A few days ago we underwent a reallocation of risk due to the increasing divergence between markets and real fundamentals. We are not secularly bearish, in part because it is difficult to see asset prices fall when faced with the wall of liquidity central banks are producing. But asset prices (equities in particularly) went from “clearly cheap” to “not obviously cheap” while economic fundamentals continued to deteriorate or have not shown any sign of improvement. Maybe the lows in May were a bit extreme, but the cheapness that ensued was partly justified by the risks of a euro break up, among other things. We have come a long way since then on asset prices, not enough on fundamentals.

Almost regardless of which region or country one looks at, high frequency data (industrial production, exports, or GDP proxies) continue to show a very soft economy. The most concerning of all is Asia, where China is obviously the big concern. There we have the combination of politics (transition to a new Party elite, which has not been void of noise and drama), difficult data and policy setup, with a historical economic phenomenon of economic convergence. As we have highlighted a few times before, it is very unlikely that any country can grow at an 8-10% pace for a long period of time. Though economics is not physics, economic convergence in China is bound to respect the deep and accepted growth literature as well as the history of other countries that transitioned from very low levels of GDP per capita to become medium or high-income countries. Even though China is still far from being a medium to high-income country, the labor markets are already showing signs that the capital labor ratio is converging. We appreciate the difficulties in judging the Chinese convergence path, or its business cycle around the medium-term convergence. We do not claim to be experts on those. But we do assign a higher than average probability to the possibility that we are witnessing a convergence to 4-6% growth rates as opposed to go back to 8+%. Though 4-6% for today’s size of the Chinese economy would still be a significant growth factor for the rest of the world, markets are fixated in a policy induced return to 8+%.

Other risk factors that justify short-term cautiousness are the so-called ‘fiscal cliff’ in the US, and its timing vis-à-vis de elections, as well as what the election result might mean not only for tax reform but economic policy in general, as well as politics in Europe around Spain and Italy applying for ECB help.

As we said repeatedly here (see previous posts), what the ECB has done is not only smart and necessary, but potentially a game changer for the euro. It has reduced (almost eliminated) the probability of a bad surprise in the short-term. However, politicians still need to act on short and medium-term issues. In the short-term they need to lay down reforms locally that make the bailouts credible (Spain has just announced them), which then allows the EU and then the ECB to provide the assistance that can sustain those economies as they transition to better health and hopefully growth. At the same time, the EU needs to move on the structural reforms at the Union level, towards a banking union and a fiscal union that would complement the monetary union. Having decided to put the ECB balance at play is a tremendously important decision, but it is not at all enough and can only sustain markets for so long.

It is more than anecdotal that fiscal uncertainty in the US has affected economic decisions (investment, consumption, thus slowing the economy). Cash in companies balance sheets is one very important data point (almost 2 trillion dollars), as well as bank deposits at the Fed (almost equivalent to the Fed’s balance sheet expansion). Then there are estimates of what large multinationals have also hoarded in cash globally ex-US. The elections (Nov. 6) will be the first step in a not so short path to clarity. Overcoming the fiscal cliff would most likely be the first political negotiation, which might happen before year-end, to be followed by a more relevant and fundamental debate and negotiation on tax reform and a medium-term fiscal adjustment profile. Though many ideas have already been debated, and despite the results of the elections we think a growth-enhancing tax reform is bound to happen, the politics and timing of it is not that obvious.

In sum, economic fundamentals have not responded yet as positively as markets have done to the wall of liquidity produced by central banks, and in most of the developed world there is a non-trivial host of more fundamental policy decisions that need to be made to reduce uncertainty and allow for a fertile growth environment.