Recovering markets may yet be a flash in the pan

Unpredictability is likely to undermine the economy still further

March 18, 2019
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Three months ago global stock markets were in a hole, having tumbled by at least 20 per cent from highs earlier in the year. Analysts were falling over themselves with predictions of a recession by 2020. Yet today the US and Chinese markets are around 20 per cent higher than late last year, with Europe and Japan up by a bit less. The FTSE 100 is up by a relatively meagre 10 per cent, but… Brexit, of course. So is the panic over for investors? And, for everyone else, does the market recovery convey optimism, or noise?

The biggest risks last year were in the US and China. In the US, as the sugar high from the tax cuts dissipated, there was concern that the Federal Reserve would raise interest rates too far and choke off what still promises to be the longest-ever expansion (if it keeps going until June). In China, there was strong evidence about a widespread economic slowdown emanating partly from the trade war, but mostly from the government’s policies designed to curb debt and leverage. More recently, though, some of these concerns have lessened.

In January, the Federal Reserve, surprised by the weakening in the economy, sent out a strong message to financial markets that the cycle of rising interest rates—the main policy rate rose 100 basis points last year to 2.25-2.5 per cent—had topped out, at least for now. Expect this message to be repeated at the Federal Open Market Committee meeting later this week. The impact was immediate: 10-year bond yields turned back down from almost 3.25 per cent, and have fallen to about 2.6 per cent. Shorter maturity instruments now discount no likelihood of monetary tightening any time soon, and the US dollar weakened.

As though on cue, recent economic data have been disappointing. GDP in the final quarter of 2018 rose by just 2.6 per cent at an annualised rate, and markets expect weaker growth to be announced soon for the first quarter of 2019. Manufacturing output fell in both December and January, and retail sales fell in three of the five months to January. Equity market analysts are warning that company earnings are liable to deteriorate.

The US economy doesn’t look in immediate danger, but it’s hard to find a sense of unbridled optimism among consumers, home-owners, businesses. Sooner or later, this long expansion will falter.

In China, where the annual National People’s Congress (the Party’s parliamentary session) has just concluded, plans to cut taxes and boost local government borrowing to pay for infrastructure, were, predictably, approved. Premier Li Keqiang announced lower taxes and fees for business amounting to about two per cent of GDP, and a slightly higher amount of railway and infrastructure construction. On top of this, the government is backing away a bit from deleveraging policies, and will almost certainly allow higher credit expansion this year.

China’s economy can certainly be stabilised in the short-term. Yet the difficulties surrounding deleveraging, the problems in the private sector in China, the risk that stimulus measures may gain less traction than in the past, stifled reform programmes, and the continuing trade war all point to a weaker growth trajectory.

For the time being, though, financial sector gloom has lifted, encouraging markets to expect the US expansion to continue and China’s economic slowdown to level off. These developments have also helped emerging markets. Though the MSCI emerging markets equity index remains 13 per cent lower than a year ago, it has risen 10 per cent so far this year, elbowing out for the moment concerns about the build up of debt in emerging markets, and their vulnerability to external currency and interest rate shocks. China is the main part of this wall of worry, but there are others too, including Brazil, Turkey, and Thailand. According to the IMF, public debt was either unsustainable or in danger of becoming so in 32 developing countries at the end of 2017.

Many emerging markets are shielded to the extent that their debt is denominated much more in local currencies than in, say, US dollars. Yet, we should remember that if domestic borrowers are therefore not at risk from a stronger US dollar, lenders now are, if local currencies fall. The ultimate consequences for credit and capital flows, and the economy, may be indistinguishable.

The US and China are not the only countries to have been surprised by untoward economic weakness. The ECB has been jolted by the sudden weakening in the Eurozone economy. Last month it lowered its GDP growth forecast from 1.7 to 1.1 per cent. In its wake,  and two years after weaning the Eurozone off cheap money, it announced a new tranche to the so-called Targeted Long-Term Refinancing Operation, or business lending programme, and pretty much assured markets that interest rates would remain at historic lows until at least next year.

No one was looking at the Eurozone as an engine of global growth, and even though some of the weakness in recent months has been attributable to transient factors, including weather patterns and the auto industry’s travails, it is clear that the region’s incapacity to deploy selective and coordinated  fiscal easing and its sensitivity to global and China trade developments constitute big blocks to its performance. Maybe the ECB’s QE programme is going to go on and on, next time in a different form.

The UK, meanwhile, remains consumed by Brexit. The Chancellor’s Spring Statement last week lowered the GDP forecast from 1.6 to 1.2 per cent, but as we all know, forecasts will count for nothing if the UK crashes out of the EU at the end of this month or in 3 months. Sterling has rallied in recent days—currently it’s at $1.33—reflecting the notion that such an outcome has become less likely. Yet, who can predict what will happen this week, let alone the next 3 months or beyond. Unfortunately, UK businesses and jobs, and the economy will remain hostage to what happens in the US, Europe and China, but also at the mercy of the politics surrounding the manner in which Brexit happens, or doesn’t. Unpredictability is likely to undermine the economy still further.