A mug’s game – propped up by printed money

British politics has perked up – to say the least. It’s just over a fortnight since the dramatic local and European elections in which Ukip surged. Now we’ve seen a riveting Newark contest, featuring a Tory fight back.

With all this, plus open warfare in the cabinet and the Queen’s Speech, complete with fainting pageboy, the Westminster village has been on overdrive. Domestic politics has dominated the airwaves over the last week – and that’s great. Clearly an econo-nerd, I’m a political junkie too.

It strikes me, though, that almost all the political analysis we hear takes it as given that the UK economy is fast-improving and, as the May 2015 general election approaches, will get better still. That may, indeed, happen and I certainly hope it does. Yet, away from high-octane TV psephology, economic news has emerged since last weekend, particularly from abroad, which could ultimately mean all political bets are off.

The United States, still the world’s largest economy by far, contracted sharply during the first quarter of this year. American GDP fell at an annual rate of 1pc during the first three months of 2014 on official figures, the first drop we’ve seen since the dark days of 2011.

America seemed well on the road to recovery, with national income expanding a buoyant 2.6pc during the last quarter of 2013. Now there’s a worrying snap-back, raising serious questions about the sustainability of the US recovery – and, in turn, the global economic outlook. For all the talk of China and the other fast-growing emerging markets, not least from me, America still makes the economic weather – and is the source of a fifth of Britain’s international trade. Granted, the US had a terrible winter, with unusually freezing conditions closing factories and construction sites. And, yes, this alarming GDP downgrade was partly explained by the revision of private firms’ inventories.

But the warning signs are there. Business investment – a vital metric of American corporate confidence – plummeted no less than 7.5pc during the first quarter. US exports were 6pc down. While household consumption rose between January and March, the latest Commerce Department figures show American shoppers retrenching, with consumer spending falling 0.1pc in April. This was the first drop in a year and, adjusted for inflation, the steepest decline since the crisis-ridden summer of 2009.

Three times since the sub-prime debacle, the US has shown signs of reaching “escape velocity” and staging a sustainable recovery. On each occasion, it then dropped back, into stagnant uncertainty, the global economy then spluttering too. A big problem is that American consumers, for so long the engine of world growth, remain on their uppers. The median US income is still 8pc lower in real terms than it was before the Lehman collapse. Although the overall economy is bigger, vast wealth has surged to the dormant coffers of the super-rich, away from ordinary Americans who’d actually spend it. This is one of the defining trends of our time, the hollowing-out of the middle class, not least in the States.

There’s a reasonable chance the US will bounce back with much better second-quarter GDP numbers. That happened in 2011, when a 1.3pc contraction was followed by a 3.2pc surge. America’s government bond market, though, also indicates there are serious storm clouds on the horizon. Falling bonds generally signal bad growth prospects and, having started the year at 3pc, the 10-year US Treasury yield has since plunged to 2.49pc.

Since shares are supposedly valued on future corporate cash flows, which in turn depend on future growth, such bond market behavior would ordinarily be associated with weak equities. Yet leading US stock indices are now testing their all-time highs. No matter that GDP is contracting or that America’s first quarter corporate earnings were down 3.4pc. The US stock market – possibly the world’s most important indicator when it comes to maintaining global economic optimism – keeps going up and up.

Why? Because America is still hooked-up to the Federal Reserve’s money-printing machine. Yes, the Fed has been “tapering”, slowing down the rate at which virtual money is being created. But the sheer scale of quantitative easing, at $45bn a month, remains vast. And don’t forget the “bad news is good news” market mantra. Worrying GDP numbers, after all, increase the chances that the Fed will relent and slow down, or even reverse, it’s tapering exercise, turning up the dial on the funny-money machine, and thus stock prices, anew. That remains the working assumption on Wall Street and across the world’s major equity markets. Forget GDP growth, forget corporate earnings, forget company analysis of any kind, in fact. It’s all about the Fed.

This blatant rigging of Western equity markets has gone on for several years now, with stocks soaring due to QE despite shaky economic fundamentals. While no-one knows when it will end, several technical indicators relating to US stocks have lately turned red. Margin debt, money borrowed by sophisticated investors to fund share sales, having peaked in January, is now falling hard. Trading volumes are also wafer thin, with an average of just 1.8bn shares in S&P500 companies trading daily over the last month, the lowest since 2008.

Again, it’s a mug-game to call the top – far riskier, and much less scientific, for instance, than studying opinion polls to predict domestic voting trends in particular UK constituencies. Be in no doubt, though, the US and several other major stock markets are on an knife-edge, sporting valuations entirely detached from economic reality and propped up by printed money.

This situation could indeed continue until May 2015 and beyond. The Western world could carry on regardless, with the UK economy strengthening as is now so widely assumed. But such a rosy outcome may not happen – and, however ghastly it is to think about it, these latest US numbers significantly increase that probability.

Then there’s the Eurozone, which accounts for around half of the UK’s overseas commerce. It is really wise to blithely assume that monetary union will remain stable, crisis-free, until the middle of next year and into 2016? Again, I sincerely hope that happens but I have my doubts. Another single currency meltdown, such as we saw in the summer of both 2011 and 2012, would obviously bring instability to UK financial markets and our broader economy too.

The Eurozone remains on the brink of recession. The 18-nation currency bloc expanded a mere 0.2pc during the first quarter, we learnt last week. Of even more concern is that inflation in May was just 0.5pc, worryingly close to deflation – which, if it took hold, could see spending fall off a cliff and widespread household and corporate distress as real debt-burdens soar.

There’s a deflation risk, in my view, because Europe’s zombie banking sector remains moribund, awash with bad debts. As a result lending has contracted every single month since the start of 2012, doing much to explain the eurozone’s economic torpor.

Rather than forcing write-downs, and restructuring the banks, it now looks as if the European Central Bank, against Germany’s better judgment, will soon join its US and American counterparts in conducting overt QE. In the meantime, as ECB boss Mario Draghi told us last week, negative deposits rates will be used to try and finally break the Eurozone’s credit crunch. To say this is an untested, high-risk strategy is an understatement.

Western equity markets are in never-neverland. Western monetary policy is beyond the pale. Yes, the UK recovery may continue, in keeping with the “feel-good factor” political narrative. But that’s a very long way from certain.