years time, simply by estimating how many 20 year olds there are living in India today and adjusting for modest migration and death rates between the ages of 20 and 40.
Demographics tell us that relative to the Europeans or Japanese the US is inhabited by a young population. This population is heavily mortgaged. A young indebted voter prefers inflation?to inflate his debts away?than a deflation in which he could lose his job and maybe his home if he fails to keep up his mortgage payments. Japanese and Europeans on the other hand can be characterized as old, savers, living off fixed incomes. The last thing they want is inflation to eat away the purchasing power of their fixed incomes. We touched on this last time. The implication is that the US will take more risks with inflation than Japan or Europe will. What does that mean for foreign exchange markets? Everything. For some reason people think a currency is an equity and they look for currencies with strong underlying economic growth. This is wrong – in the long-run at least. Lesson number three is that a currency is a cash instrument. It is a bond. Inflation hurts bonds. The list of countries with the strongest currencies in the post-1950 developed world does not include fast growing US or post-Thatcher Britain, but low inflation Switzerland, Japan and Germany. A period of policy conflict that includes rising global prices will be bad for the dollar, good for the euro and yen. It has already been. There is a bit further to go.
One of the reasons why I am a long-run optimist about India is it?s demographics. India is just moving into the demographic sweet spot?a young population, that is saving, with a falling birthrate. China?s past growth spurt matches its move into this demographic sweet spot twenty five ago. Thanks to the one-child policy, China is moving out of this demographic sweet spot as its population ages. It is said that the Chinese will grow old before they grow rich. On this important front, India is better positioned.
Avinash D Persaud is Chairman of Intelligence Capital Ltd, and Emeritus Professor of Gresham College
