Note: The six-bear average, referenced in several posts over the last year or so, is a history-based “forecast” derived from the recovery path of US equities after the six twentieth-century bear markets that involved a fall in the Dow Industrials index of about 50%. (The Dow fell by 54% between October 2007 and March 2009.) At yesterday’s close of 11247, the Dow was 1% above the average, which falls to a low in late October before embarking on a year-long recovery – see first chart below. A post from May 2010 details the component bear markets and subsequent equity market performance. The last update was in early August.
Reader’s comment: It looks to me like the average in the next couple of months comprises one very positive outcome and five outcomes that are about 10% lower than where we are now. Which bear market is the really positive one? Is there any reason why we should not be looking at the average excluding that one? On this basis there would be significant short-term downside from here as the reality of slower economic recovery and growth gets fully discounted?

Answer: Many thanks for your interesting question. The positive outlier is the rise from the bear market low of June 1901 – the earliest of the six cycles included in the calculation of the average. A “five-bear average”, excluding this rise, is currently 7% lower than the six-bear version. Moreover, it falls to a bottom 14% below the current level of the Dow by late December, as the following chart shows.

To exclude the post-1901 rise from the calculation, however, would seem to me to be unscientific, displaying bearish bias. The six bears were chosen simply on the basis that, like the 2007-09 episode, they involved a fall in the Dow of about 50%. If I were to omit the post-1901 rise because it looks too bullish, should I not also exclude the most pessimistic of the six scenarios, for balance?

A further point, which was not evident in the original chart (above) but is in the one below, is that the post-1901 line switches from being well above the average to below it during the course of 2012. So the five-bear average ends next year above the six-bear version, and above the current level of the Dow.

Whether or not the post-1901 rise is included, therefore, the analysis suggests that buying now will yield a profit on a 12+ month view. The issue is the extent and duration of any further near-term weakness.

The outlook for the global economy and markets is multi-polar, depending on how the eurocrisis develops.

Without the crisis, economic momentum and risk assets would probably now be recovering in response to faster G7 real money expansion since the spring. Recent heightened fears of an imminent hard Greek default and associated funding difficulties faced by some European banks threaten to delay the expected revival until late 2011.

An immediate involuntary write-down of Greek sovereign debt, even if accompanied by measures to shore up bank capital and ensure continued access to funding (including for Greek banks), would represent a further negative “shock”, probably extending economic weakness into early 2012.

As a recent Citi report argues, however, by far the worst-case scenario would be a Greek default accompanied by exit from EMU, involving the redenomination of Greek bank liabilities from euros to new drachmas. This precedent would trigger huge capital flight from other peripheral banking systems, requiring a massive expansion of ECB support to avert collapse. Associated damage to global business and consumer confidence would probably be sufficient to trigger another recession.

The base-case view here, admittedly held with limited conviction, is that, while a large write-down of Greek sovereign debt will ultimately be required, the Greek government will delay initiating such action until the country’s primary deficit has been closed – unlikely before 2013 at the earliest. Official lenders to Greece, meanwhile, will prefer to tolerate non-compliance with fiscal targets and continue to advance funding providing that the government maintains the illusion of co-operation – most of the cash, after all, is being used to service debt held mainly by European financial institutions rather than to cover the Greek primary deficit.

The risk, of course, is that populist pressure either in Greece or “core” Eurozone countries overwhelms such rational considerations, resulting in an immediate withdrawal of funding and involuntary default.

The challenging task for the Eurozone authorities in the latter scenario would be to prevent a Greek default from spiralling into forced exit from EMU. A key requirement would be a plan to allow the ECB to continue to act as lender of last resort to the Greek banking system – the banks, for example, could be recapitalised by the EFSF / IMF with the ECB granted preferred creditor status in some form.

“Kicking the can down the road” is still the least worst option.

The Swiss National Bank’s recent liquidity injection has pushed global bank reserves – the amount of cash held by banks in their accounts with central banks – to a new record.

The first chart below is the regular presentation of G3 bank reserves amended to include Switzerland. G3 reserves have retreated from a high in early August but the fall has been more than offset by the Swiss injection.

Swiss reserves – i.e. sight deposits of domestic banks with the Swiss National Bank (SNB) – have surged from CHF29 billion at the start of August to CHF208 billion last week. Total sight deposits – including holdings of Swiss non-banks and foreign institutions – have risen from CHF33 billion to CHF253 billion over the same period. The CHF220 billion rise is equivalent to 39% of Swiss annual GDP.

The SNB last week committed to unlimited foreign exchange intervention to defend a 1.20 floor for the euro-Swiss franc exchange rate. Some market participants may regard 1.20 as an attractive level to acquire francs to hedge against EMU breaking apart, forcing the SNB to abandon the floor. Such inflows would further swell sight deposits, although the SNB could try to sterilise the impact via bill sales or repos / swaps.

The SNB’s actions should support Swiss asset prices. Swiss equities outperformed world markets after the central bank set a floor for the deutschemark-franc exchange rate in October 1978, even though the policy was successful in weakening the currency.

The SNB’s liquidity injection contrasts with a recent reduction in Bank of Japan reserves, which correlate negatively with the yen – second chart. Markets may continue to pressure the Japanese currency higher to force a Swiss-style policy U-turn.

A post in March signalled a slowdown in emerging economies that would relieve upward pressure on commodity prices. This slowdown is well under way – combined industrial output in seven large emerging economies (the “E7”) rose by only 1% in the six months to July versus a 7% gain in the prior half-year.

Commodity prices, meanwhile, have softened – the Journal of Commerce index of 18 industrial raw material prices is currently 7% below its level at end-March. The tight correlation between changes in E7 industrial output and commodity prices described in the earlier post has persisted.

The forecast of slower growth was based on real money trends and a leading indicator derived from the OECD’s country leading indices. Both remain soft but suggest that economic weakness will abate. Commodity prices, therefore, may stabilise or revive in late 2011, although a return to earlier strength is not yet signalled.

E7 six-month real narrow money growth has revived from a low in May but remains historically weak. The increase partly reflects a slowdown in inflation that should extend into late 2011 as food and energy price pressures abate. Lower inflation, in turn, should allow monetary policies to ease in some emerging economies.

The OECD-based leading indicator bottomed in April and has led six-month industrial output growth by between two and five months at the last four turning points, suggesting that economic momentum will revive from September at the latest. Caveat: the latest indicator reading is for July – it may suffer a setback in August because of financial market weakness.

A recent pick-up in the Baltic dry index of bulk freight rates could be an early sign that E7 industrial weakness and associated commodity price declines are approaching an end.

Some bearish commentators claim that the world economy has not yet recovered from the 2008-09 recession. This is patently untrue. A proxy for global industrial production, comprising output in the G7 economies and seven large emerging economies (the “E7”), stood 4% above its pre-recession peak in July – see first chart.

True, G7 output is still 8% below the prior peak, though has recovered 15% from its early 2009 trough. This sub-par performance, however, reflects the rapidly-rising weight of emerging economies in production and demand rather than global weakness. E7 industrial output has surged 36% since early 2009 to stand 23% above its pre-recession high – second chart.

Numerous posts over the last two years have drawn a comparison between the recent cycle and the 1974-75 recession and subsequent recovery. G7 industrial output fell by 12% in the mid 1970s, similar to the 14% decline in G7 plus E7 production during the recent downturn. (The G7 dominated the capitalistic world in the 1970s – the E7 economies were small and isolated.) G7 production rose by 16% in the first two years after the trough (i.e. between May 1975 and May 1977) versus a 21% G7 plus E7 increase between February 2009 and February 2011.

The recent loss of global economic momentum also echoes the 1970s, as shown by the third chart, which compares annual industrial output growth across the two periods. The cyclical resemblance suggests that another global recession will be avoided and that output weakness will abate in late 2011 ahead of a pick-up in 2012. Interestingly, such a scenario is also implied by stronger G7 real narrow money expansion since the spring, documented in several recent posts.

The MPC-ometer’s suggestion that a majority would vote in favour of more QE this month proved incorrect but the minutes are likely to reveal a further dovish shift, with Adam Posen no longer isolated. Perhaps some members were deterred from voting for immediate action by the apparent assault on the Committee’s independence by Chancellor Osborne in a speech earlier this week, in which he stated that "we will do everything we can to keep monetary conditions throughout the economy as growth-friendly as possible” (noted by David Smith).