Investors keep wondering why there is such an apparent disconnect between financial markets and the real economy. Although it is still early days, financial markets seem to have recovered from the doldrums that they experienced at the peak of the pandemic in March.
The negative effects on EU economies seem to be much worse, and few economists hope that economic growth will bounce back anytime soon.
A few primary considerations need to be highlighted. Financial markets are driven by investors’ sentiment that, almost by definition, are often fickle. The real economy is driven by fundamental principles that are rarely proven wrong.
The widespread slowdown of economic activity as a result of the pandemic has made it necessary for governments and central banks to use most of the monetary and fiscal tools that they control. Financial markets were so impressed that asset prices held up well despite the economic slowdown. But some investors fear that this phenomenon may not last for long, especially in Europe as many economies are still surviving on borrowed time.
The injection of massive liquidity in financial markets has helped many businesses struggling to keep afloat to keep their doors open. But the risk of over-reliance on cheap credit is a real one. No one can really predict whether easy money policies would lead to massive inflationary pressures or usher an even deeper recession in a few years.
No one can really predict whether easy money policies would lead to massive inflationary pressures or usher an even deeper recession in a few years
Government policies that aim to redistribute wealth and address public deficits in the next few years could lead to higher taxes, tightening of regulations and a more inflationary environment. All these would be bad news for corporate profit margins.
Bondholders in the current low-interest-rate scenario will experience a significant erosion of value if inflation returns with a bang in the medium term. No wonder some experienced fund managers with a long-term view are not convinced that the rebound in financial markets will last for a long time.
The Federal Reserve’s and the ECB’s decision to buy corporate and sovereign bonds, including those that are below investment grade has calmed markets until economies start to recover. But the problem of small businesses that are only marginally viable will feedback and hurt more significant economies.
In the EU, there is an urgent need for some of the larger member states to restructure their economies by managing their public finances better and by creating incentives for productive investment. This will be an arduous task as populist politicians exploit the prospect of more hardships being imposed on ordinary people to improve the economic fundamentals.
Banks have been cautious in extending credit to zombie companies that are only kept in existence by some perceived benefit that their presence may have on jobs and regional economic activities. Governments prefer to issue liquidity guarantees to these companies while failing to acknowledge that the real problem they face is one of solvency.
Worryingly, retail investors in pursuit of a reasonable yield for their money have been pouring money in companies that do not pass the banks’ strict creditworthiness test and resort to raising money directly in financial markets. So far, the central banks’ commitment to underwrite the risks of sub-investment grade securities has averted a collapse of the junk bonds market. It has also penalised cautious investors who understand the dynamics of the pricing of risk.
Sooner or later the chickens will come home to roost. The way out of the economic crisis that is afflicting some EU economies is not to keep lame businesses in existence but to energise their economies and allow markets to assess the risk profiles of different economic operators.
The pandemic has forced the EU’s political leaders to take remarkable short-term fiscal measures to cushion the impact on fragile economies. But the complex and often ineffective governance structure of the EU does not augur well for the leadership that is needed to restructure the economies of various member states.
The European Parliament is deprived of any real power and has been rendered into a glorified talking shop. The European Council has all the power. But narrow national interests and the threats of vetoes by individual political leaders often lead to fudged solutions that fail to address the fundamental weaknesses that afflict the EU economies.
The pious intentions of the European Commission and the desperate measures taken by the ECB to avoid an economic meltdown will never be enough to turn Europe into the political and economic power that it has the potential to be.
johncassarwhite@yahoo.com