Financial markets may hate uncertainty, but it appears they are going to have to learn to live with it. The current economic picture is extremely fuzzy, and is likely to stay that way. This situation poses a tough challenge for policy-makers, analysts and investors.

In general, economic cycles are well understood and reasonably predictable. But the trajectory of the global economy has been highly volatile since the financial crisis morphed into a painful recession and unleashed a variety of powerful economic forces.

The fundamental composition of economic growth has been altered, with governments stepping up their spending as household consumption and business investment dropped in most of the world’s major economies at the same time.

Throwing money at a synchronized worldwide recession was the easy part; turning off the fiscal and monetary hoses without reigniting the recession is proving to be a much trickier task. The result of this foray into uncharted waters for policy-makers is exceptional economic uncertainty for both markets and investors.

In many parts of the developed world, the credit crisis had touched off a major deleveraging trend among both households and businesses, suggesting that private demand will be fundamentally lower in the foreseeable future. Yet, at the same time, governments can’t go on stimulating their economies forever. Indeed, governments are already under growing pressure to rein in their own spending in response to growing public-debt burdens — particularly at a time when many governments also face looming demographical challenges
that will stress public finances and restrain underlying economic growth.

The hope is that the economic recovery will show enough strength for private demand to re-emerge, allowing governments to consolidate their finances before they get much worse.

But, so far, that has not been the case. As the Bank of Canada observes in the July issue of its Monetary Policy Report: “The global economic recovery is proceeding but is not yet self sustaining…. The hand-off from public stimulus to private demand in advanced economies is proceeding but has yet to be accomplished.”

Both the ability of the economic recovery to achieve self-sufficiency and the timing of that shift are central sources of the uncertainty now dogging financial markets. Already, it appears that the recovery is losing steam. In the July MPR, the BofC cut its GDP growth forecasts for 2010 and 2011 for Canada, the U.S. and Europe, noting: “Greater emphasis on balance sheet repair by households, banks and governments in a number of advanced economies is expected to temper the pace of global growth.”

For households, the crucial issues are jobs, incomes and the housing markets. As long as those critical components remain impaired, it’s hard for consumer demand to revive.

Yet businesses likely aren’t going to be confident enough to ramp up their investments until the recovery is more certain. They do not want to be caught out if the recession does reappear.

So, until policy-makers are convinced that the recovery is sustainable, they have little choice but to keep providing stimulus. Otherwise, they risk allowing the economy to slip back into recession.

The problem is that, at a time when developed economies still seem to be leaning heavily on public spending, governments are also being pushed in the opposite direction — at least, in terms of the fiscal stimulus they can supply — as they begin to realize the limits to the amount of debt they can pile up.

The danger of flirting with these limits became clear last spring, when market concerns about European sovereign debt arose, leading to a spike in counterparty risk and the threat of money markets freezing up. Although some of that fear has since ebbed, it remains yet another huge source of market uncertainty.

“Uncertainty about bank exposures to sovereign debt of the countries facing policy challenges has led to significant interbank funding strains,” notes the International Monetary Fund in a report assessing the state of the global financial system, released in early July.
@page_break@However, sovereign debt exposures are just one of the big sources of uncertainty hanging over the financial system. The overall health of some of the banks in the U.S., Britain and the rest of Europe remains a concern — and not just because they may be holding some impaired sovereign debt on their books. The IMF says that the pressure on banks has “been exacerbated by the legacy of unfinished cleansing of bank balance sheets over the past three years….”

European banking regulators have tried to clear up some of the uncertainty about the health of the region’s banks by launching a new round of stress testing. Those tests, the results of which were revealed by regulators in late July, found that most banks would be able to weather a double-dip recession. The regulators have calculated, however, that seven banks would see their Tier 1 capital ratios fall below 6%.

Whether these tests do anything to dispel the uncertainty about the health of the banks and bolster confidence remains to be seen. These exercises are inherently political, which undermines their credibility somewhat. And critics can always argue that the tests aren’t tough enough.

Moreover, the banking industry faces other sources of uncertainty beyond just the current health of certain banks’ balance sheets — namely, the impact of regulatory reform, which remains a work in progress and leaves both bankers and investors uneasy.

Global banking regulators have yet to settle on the details of new capital requirements, leverage limits and liquidity standards. The U.S. has just passed major financial services industry regulatory reforms, but analysts point out that many of the details have yet to be filled in by the U.S. regulators. Without knowing just how the new rules are going to work, or when they will kick in, it is impossible to gauge their impact on the industry.

The IMF says that the lack of specific reforms and the uncertainty of the time frame for their implementation are adding to investor uncertainty and, at the same time, “making it difficult for banks to take business decisions about various activities and constraining their willingness to lend.”

As if worries about the health of government finances, the financial system and the banks weren’t enough, the extreme levels of monetary stimulus that are still being supplied by central banks is yet another powerful source of uncertainty.

The U.S. Federal Reserve Board’s latest Monetary Policy Report points to extraordinarily loose monetary policy, the uncertain timing of the withdrawal of this economic support and an uncommonly large gap between inflation expectations and current inflation as factors contributing to a particularly hazy inflation outlook.

In the short term, the faltering economic recovery may help remove some of the uncertainty about monetary policy — at least, in the U.S., where no one is expecting the Fed will be able to begin raising rates anytime soon. Canada is a murkier situation, however, because, while domestic conditions have been fairly strong, worries about the U.S. and Europe are keeping central bankers cautious about the timing of their rate hikes.

But investors must remain worried about the long-run effects of both the fiscal and monetary stimulus measures that have been used to keep the global economy afloat over the past couple of years. “High long-term uncertainty now seems likely to keep investors from equity markets, despite strong earnings,” suggests a recent research report from JPMorgan Chase & Co.

Indeed, for investors, short of pulling out of markets entirely and hiding everything under their mattresses, extreme uncertainty calls for extreme portfolio caution.

Says a recent research report from UBS Financial Services Inc. : “Intuitively, investors should overweight defensive sectors of the equity market in a more uncertain economic environment. The historical record also supports this positioning.”

The UBS report points to consumer staples and utilities as two sectors that “offer reasonably sustainable earnings growth even in an uncertain economic environment.”

David Rosenberg, chief economist with Toronto-based Gluskin Sheff & Associates Inc. , indicates in a report that “yield works” in the sort of deleveraging deflationary cycle he sees dominating the market for the next few years: “Within the equity market, this implies a focus on squeezing as much income out of the portfolio as possible, so a reliance on reliable dividend yield and dividend growth makes perfect sense.”

And at a strategic level, Rosen-berg’s report suggests, an approach that “seeks to minimize both the volatility of the portfolio and the correlation with the equity market is completely appropriate.”

Finally, the report adds, gold also represents a hedge against financial instability.

On a positive note, a report from UBS Securities Canada Inc. says that the Toronto Stock Exchange’s heavy weightings in golds, which are countercyclical, and in financials, which tend to generate more stable earnings, mean the Canadian market’s earnings “should hold up better than most in today’s uncertain macro environment.”

Although the markets may hate uncertainty, it can hardly be avoided — particularly at a time when the global economy is facing such major tectonic shifts. The challenge for policy-makers will be to navigate through some highly murky waters. For investors, it may just be time to hunker down and wait for a clearing trend.

IE