Market hopes are still on shaky ground

A FEW weeks ago I was caught in North America by the Icelandic volcanic eruption. Chaos ruled for some time as it was uncertain how I might get home. Since then ash clouds randomly drift into and out of UK air space, and travel plans need to change at short notice.

Don't worry, this article is about financial markets, it is not a misplaced report from a travel supplement! I would like to warn readers that the future looks very different to the past; we have entered a 'brave new world' where volatility is the order of the day.

Part of my job is to read reams of research about the global economy. Some commentators argue that most countries are growing, unemployment has peaked at levels rather lower than many feared, even house prices are on the up. Normal service is being resumed – or is it? When we look carefully, we see a more complicated picture. Many small firms, on both sides of the Atlantic, still report difficulties in getting access to credit. An unpleasant combination of stagnant wages, rising inflation and higher taxes restrain household incomes. High street spending is not performing as it would in past recoveries.

It is easy to understand why – so many aspects of the crisis, the recession and the response from governments were unusual. Unusually, there were banking crises in much of the western world but very few in the emerging economies, private sector debt had risen to the highest levels seen in generations even before the crisis, too many economies were unbalanced as more resources flowed into housing and credit as opposed to manufacturing and trade, central banks responded by accepting quantitative easing, the electronic creation of money. We have learned a harsh lesson – when a crisis appears, governments have no rules and create new ones.

The volcano in Iceland is grumbling away, periodically throwing out vast plumes of ash. The financial crisis is grumbling away, periodically creating a new crisis. Countries need to adjust to the new situation; all governments can do is spread the pain.

Let me give some examples. The first would be China. Yes, growth has been strong in 2010 – but so it should when the government instructed the banks to boost lending by 25 per cent in 2009. Now it is dealing with a jump in property prices, causing social unrest where families cannot afford a new home. Consumer inflation has reached almost 3 per cent and looks on course for 4 per cent, even 5 per cent, this summer. No wonder tighter policy is being seen – nor that China's stock market has lost more than 20 per cent since the start of the year.

The bill is coming due for China, as it is for Europe. One way of thinking about recent events is that consumers and companies ran up large debts in the good years, debts which threatened to bring them down in the recession. The governments stepped in to take on the burden, and now must deal with annual borrowing two, three, even four times the old Maastricht criteria. With the latest ?750 billion package, the eurozone has bought itself some time – but the crisis has not been solved, more shocks will appear.

As intelligent investors we need to look ahead – what could be next on the radar? There is growing discussion about whether the new Conservative-Liberal Democrat coalition can push through a tight budget on 22 June. However, the UK knows what it needs to do to avoid some of the problems seen on the Continent. We must look further afield: on many estimates the US government's finances are not on a sustainable path. When does the Obama administration debate these issues? Will it be successful?

By no means do all the aftershocks relate to taxes and spending. How should we regulate the financial sector? My worry is that there are a multitude of conflicting proposals: the US might ban banks from proprietary trading, the UK is debating narrow vs universal banking models, the EU has been criticised for its proposals to over-haul the rules for hedge funds and private equity. Underneath all this there are some very technical discussions about new capital rules for global banks. These could force them to raise significant amounts of new money, and impact on their ability to lend to businesses and households as the recovery unfolds.

This financial crisis was unusual, and the aftershocks from the crisis will be felt for some time. Just as the Icelandic volcano will cause periodic disruption, so too markets, will wax and wane, sometimes violently. There is a positive backdrop from the economic recovery and better company profits, a negative slant from fiscal, banking or other crises. When do I get on that plane for my next trip to our American offices?

Andrew Milligan, head of global strategy, Standard Life Investments