As markets shook off recent shocks, investors pushed valuations up so much that equities and bonds seemed to be priced to perfection, leaving little room for error. Small disappointments in, say, earnings could thus lead to massive, outsized corrections in stock prices. Now that markets seem to be getting nervous again, and since macro considerations appear to be quite important, it is timely to think about the main political and economic assumptions underpinning current valuations. What could upset these investor perceptions and lead to abrupt corrections?
Aside from the continuing search for yield, another major factor has been investors’ need for relative safety. Because there has been a rash of deeply troubling events — Brexit, frequent terrorist attacks, the eurozone migrant crisis, the risks of a Donald Trump victory in the US presidential election in November and so many others — investors perceive the world to be a dangerous place and have moved funds to asset classes that seem safer than others, whether they are US and German bonds or the few emerging markets that seem to be on the upswing such as Indonesia.
The question is what can change these perceptions? Here are our best guesses in four key areas of risk.
US growth revives and Fed tightens faster than expected
The US economy appears to be caught in a low growth, low inflation trap for some time. Investors have grown wary of forecasts of a strong rebound after so many disappointments. They have convinced themselves that a myriad of reasons, such as low productivity, excessive business caution after the near-death experience of the financial crisis and deleveraging, will keep limiting the US economic recovery. That view has, in turn, meant that markets believe that the US Federal Reserve will only undertake the most minimal rate increases. We think the chances are growing that this view will be upturned soon:
• The data does show that the American economy is shaking off the lethargy that hit it in the first half of this year. Industrial production has turned around, with the manufacturing sector registering growth after a long series of contractions. Housing starts have also turned in a strong performance, a view supported by the improvement in home builders’ confidence. The drag on the economy from overly high inventories seems to be fading. The labour market is also registering consistent strength.
•Until recently, the Fed was signalling extreme caution on monetary tightening, giving the impression that they would jump on virtually any excuse to keep rates where they are. However, this week has seen a shift, with statements by two key Fed officials indicating that they believe the economy to be performing better and pointedly observing that markets might be too sanguine about the pace of Fed rate increases.
We believe that the US economy could well continue to provide gentle upside surprises, which will cause the Fed to raise rates at least twice this year. Perhaps this might cause some corrections in prices of risky assets but we suspect that the damage may not be widespread or sustained. In fact, if the Fed were to pursue the normalisation of monetary policy, they would be sending the message that, despite all the apparent risks, the US economy was performing reasonably well and returning to normal. It could even be the trigger to jump-start the missing ingredient in the US recovery — capital spending, which has remained unremittingly weak.
More good deflation and less bad deflation?
Another concern of investors has been that we are caught in a deflationary trap. Indeed, inflation has been persistently low for several years in developed economies and central banks’ efforts to push prices up have appeared to be unsuccessful. The trouble is that investors have not been distinguishing between good deflation and bad deflation. Good deflation stems from constructive developments while bad deflation stems from monetary policy errors or a breakdown in the credit system following a financial crisis.
We would argue that there is more good deflation than bad deflation now, and investors will gradually begin to appreciate this:
•In recent weeks, we have seen oil prices fall again and, despite a recent bounce, we see oil prices remaining low and keeping inflation in check. Oil price falls worry investors because they could trigger more defaults by indebted oil-related companies and because reduced spending by oil producers hurts demand as oil firms cut back on capital spending and oil exporting countries run into fiscal deficits and are forced to cut budgets. Certainly, the downsides from low oil prices are real and are usually felt upfront. However, there are substantial upsides from low oil prices — consumers can spend more, industries that use oil will enjoy higher profits, lower inflation allows central banks, especially in emerging markets, to ease monetary policy. Typically, these benefits become clearer only after a long lag, giving the impression that low oil prices are a bad thing. We believe we are at a turning point where the bad effects of oil prices are giving way to the uplifting effects.
• We have also seen food prices fall significantly in recent weeks. Since the middle of the year, prices of corn, wheat, soybeans, rice and palm oil have fallen. These food crops account for about 75% of the World Bank’s index of emerging markets food prices and hence, have a powerful impact on consumers in emerging economies.
Overall, deflation in all traded goods (primary as well as industrial goods) is easing, as shown in global trade data. We believe that the deflationary scare is coming to an end and that should be good news for investors.
What about China?
The most recent developments in China suggest that the risks will be to the downside.
At best, China’s astute policymakers will keep its economy from falling off the tracks but China’s impact on the rest of the world could well be more negative than positive.
• First, the jostling for power within the senior leadership is reaching a climax. In recent months, President Xi Jinping has been focused laser-like on ensuring that his loyalists squeeze out his rivals in the leadership line-up that will be announced at the 19th Congress of the Chinese Communist Party in late 2017. While the congress is still a year away, the key decisions are likely to be made in the next few months. Xi has attacked the Communist Youth League, which is the power base of Prime Minister Li Keqiang and former President Hu Jintao. He has also weakened the faction loyal to Jiang Zemin, who was China’s leader from 1989 to 2002. However, it is not likely that Xi’s opponents will simply cave in and go away. There is likely to be a pushback, which would complicate political risks. Moreover, it does also appear that economic policymaking has become politicised and part of the power struggle, which raises the risk of policy errors being made.
• Second, the economic data is discouraging. Despite tremendous policy efforts to boost the economy, the data for July showed across-the-board weaknesses in exports, industrial production and fixed investment. In particular, private investment is now barely growing, up only 2.1% in January to July over the same period last year — the slowest growth since records have been kept. Since private investment is about two-thirds of investment and total investment is about 45% of the economy, this persistent weakening is a big deal. Some may feel that this is too pessimistic a view on China. They should look at what domestic Chinese economic agents are doing: the trade and other data show clear evidence of continuing large-scale capital flight. For example, the discrepancies between Hong Kong and Chinese trade data suggest substantial amounts of capital outflows disguised as trade flows. Clearly, Chinese businessmen know something we do not and are taking no chances.
• Consequently, the rest of the world will see prices of cyclical commodities consumed by China — such as energy and base metals — to continue to weaken. Exporters of capital goods to China will see further falls in demand. In addition, policy action has to be ramped up. That could mean further depreciation of the renminbi.
And, finally, what about political risks?
The list of political risks in developed countries is long and sufficient to have caused investors a lot of grief. Here, the direction of surprise is more difficult to predict. Our guess is that things could be worse than expected.
• The world is not out of the woods as far as terrorism is concerned. In time, the security and intelligence services will come to grips with this new wave of violence we have seen in recent months as they have successfully done with previous waves. But in the near term, more terrorist attacks could erupt and hurt sentiment.
• In recent weeks, the risks of a Donald Trump victory appear to have decisively receded, with many polls showing the Democratic candidate Hillary Clinton heading for a landslide win. However, this is too optimistic a reading. Trump has just reorganised his campaign team and will recalibrate his strategy. These new tactics may not mean that he will win the election — we still believe he will not. But, his likely strategy of appealing to those who believe they have lost out from globalisation could reverse Clinton’s recent poll gains and promote a shift in US policy towards protectionism and maybe even isolationism. Typically, voting trends in an American presidential election only become clear after the first presidential debate, which is slated for the end of September. Until then, the polls could be volatile and we would not be surprised if Clinton’s widening lead is reversed for some time.
• Europe and the Middle East are not looking good either. The worst impact from Brexit is only just beginning to unfold. Moreover, Russia’s President Vladimir Putin appears to be upping the ante in Ukraine as his domestic political pressures grow. Similarly, pressures continue to build across the Middle East, from Libya through to Afghanistan.
The bottom line
In short, the US economy could look better and deflation fears are set to ebb, but risks related to China and world politics may well upset investors.
• In this scenario, the US dollar is likely to firm again, possibly bringing up Asian currencies linked to it.
• Large emerging economies such as India and Indonesia are likely to remain in favour.
• Asian exporters of manufactured goods such as South Korea, Taiwan, Malaysia and Singapore could see wind in their sails and enjoy stronger-than-expected growth as a result.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy
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