by David Bassanese

Global stock markets these days are looking for any excuse to rally. But some excuses are better than others.  

The steady progress in the United States economy is a justifiable cause for celebration. So too is China’s still encouraging efforts to re-balance its economy, albeit to the detriment of local miners. There are also welcome signs of a revival in Australian business and consumer confidence, helped by the housing sector recovery.

But some excuses just don’t hold water – in particular, investor hopes that central banks of Europe and Japan will do what it takes to revive their own moribund economies.

As Australia’s Reserve Bank Governor Glenn Stevens has made plain in recent weeks, central banks can only do so much. Central banks can slash interest rates and encourage business to invest and employ more staff, but it can’t make them if they still don’t see any profits in it even with cheap money.  

To paraphrase Stevens, “you can lead a horse to water, but you can’t make it drink.”

Perhaps in exasperation, our own central bank has recently lamented a lack of “animal spirits”, and expressed frustration that even in Australia businesses seem more intent on hoarding cash and paying out bumper dividends than investing in new investment opportunities.

Yet with cautious local consumer spending, a still high Australian dollar, collapsing commodity prices, and austere fiscal policy out of Canberra, it’s hard to blame business for not wanting to invest all that rapidly. 

That said, we can be confident business investment in Australia will eventually pick up – indeed, given recent improvements in monthly business confidence indicators, Thursday’s official June quarter capital expenditure survey is likely to reveal a further modest improvement in non-mining investment intentions, thanks in particular to the flow on effects of the housing boom.

Australia still has a fairly competitive economy and solid underlying population growth. Long-run potential growth for the economy is still around three per cent or so.

Similarly, we can have confidence that the American economy will grow reasonably well over the medium-term. Its economy is even more competitive than our own, and also has reasonably good underlying population growth. It’s because of the sound underlying foundations of the American economy that low interest rates and quantitative easing by the Federal Reserve have worked in kick starting economic growth after the shock of the financial crisis.

Sadly, the same can’t be said for Japan or Europe. The Bank of Japan’s desperate lurch into US-style quantitative easing has so far had a modest effect so far in lifting inflation and exports, though largely by cheapening the yen. Otherwise, not much has changed in the Japanese economy – population ageing and tight control on immigration mean growth in the working-age population is still going backwards. Its lack of market opening structural reform is also constraining the growth in labour productivity.  

Evidence of the mixed economic effects of Japanese QE policies is the fact the Nikkei has lifted only three per cent since May 2013, while America’s S&P 500 is up a further 20 per cent.

Europe seems to be slowly but surely going the way of Japan. The region’s pampered population is also ageing and very resistant to reforms that would threaten cosy but increasingly unaffordable social-welfare policies. Germany has undertaken some worthy labour market reforms – which has clearly benefited its economy - but the other major economies such as France and Italy remain resistant. 

Weak growth and expensive social programs, meanwhile, have left European government budgets under immense pressure. Fiscal austerity to deal with budget excess has only made the situation worse in the short-term – so much so that even European Central Bank Mario Draghi suggests government might ease up a little.  

And super Mario is still promising to do “whatever it takes” to support the region’s economy and avoid deflation.

But again, given the entrenched structural problems facing Europe, it’s hard to see how sending already low long-term European bond yields even lower will make much difference. In a sense, Europe – like Japan – seems in a classic “liquidity trap”, where business remains reticent to invest even with effectively free funding. What’s more, the housing and stock market wealth effects produced by monetary stimulus also don’t seem to be as effective in Europe and Japan as they are for with more highly leveraged households in the United States and Australia. 

Of course, as in Japan, one at least short-term positive from European quantitative easing might be a brief lift in exports and inflation due to even further weakness in the Euro. But that amounts to nothing more than continuation of the beggar-thy-neighbour global currency war, which has unfairly hurt the Australian economy.

It’s for these reasons I remain a long-term bear on both Europe and Japan. Some might suggest that reforms might come once their economic problems deepen – but I fear that that won’t be before possibly wrenching political stability, such as a lurch to right-wing nationalist fringe parties.

In short, long-term investors should not be duped into thinking central banks in Japan and Europe can fix their economies long-term growth problems – and these central banks should avoid giving the impression that they can.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.