Nick Beecroft, Senior Markets Consultant
On ‘Black Monday’, Monday, October 19, 1987, stock markets from Hong Kong to the US crashed, with the Dow Jones Industrial Average (DJIA) dropping by 508 points to 1738.74 (22.61%).
Those were nervous times; in the weeks preceding the crash the markets had become increasingly concerned about the deterioration in macro-economic indicators, including the US trade deficit and inflation, (uncomfortably high), and the dollar was disturbingly weak, implying imminent increases in US interest rates. US Treasury yields also seemed to be on the point of exploding, but perhaps the straw that broke the camel’s back was US Treasury Secretary James Baker’s comment over the weekend to the effect that the US would drive the dollar down further, (to address the burgeoning trade deficit), unless the Germans changed their monetary policy, halting interest rate increases, which he believed were stifling growth and causing excessive Deutsche Mark strength.
This very public policy rift between the politicians and central bankers of West’s largest economies was extremely unnerving for already febrile markets.
The parallel with the present day is obvious and perhaps very disturbing; i.e. the major rift that was apparent at the recent G20 meeting, with the US cautioning against excessively brutal and precipitate austerity measures and almost unanimous opposition from the nineteen other countries present, who displayed the characteristic zeal of new converts, in this case to fiscal probity.
Moreover, the debate also rages at the very heart of the Obama administration, with Budget Director Peter Orszag resigning last week, ostensibly to spend more time with his family, but by all accounts in reality over his concerns at the US budget deficit trajectory, or rather at the lack of urgency shown by the administration in devising a plan to cut same.
Once again, the main dispute could be said to be between the US and Germany, with the latter intent upon ‘hair-shirt’ fiscal policies, even though Germany’s bunds are still seen as a safe-haven amid Europe’s debt crisis, and its budget deficit is a very respectable 60% of GDP.
The last thing the markets need or want right now is to have to face the possibility that the world’s finest economic brains are utterly divided as to the best way to proceed. Yes, as in 1987, these are nervous times, as evidenced by the surge in the price of gold. This time the buyers of gold are not primarily driven by fears of inflation, this time they’re just party to an all-pervading fear that something very unpleasant is out there, probably driven by the debt crisis, which has now morphed from a private debt problem to the infinitely more worrying sovereign debt variety - as one commentator put it rather pithily recently, ‘who’s going to bail us out now the governments have run out of money, the Martians?’
This time US should be, and indeed is, more afraid of deflation and a strong US dollar. Judging from the Fed’s post-meeting statement last week, and previous meetings’ minutes, the FOMC is certainly concerned about the possibility of deflation. A strong dollar will do nothing to help President Obama’s plan to double exports over the next five years and it will bear down on inflation.
Right now, the US needs Germany to boost domestic consumption and, as we move further into the second half of this year, the fiscal policy debate between the ‘spendthrift’ US and ‘prudent’ Germany/Europe will become ever more heated. Suspicion will grow amongst the usual suspects in Congress that the EU is quietly very happy to see the Euro depreciate massively against the dollar, and soon we will hear strident comparisons with China.
Expect, at best, lack-lustre equity performance, and continuing safe-haven buying of the US dollar and Treasury bonds or, at worst, a crash.
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