The powerful macro forces that drive global economy and move stock markets have changed direction post the peak of the Global Financial Crisis (GFC). Governments are tightening their Fiscal Policies and Central Banks are expending their Balance Sheets (also known as quantitative easing or money printing) as part of globally synchronized deleveraging process
The two opposing forces pull the global economy in different directions. The fiscal cuts are slowing economic growth but are counter-balanced by a stimulative nature of the Central Banks' easing. Markets will be watching the balancing act for signs of which force will emerge stronger; the outcome will be reflected in stock and bond markets valuations. So far, the positive monetary stimulus has been stronger resulting in rising stock and bond markets.
I think there is a good chance the trend should continue. Why? Because this is a less painful way to gently deleverage global economy starting from a most vulnerable highly geared sector - the banking system - while maintaining the status-quo of its ownership structure.
I am certain of one thing: the global synchronization of the policies will further synchronize global economic cycles. This will limit investors' ability to reduce risk by international diversification of their investments. To effectively manage risk and enhance returns in such environment, investors will need to time the markets and apply dynamic asset allocation top-down macroeconomic methodologies.
The superior returns are more likely to come from timing markets than from picking stocks and bonds. Not surprisingly, the Global Macro strategy outperformed in the hedge funds league table over 1, 5 and 10 last years.
Source: JP Morgan
Gavyn Davies, Financial Times macroeconomist, assembled the relevant macro data in two graphs to illustrate the major synchronized shift in the global economic policies: from stimulative fiscal policy during GFC to tightening post GFC and counter-balanced by stimulative central banks' balance sheet expansion.
Fiscal tightening post-GFC slows economy
Central banks buying assets stimulates economy
The USA has pushed the bulk of its fiscal tightening beyond 2012 presidential elections which should help reduce unemployment and re-elect Obama.
U.K. is tightening its fiscal policy most aggressively and the eurozone is not far behind. The tough austerity measures will be challenged by left-side voters in the elections in various European countries leading to increased volatility in the stock markets.
The newly elected European Governments may under pressure ease the austerity measures and I would view it as a positive for the stock market because it would add to the aggregate demand when economy is slowing.
EU Maastricht Treaty target is unrealistic
The GFC required a massive Keynesian fiscal demand side stimulus financed by public borrowings in addition to easing of the monetary policies. Governments are now planning to reduce the excessive borrowings by tightening their fiscal policies while supplying easy money. This should keep bond rates down and values up (for a while at least until inflation becomes the fear).
Europe, led by Germany, has been religiously aiming for the low debt and deficit targets agreed at the formation of the eurozone. The German psyche seems still driven by bad memories of the 1920s Weimar Republic hyperinflation.
In reality, the ambitious low debt & deficit targets are unachievable in mid-term. While it is easier to reduce the short term deficit it is much harder to reduce the outstanding long term debt. And short term cuts in public spending will slow the economy, add to unemployment and reduce ability to create a surplus required to repay the long term debt.
JP Morgan's chart shows Europe plans to tighten fiscal policies to reduce deficits by 2014 towards the 3% goal set by the Maastricht Treaty. Reduction of debt is not planned and the 60% debt target is an illusion for most European countries including economically strong Germany.
Only some Eastern European countries (e.g. Poland) could meet the 60% debt target. They were not included on the chart as they are not yet a part of the eurozone. Merging them with the monetary union would help reduce the overall level of eurozone debt as % of aggregated GDP.
EU policy mistake
EU stepped on the monetary brakes by increasing interest rates too early post the GFC and at the same time reduced public spending. The anti-growth strategy on both fiscal and monetary front landed EU in the second dip of the financial crisis and economic slowdown. The inevitable financial stress showed first in Greece, Spain, Portugal, Ireland and Italy - the weakest links of the eurozone with highest debt.
ECB & IMF rescue
The eurozone was stabilized by the recent delayed but decisive action of the European Central Bank and IMF. A cut in Euro interest rates and €1tn LTRO liquidity injection stopped the looming disaster which could have dragged the global economy into a double dip recession. The ECB and IMF came to the rescue after EU members agreed to surrender some of their fiscal powers to Brussels. As a result, we have more politically and economically unified Europe with stabilized banking sector hopefully on the way to economic recovery.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.