9 February 2016

The root causes of the current malaise

Since the start of the year, the world economy has undergone severe financial market volatility, marked by sharply falling prices for equities and other risky assets.


Several factors are coming to an uncomfortable head. There are concerns about a hard landing for the Chinese economy and the fast deterioration of their foreign currency reserves as they battle to prevent excessive devaluation of the renminbi, faced with increasing capital flight. There are also fears that growth in the United States is starting to stutter, just as the Fed has begun raising interest rates; and in the Middle East, there are well-founded fears of direct Saudi-Iranian conflict, as their proxy wars in Syria and Yemen escalate, while Russia and Turkey are also courting disaster. More ominously, the weakness in commodity and energy markets is increasingly seen as flagging weaker demand, despite boosting Western consumer sentiment through the equivalent of a massive tax cut.

The fall in oil prices, along with general market illiquidity, the leveraged state of US shale gas operators and that of oil companies, and fragile sovereign wealth funds in oil-exporting economies, is engendering worries of a systemic crisis in credit markets. On top of this, there are growing and incipient fears that the very structure of the Eurozone is exhibiting historic divisions and flaws, under the pressure of the mass migration crisis. These factors are compounded by the threat of the British referendum (or Brexit) this year. Underlying all this, populist and more extreme factions on both right and left wing sides of the spectrum are proliferating, much to the glee of Russia.

Overlaying this combination of risks, some pervasive factors apply to the global economic scene. Output, economic policies, subdued inflation and the behaviour of key asset prices and financial markets are synchronised, creating a persistent degree of malaise. Worldwide, high public and private debt levels in both developed and emerging countries are inhibiting growth. Widespread ageing of population demographics implies lower levels of investment and higher savings ratios. Low interest rates mean that unproductive capacity has not been withdrawn over this cycle; this in turn deters capital expenditure by healthier competitors (as referenced in John Royden’s article in Prospects Issue 11 about Zombie companies). Structural reforms have been slow, particularly in Europe and Japan. In addition, despite a welter of technological advances, global productivity rates have simply not kicked in. This puzzle has left many economists talking about structural and cyclical stagnation.

Growth has been slow to react to low interest rate policies. Overall leverage in the US, Europe and Emerging Markets is the underlying legacy here. Unconventional monetary policies have proliferated since the Great Financial Crash, often in a conflating and indistinct way. It is perfectly fair to evaluate zero interest rate policies (ZIRP) as having both monetary and fiscal aspects. These policies have pervaded Western and some Emerging Market economies. Both the European Central Bank and the Bank of Japan have reiterated of late that one should expect more of the same. In neither economic zone have lending and inflation criteria really responded yet.

The likely consequences of these new policies was widely misinterpreted. Stimulatory interest rate policies were seen as bloating central banks’ balance sheets, in effect debasing core currencies. The fear initially was of runaway inflation, spiking long term interest rates along with a collapse in the US Dollar. Gold, as a monetary hedge, was expected to strengthen as caution rose.

Instead, inflation has remained low. Fears abound of a Chinese devaluation of the renminbi, which would export deflation and lower growth world-wide so as to prop up inefficient state controlled industries. The challenge for central banks is to avoid deflation with sundry attempts to kick start inflation. Since 2008-09, the US Dollar has surged, gold and commodity prices have been weaker and global fixed interest markets have even strengthened until yields are negative in some markets. According to the text books, the outcome seems an aberration.

Many firms are suffering an excess of capacity, exacerbated by Chinese over-investment. Globally, unemployment rates remain too high to allow workers much bargaining power. In economic terms, the velocity of money that was expected to blossom has failed to arrive. Banks are instead hoarding the boost to money supply in excess reserves rather than lending it out.

In China, where a colossal housing boom was experienced, we now see ghost apartments and office blocks. In addition, the stronger US Dollar has caused retrenchment in commodity prices as over-investment in supply chains starts to correct itself. Both energy and the metals sector have in effect seen excessive exploration and investment in new capacity.

Quantitative Easing (QE) appears to have driven a series of global asset bubbles that, with the hike in US interest rates and China’s devaluation of the renminbi last August, are now beginning to unwind. The underlying question is, how long can ailing economic funda mentals persist with financial markets driven upwards by central bank easing?

This divergence is being assessed at present. In addition, markets have been surprisingly ambivalent towards greater geo-political risk. There is the chaos of the Middle East to consider, Europe’s structures under pressure, boundary issues in Asia and a Russia that is creating problems abroad, if only to deflect criticism away from its own domestic situation.

I think that one is seeing the ramifications of QE’s eventual and gradual unwinding taking place at a time of considerable geo-political unease. Markets are now seeing increasing discussion of purer Keynesian fiscal stimulus to head off deflationary risks. Such monetary practices bring with them the risk of inflationary overshoot, but that all remains another genie in the bottle for now. I am watching carefully to see what international coordination can be brought to China’s aid, given that the stability of their Communist regime is internationally beneficial and that social unrest must be avoided.


Related articles

There is a lot going on at the moment.

James Godrich reviews the portfolios within the Coleman Street Investment service.

The news that the Chancellor of the Exchequer has found it necessary to cancel the autumn budget underscores the difficult situation in which we find ourselves.