Waiting for risk markets to bounce
While risk markets look a little shaky in the near term, the prospective easing of the world’s major central banks could see optimism return later in the year, writes Andrew Hunt.
It has become a tradition for the majority of the world’s economic forecasters to start the year with an optimistic frame of mind.
This has certainly been the case for the last five years and the consensus view is that 2014 will witness the long-awaited surge in US capital expenditure, an economic recovery in Europe, a re-balancing of China’s economy towards more consumption-led growth and Japan’s emergence from its lost decades.
These are the types of high hopes that have been dashed before; however, on this occasion forecasters have been able to take heart from a slew of seemingly very buoyant confidence indices such as the US and European Purchasing Managers’ Surveys.
Unfortunately, the messages that emanate from these surveys have been heavily influenced by an unfortunate level of distortion within the seasonal adjustment processes that take place.
Specifically, the exact timing of the global financial crisis in 2008 had the effect of “cancelling Christmas” for many companies and this Grinch-like phenomenon distorted the seasonal adjustment systems to such an extent that even today many of these models now implicitly assume that Christmas has been cancelled indefinitely.
The result is that they tend to portray the customary year-end surge in consumer spending (in Europe, some 40 per cent of annual retail spending occurs in the run-up to Christmas) as a change in the underlying economy rather than merely a regular seasonal event.
As such, much of the survey data has been biased upwards and many forecasters both in the public and private sectors have perhaps set their sights too high.
An examination of the more objective economic data for the USA shows that last year’s rapid growth in the transportation sector is cooling and that housing market data has begun to look a little more equivocal. Crucially, household disposable incomes are falling in nominal terms despite the rise in total employment.
Moreover, much of the recent increase in the volume of total consumer expenditure has been the result of rising energy consumption associated with the very cold weather.
As most people in the real world know, having to pay more simply in order to keep warm generally reduces the amount of money left over for more discretionary spending in the future, particularly within a weak income growth environment.
In Japan, it’s true that nominal wages have started to increase for the first time in almost a decade but unfortunately the forthcoming hike in the goods and services tax rate will imply that consumer prices will rise by even more, with the result that real wages will decline this year.
Meanwhile, outside a few specific areas of the service sector, such as warehousing, corporate expenditure trends remain essentially weak. Therefore, in the near term at least, Japan’s rate of economic growth may also disappoint the optimists.
Development lags
In Europe there remains a great deal of optimism over growth although actual momentum is slowing, particularly in Germany, Holland and Spain.
France and Italy may be stabilising following an ‘opportunistic’ easing of fiscal policy but generally there’s little evidence that Europe is bouncing back.
Indeed, household incomes in most countries are continuing to fall and the credit crunch seems to be getting worse rather than better. It therefore seems that economic growth in much of the developed world is likely to disappoint.
The expected result is that earnings forecasts for companies will soon be revised downward quite heavily.
Unfortunately, it’s not only in the developed world that economic growth rates seem set to disappoint. In the years that followed the global financial crisis, monetary policies in the West gave rise to an almost unprecedented surge in global capital movements, many of which found their way into the emerging markets.
These flows had the effect of stimulating not just asset prices but also the underlying real economies, with the result that many of the emerging markets not only overheated but became addicted to further capital inflows via their expanding current account deficits.
However, as the developed world’s central banks have started to moderate their quantitative easing regimes over recent weeks, the flow of credit to the developing world has started to diminish.
As such, we’ve witnessed weakness in many emerging market currencies and slowing domestic growth.
These slower rates of growth are already impacting earnings forecasts not just for domestic companies but also for many of the world’s multinational corporations.
Perhaps more importantly, the weakness in the emerging market currencies is creating a deflationary bias within world trade.
Over the last 20 years, the outsourcing of production from the developed to the emerging world has made global inflation rates much more sensitive to emerging market inflation and currency trends, with the result that even the usually upbeat IMF has recently begun to warn about the rising threat of outright deflation within the global system.
As Japan has shown, deflation disadvantages debtors in (both the public and private sectors) and compresses both corporate earnings and investment spending.
Contrary to the consensus’s expectations for 2014, the current situation is positive for high quality bonds but essentially negative for share markets.
It could also be argued that the implied deleveraging within the emerging markets is positive for the US dollar but negative for the commodity and cyclically sensitive currencies, such as the Australian dollar.
However, in time the world’s central bankers will be obliged to react to the weaker than expected economic conditions and the renewed threat of deflation.
Hence, by the second half of the year, easier monetary policies in the developed world are envisaged alongside a revival in global capital flows and a possible return of optimism within the financial markets that will likely be share market friendly, bond market negative and negative for the US dollar.
Consequently, 2014 could be a game of ‘two halves’ in which investors may have to be quite nimble.
All eyes on China
Of course there are unknowns within this forecast. Firstly, there’s the assumption that the world’s central bankers will be prepared to launch yet another quantitative easing despite the growing dissent over the longer term costs of QE from academia and their own ranks.
Secondly, there’s the assumption that the slowdown in the near term won’t morph into an economic crisis. With regard to the latter, China will be the key determinant of this risk.
It’s now accepted that China’s rapid economic expansion since 2009 was built primarily on huge levels of credit-financed capital spending.
What is less appreciated is the extent to which China’s credit boom was itself financed by massive borrowings from abroad. Indeed, China may well have become the world’s largest foreigner borrower nation over recent years.
Therefore, on the basis that global financial crises tend to occur not only when large sums are involved but also as a result of ‘things that the markets were previously unaware of’, China stands out as being a potential source of stress for the global system.
For example, Hong Kong’s banks have borrowed very significant amounts of dollars, yen and euros in the short-term international credit markets and then used the resulting funds to fund the acquisition of very large long-term claims on Chinese entities.
As a result, Hong Kong’s banking system has currency, credit and duration risk with regard to China that may be larger than is prudent.
There are real fears that if the Western central banks fail to reflate global capital flows quickly enough, China’s economy could be drawn into the whirlpool of weak currencies, weakening financial systems and contagion effects that has already engulfed Turkey, Argentina and others.
A similar type of event befell China in 1994 but at that time China was only the equivalent of 6 per cent of US GDP and the financial links between China and the rest of the world were relatively minor.
Today, China is the second largest economy and any balance of payments-induced weakness in China – that would in all probability be beyond the scope of even China’s government to manage - would lead us to become a great deal more negative over the outlook for world growth and share markets this year.
In summary, although the risk markets may find conditions difficult in the near term, if the world’s major central banks ease before China can run into too many problems, then there’s no reason why optimism could not return to share markets later this year.
Andrew Hunt is the director of Andrew Hunt Economics and a consultant to van Eyk Research.
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