Financial markets have been on a wild ride since the year began. Prices of equities, bonds, currencies and commodities have fluctuated, sometimes wildly, and have confounded the forecasts of the best pundits. How does an investor make sense of this market turbulence? Perhaps a good starting point is to try to clarify the likely directions that the major determinants of investment returns — cash flows of companies, valuations and currency changes — will take. If we do so, three things become clear:
• Volatility is here to stay,
• The challenge from deflation is real, but probably exaggerated, and
• Economic growth prospects are likely to be better than consensus thinks.
Volatility is here to stay:
The great unwinding
There will be no respite from the wild swings in financial markets for a simple reason. There is a great unwinding going on in geopolitics, monetary conditions and the imbalances that have built up in major emerging markets. This unwinding changes some of the basic parameters that drive markets and does so in an unpredictable manner — which means that markets will keep being taken by surprise.
First, the impact of geopolitical developments is becoming even more difficult for investors to predict because basic political structures that have been around for decades are breaking down:
• In previous columns, we have pointed out the unravelling in the Middle East, with countries such as Libya, Syria, Iraq and Yemen coming apart at the seams, creating unknowable implications for the rest of the world. While recent weeks have seen modest progress in bringing the extremist Islamic State group under control, other fractures within these countries continue to deepen, while the challenges of political succession, especially in some monarchies, will become more acute. Political risks could well cause oil prices to spike up or instigate religious tensions in our region.
• In Europe, a new Cold War has started: The Ukraine crisis has reignited, with the US now threatening to counter the alleged inflow of Russian soldiers and weapons with arms supplies to the Ukrainian government, a move that could well precipitate serious tensions between Russia and the US. Even if ongoing efforts by Germany and France to broker a compromise do succeed, chances are that the respite will only be temporary, given how many other ceasefires have broken down.
• In the rest of Europe, dissatisfied voters are expressing their disgust with the current political elites and the austerity policies that much of Europe has followed: There is a real risk that elections will bring more radical parties closer to power, which will then crystallise huge policy uncertainty. For example, in the UK, the rise of anti-European and anti-immigrant sentiments has forced the ruling Conservatives to promise a referendum on membership of the European Union by 2017. This means that a Conservative victory in the May 2015 election will usher in a two-year period of extreme uncertainty, which will set the country’s economic recovery back. There are also major elections in Spain and Portugal, two other crisis-hit countries, at the end of the year.
Second, debt, real-estate and other investment bubbles are unwinding in some countries just as financial or monetary imbalances are turning critical in others: This is a particular concern in emerging economies and especially in China, where several things are going wrong at the same time — economic activity has lost steam despite calibrated policy stimulus; a massive overhang of excess capacity is undermining the incentive to invest and depressing pricing power; corporate profitability is consequently falling, straining the ability to repay the huge debts that have built up; and the real-estate sector is losing momentum despite strong demand among urbanites to upgrade to better-quality homes. We are in uncharted territory in China because poor data makes it hard for us to truly understand the risks, while even poorer transparency in financial arrangements and policymaking compounds that inability to accurately assess risks. Note that the Bank for International Settlements (BIS) has raised concerns over the surging cross-border claims on China that grew at annual rates of close to 50% in 2014, bringing the outstanding stock of cross-border claims on China to US$1.1 trillion — thus, any stresses in China will have global repercussions.
Third, the extraordinary monetary easing in the US is being unwound just as the eurozone is going in the opposite direction, while Japan maintains its aggressive easing. This will produce even greater financial volatility:
• The BIS has flagged its concerns over how this divergence leads to substantial changes in currencies, in particular a stronger US dollar. In Asia, some currencies have depreciated more quickly than others, raising concerns in countries with relatively firmer currencies that their export competitiveness might be at risk. If these countries intervene to weaken their currencies, we could see competitive depreciations that create even more uncertainty.
• The BIS worries that the combination of a strong US dollar and weak commodity prices has produced sizeable currency depreciations in emerging economies, which piled up large increases in US dollar-denominated debt during the boom years, but will now struggle to repay that debt in ever-more-expensive dollars.
• With the US Federal Reserve certain to raise rates later in the year, global investors will be looking to reallocate capital back to the US and out of emerging markets. It does not help that large emerging economies such as Brazil, Turkey and South Africa are facing a comeuppance after years of policy errors that have made investors jittery. As capital flows out, there is likely to be a scramble for US dollar funding in these emerging economies, which will create more financial strains there.
Deflationary risks are not as dangerous as advertised
Recent months have seen very low inflation or even outright deflation in many countries across the world. Some observers worry that deflation will hurt economic vitality because it raises the real value of debt and strains repayment ability, potentially causing some distress. The last thing a world awash with debt needs is to lose the easy option of allowing high inflation to reduce debt burdens. Moreover, deflation is also more difficult for central banks to tackle because interest rates can only be cut to zero, not below. But if there is deflation, even zero interest rates will mean positive real interest rates, which can hurt economic health. Also, deflation encourages consumers to cut back on current spending and save more — on the basis that deferring spending will give them an opportunity to buy desired objects at a lower price later.
So, there are clear downsides from the low inflation/occasional deflation evident around the world. Still, we would argue that the risks are contained, for two reasons. First, there is good deflation and there is bad deflation and what we are seeing today is more of the latter. Bad deflation arises from overly tight monetary policies or from a financial crisis that makes the credit system dysfunctional. Good deflation results from a sharp fall in costs as a result of efficiency gains, technological breakthroughs or the discovery of new supplies of raw materials. Much of what we are seeing today is good deflation. Oil prices are falling mainly because a technological breakthrough helped spark off the shale oil revolution. Another example is the fall in unit labour costs in countries such as Spain and Portugal: This necessary adjustment is helping the eurozone regain competitiveness. On balance, we would say that deflationary risks have been exaggerated.
Second, policy action is being taken in the regions at the greatest risk of suffering from bad deflation. The European Central Bank is about to embark on its form of quantitative easing, while Japan is maintaining a fairly aggressive pace of QE as well. Policy moves should contain the worst risks from bad deflation.
Economic growth drivers probably better than expected
If volatility is bad news and deflation, a mixed story, at least the outlook for global economic growth is good. In essence, prospects for the G3 economies are brightening, while lower oil prices and falling bond yields are additional and powerful positives, helping economic growth across the world.
In the US, a set of mutually reinforcing drivers is falling into place, which is likely to fuel stronger growth there — recoveries in labour, credit and housing markets interacting together to boost growth. After months of poor data, there is even some glimmer of hope in the eurozone, where industrial production in France and Italy rebounded smartly in December, while Japan, too, is beginning to eke out some better numbers. The rise in the latest Organisation for Economic Co-operation and Development composite lead indicator suggests a pickup in global economic growth from around 2.5% last year to around 3% this year. In other words, when the pluses and minuses are toted up, the bottom line is still an acceleration in global growth.
Implications for the investment environment
In essence, a stronger global economy and policies to counter deflationary risks should be positive. But the practical effect of a likely series of political and financial stresses will be to keep financial markets off balance and gyrating unsteadily through much of the year. Even professional investors will struggle to make decent returns, especially on equities, which means layman investors should tread very carefully indeed.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy
This article first appeared in Forum, The Edge Malaysia Weekly, on February 23 - March 1 , 2015.