Sharp corrections in the prices of equities, bonds and commodities dominated the headlines recently as the exuberance of financial markets in the past few months gave way to volatility and uncertainty. Some argue that this is just one of those healthy market corrections that will eventually pave the way for another round of upward moves. But others fear that this episode is a prelude to a more prolonged period of financial market weakness. Which is the better explanation and what does it mean for our part of the world?
Two big changes: diminishing liquidity …
If we look beyond the day-to-day turbulence, we can see two big changes that will drive financial markets in the near future: Liquidity conditions for financial markets will tighten and market psychology will be more susceptible to nervousness.
First, liquidity is becoming less supportive of financial markets.
Our proxy measure for the liquidity available to drive financial markets shows that this vital source of market support has been contracting modestly since late 2017, after growing rapidly for many years. Well before central bank tightening drives liquidity down, the growing appetite of a recovering corporate sector for funds is absorbing existing liquidity and diverting it away from financial markets.
There are several reasons this will get worse. For one, analysts estimate that by the third quarter of this year, global central banks’ purchases of bonds will turn negative. That means a powerful source of extra liquidity will disappear.
Moreover, this liquidity decline could turn into a crunch as central banks become more determined to tighten monetary policies. For example, even as the financial turbulence was shaking markets, the Bank of England made it clear that it would be raising rates earlier and faster than planned. Similarly, in the US, influential policymakers were undeterred by the market disturbances: For example, New York Federal Reserve president William Dudley said that up to four rate hikes might be needed in 2018 as opposed to the three rate increases that the Fed had earlier penned in.
This pattern of monetary tightening is also evident in emerging economies. China is clearly pursuing more restrictive credit policies in an effort to reduce leverage in the economy. With some exceptions such as Brazil, where inflation is receding, and Turkey, emerging market central banks are more likely to tighten policy rather than ease.
… and more nervous investors
The second big change in drivers of markets is the psychology of investors. For many years, easy money dominated and shaped market behaviour. Because their overwhelming priority was to contain downside risks, central bankers kept monetary conditions as loose as possible. In that salubrious environment, corrections in financial markets were fairly quickly reversed. Investors were therefore persuaded that a strategy of buying markets on dips would work well for them. This has been a good strategy — until now.
Now, with the shock of recent market losses fresh in their minds and the growing likelihood that
liquidity conditions will turn down, buying on dips may not work so well any more. This is a significant shift in psychology. It means that, where before investors were super-sensitive to good news, driving markets up on even spuriously positive news while downplaying bad news, it will now be the reverse: More nervous investors will tend to be sensitive to bad news while downplaying the good news.
In other words, even if markets bounce back, investors are likely to be so cautious that the rebound will be tenuous and fragile.
The market environment will get increasingly fragile
Unfortunately, the story does not end here. There are several political and economic factors that could compound the investors’ sense of unease.
One is global growth, which you would think is a good thing. But, we could soon have too much of this good thing. The reason is that while central banks are likely to tighten monetary policy cautiously, governments are turning on the fiscal spigots more enthusiastically. Recent moves to step up spending in the US are not unique: The new coalition government in Germany is set to ramp up spending as well. Similarly, in emerging economies such as India, recent budgets suggest a renewed urge to add demand to the economy through fiscal spending. With global growth already robust, this added demand will probably create excess demand and lead to more inflationary pressures.
In this context, the direction of US fiscal policy is a particular risk. The latest bill to be passed in Congress would raise defence spending by about US$165 billion over two years while expanding other domestic spending by about US$131 billion over the same time frame — according to its promoters. But, many independent economists believe that the actual spending could be much larger. The amounts are huge, even for the US$20 trillion US economy, adding something like 0.75% to 1.25% of GDP at a time when the economy is already at full employment. And, Congress is still not done with additional spending plans — there could be more spending if President Donald Trump’s desire for massive infrastructure projects materialises. All this would almost certainly raise the risks of the economy overheating.
What are the consequences of this fiscal trajectory?
An immediate issue will be the dilemma that the Fed now faces. If it hesitates to tighten policy more aggressively in the face of this potentially inflationary fiscal stimulus, its credibility would weaken, prompting bond yields to rise even more as markets lose confidence in the Fed’s inflation-
fighting credentials. Financial distortions would grow as liquidity remains over-easy. However, if the Fed acts aggressively, raising rates faster to contain inflationary expectations, bond yields would still rise, albeit modestly, but the near-term risks for financial asset prices will be very high.
The longer-term consequences of this fiscal profligacy are even graver and markets are seriously under-pricing them.
First, the surging fiscal deficits would almost certainly widen the US current account deficit. The current account deficit reflects the savings and investment behaviour of the economy. The trouble is that households and the government are reducing their savings rate. The household savings rate has already fallen sharply in recent months, to just 2.4% in December from above 5% in 2013 to 2016. As the new tax and spending policies boost deficits, the government’s savings rate is falling further. Assuming little change in corporate savings, then the combination of this falling savings rate and the likely step-up in investment would be to push up the current account deficit from around 2% of GDP to 3% to 4% of GDP. Then, we would again have a replay of the global imbalances that troubled the world economy a decade ago. If that happens, the US dollar would also be at risk.
Second, given the protectionist tendencies of the Trump administration, any such deterioration of the US external deficit could well be blamed on its trading partners and be used as a reason to impose even more trade restrictions.
Third, the medium-term projections for the US fiscal position were already worrying before this spending binge. Given the ageing of the population, the country needs to build fiscal buffers so that the federal government can continue to honour its obligations on social security and other entitlements. Such entitlement spending is forecast to grow explosively after 2019. Instead, Congress is doing the opposite, as its planned spending surge will amplify budget deficits on a grand scale, turning what could be a parlous but remediable situation in the 2020s into a very dangerous one. The US bond yields are bound to soar over time.
What could happen in the near term?
In short, markets will be nervous in the short term and over time will be focusing on the long-term pitfalls. Investors will be highly sensitive to any bad news. The problem is that there are many more things that could go badly wrong in the coming months than things that could go brilliantly right:
• US political risks: Trump’s election campaign is the subject of a special investigation by Special Counsel Robert Mueller: The indictments of some of the Trump campaign staff could suggest that Mueller is closing in on something that could embarrass or even undermine the president. If Trump decides to fire Mueller as has been rumoured, that could spark off a constitutional crisis;
• Trade tensions: The renegotiation of the North American Free Trade Agreement has been making slow progress and is entering a tense phase. Trump’s trade team may see value in threatening a US walkout from Nafta to pressure Canada and Mexico. It is also clear that there will be a rash of measures against China in the coming weeks and months. China has indicated clearly that it will retaliate against any US restrictions; and
• North Korean nuclear programme: North Korea and South Korea have edged closer in recent weeks. A high-level North Korean delegation attended the opening ceremony of the Winter Olympics that South Korea is hosting. Both Koreas also agreed to jointly field an ice hockey team for the games. North Korean leader Kim Jong-un has used the diplomatic opening to invite South Korean President Moon Jae-in to visit North Korea. This apparent thaw in North-South relations might appear to have reduced the chances of conflict. But, it has emerged that some kind of US military strike might be in the planning stage. The Trump administration withdrew the nomination of a highly regarded academic as ambassador to South Korea, reportedly because he objected to the idea of the US conducting a “bloody nose” military strike on North Korea. Senior administration officials such as national security adviser H R McMaster and others have raised the possibility of a “preventive war”. One thing is certain — the US sees a credible North Korean nuclear capacity as a threat that cannot be tolerated and will have to do something about it.
So, what does all this mean for our region?
In essence, the fundamentals have shifted in favour of rising bond yields and tighter liquidity conditions for markets in the near term. In the longer term, the damaging consequences of current US fiscal policies will gradually be reflected in investor thinking and pricing of assets. In this nervous environment, there are enough potential flashpoints that could act as triggers for more rounds of severe market corrections.
Financial market pressures will therefore grow on the region’s equity, bond and currency markets as global investors cut back exposure to riskier emerging-market assets. Countries that are likely to be most vulnerable will be those with current account deficits and high levels of foreign ownership of stocks and bonds such as Indonesia. However, Indonesia and other countries in the region have improved their economic fundamentals since the 2013 “taper tantrum” and have built further policy credibility with investors. Indonesia is thus probably less exposed to damaging outflows than in 2013. In other words, there will be more downside in regional markets, but the worst of the knock-on effects on currencies and the real economy can be contained.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy