Investors' fears grow over turning off of the liquidity tap

Published on Saturday 3 October 2009 13:37

SINCE global stocks hit their low point in March, investors' main concerns have been the recession and whether government efforts to kick-start growth are having the desired effect. Now that the worst seems to be behind us, we've found something new to worry about – how quickly that stimulus will be shut off again.

After unprecedented levels of fiscal support, the nature and timing of the eventual exit from rock– bottom interest rates, quantitative easing and short-term tax cuts is uncertain. Nothing on quite this scale has ever been attempted before. This is uncharted territory.

When and how interest rate and tax incentives are wound back is crucial for the future direction of markets. Investors are now lavishing the kind of attention on the comments of central bankers that Kremlinologists used to give to every word from Moscow.

Over the past couple of years, governments around the world have employed extraordinary levels of stimulus to counter the downturn. Relative to the size of today's global economy, something like three times more firepower has been deployed than during the Great Depression. These measures have seen interest rates slashed lower than ever before. The balance sheet of the US Federal Reserve has ballooned to almost $2 trillion and governments, notably Britain's, have run up unprecedented levels of borrowings.

These measures may have been essential to contain threats to the stability of the global financial system, but they are not sustainable. In order to maintain the confidence of financial markets, the authorities must at some point unwind the largesse.

They must find a credible path to the exit.

While the markets have started worrying that the easy money is about to dry up, it is clear that an exit is not imminent. As Jean-Claude Trichet, head of the European Central Bank, said: "It is premature to declare the financial crisis over. Today is not the time to exit."

At home, Bank of England governor Mervyn King has warned that, even if activity as measured by gross domestic product starts to pick up, it will still feel like we are in a recession. The heads of the G20 group of leading nations confirmed that "we will continue to implement decisively our necessary financial support measures… until recovery is secured."

The reason they are all so cautious about shutting off liquidity is that, in the past, premature tightening has had a disastrous impact on nascent recoveries. In the 1930s, America suffered a second deep recession after policy was tightened, while blame for Japan's many false dawns during its 20-year slump has been levelled at overhasty policy shifts.

There is a danger in the other direction, however. Leave the tightening too late, for fear of snuffing out recovery, and central banks risk triggering a more familiar problem: rampant inflation.

With more than $800 billion waiting on the sidelines in the form of bank reserves in the vaults of the Federal Reserve, the potential inflationary problem is enormous. The recent rise in the gold price – above $1,000 an ounce – is a worrying straw in the wind.

As the simmering row between the government and opposition over tax rises and spending cuts has shown, monetary tightening is just one aspect of the exit from recent extraordinary measures. Just as important is the fiscal squeeze that both main parties now accept as inevitable. It is clear that if government debt is to be brought back to sustainable levels, then years of austerity beckon.

Investors face a high degree of uncertainty as economies navigate their way back to normality.

Central bankers' caution about turning off the taps has fuelled the recent market rally but the realisation that this is a deferral, not a cancellation, of the unavoidable is now threatening to end the party.

Investors need to prepare themselves. A delayed exit would be favourable for equities and especially those real assets such as commodities and property that tend to outperform in an inflationary environment. Once exit is imminent, however, investors must judge whether it reflects sustainable growth or threatens a renewed downturn.

The rather messy reality is that taxes are likely to rise to rescue government balance sheets while interest rates stay lower for longer to fend off a renewed slump. The temptation for the authorities to hold back until they are absolutely convinced by the strength of economic recovery means the balance of risks is weighted towards over-stimulation and a return of inflation.

Tom Stevenson is market and investment commentator, Fidelity International