Economic commentator Andrew Smithers has a dim view of growth prospects for the eurozone, UK and Japan but overall, he takes an unusually mild approach in his latest world market report to clients.
In short, says Smithers:
• The unexpected surge in worldwide inflation shows that output has been running well above its equilibrium level. Growth must therefore slow to well below trend rates if inflation is to fall back.
• Below trend growth will mean lower profits in terms of national accounts. Larger falls are likely in company accounts, as the profits booked by the change from historic cost to current value accounting turn to losses.
• The change has also given a “misleadingly optimistic view” of company balance sheets, he says.
The misunderstood problem of corporate balance sheets will cause problems for banks and other lenders, and lead to higher equity supply as banks become increasingly unwilling and unable to extend credit.
• The US was the first major economy to suffer from weak domestic demand, but this has now become widespread. The fall in domestic US corporate profits has so far been partly offset by rising profits from foreign subsidiaries. With weak demand now becoming general and a stronger dollar, argues Smithers, US foreign subsidiaries will see falling profits in dollar terms in 2009, thus accentuating, rather than limiting, the fall in US domestic profits.
• There are three main possible outcomes for the key economies: (i) Recovery to trend growth or above, beginning in 2009. (ii) Below trend growth, with or without mild recession, over the next 18 months or more. (iii) A major recession in terms of either depth or duration.
• Early recovery would lead to a sharp rise in inflationary expectations which have, so far, remained surprisingly and happily constrained. Fortunately, improved demand seems increasingly unlikely with economic weakness appearing in all major economies.
The best possible outcome, which is weak growth or mild recession, continues to look the most likely as well as the most desirable outcome. A major recession is the next most likely but, if demand deteriorates much more, the response should be some fiscal and monetary stimuli.
• In conclusion, then: Bonds are extremely overpriced, though likely to be supported by economic weakness. Shares are both overpriced and likely to be hurt by falling profits. Cash is better than either.