“Reaching the bottom of the slump is not when you start with exit strategies. We need to choose a point when we’ve already got some way out of the trough”. So said German Chancellor Angela Merkel today at the G8 summit in L’Aquila, Italy. The comments signal something of a volte face by Merkel, a leader in the “sound money” mould typical in Germany. Last month she was urging EU leaders to formulate “reliable and credible exit strategies” and she began this week’s summit in the same vein.
President Obama echoed Merkel’s new found sentiments. He said that the G8 leaders “agreed that full recovery is still ways off, that it would be premature to begin winding down our stimulus plans”. But only a few days prior he said that spending more borrowed money would be “potentially counterproductive”. Even the consensus that “the worst was now behind us” was broken by Russian President Dmitry Medvedev. “It’s not quite clear whether we’ve hit bottom and how long the crisis will last”, a view somewhat more pessimistic than his G8 counterparts.
The lack of clarity emanating from the summit was all too predictable. The event has been farcical from the start, with Italy’s leadership non-existent. But there has been a noticeable change in tone over the past few weeks, both from politicians and investors. The talk of inflation running out of control has dissipated, replaced by concerns over a double-dip recession. A realisation that large output gaps in the major economies mean excess inflation is unlikely has sunk in, though the hawks are still vocal in their intransigence.
Credit markets have reflected the uncertain mood. The prospect of the Markit iTraxx Europe index breaching the 100bp level – as it nearly did at the beginning of June – now seems a long way off. Spreads have widened considerably since then in anticipation of anaemic growth in the second-half of the year. Risk aversion is now the name of the game; Keynes’ animal spirits are in short supply. Today’s US consumer sentiment survey, the latest in a string of disappointing economic releases, added to the pessimistic mood. The University of Michigan index fell to 64.6 from 70.8 last month, suggesting that rising unemployment is taking its toll on the US consumer.
Investors have been waiting for earnings season to provide some direction. It got off to a relatively good start, with Alcoa posting a lower than expected loss. But Chevron’s warning that its second-quarter earnings could disappoint has hit markets today, sending spreads wider. The March-June rally was propelled by positive surprises from corporates, as well as decisive actions from governments. A reversal in fortunes could trigger a sustained sell-off, though spreads are unlikely to return to March levels. A second fiscal stimulus – though anathema to Merkel and her cohorts – could follow.