As loose monetary policy starts to look like part of the problem rather than the solution, lingering sluggish growth and rising debt are a recipe for more volatile financial markets. Since the best solution, to implement rapid far-reaching reforms, is politically unfeasible, ECR Research asks: what is the answer?
Lately, share prices have been fluctuating far more than in recent years. We suspect that larger movements are on the horizon, including in most other financial markets such as the currency and commodity markets.
This forecast is partly – but not exclusively – due to the fact that most markets are less liquid than before, because of new regulations, specifically those for the financial sector. Also relevant is the fact that global economies are generally less stable. Moreover, the authorities are running out of options when it comes to taking countermeasures. All of this is intimately connected with the massive debts that have been accumulated over the past few decades. In addition, there is overcapacity in manufacturing; a sector that is very important to the emerging economies but whose significance has paled in the industrialised world.
To keep the situation under control, growth needs to stay high in other sectors in the developed countries, for instance, the services sector. Otherwise, economies are in danger of collapsing under the debt burden. Maintaining growth at an acceptable level and lowering unemployment require loose monetary policy virtually everywhere (fiscal stimulus is out of the question in most cases, due to high public debts). Only in the US and Japan have jobless rates fallen to the extent that growth will soon have to slow to potential (ie the sum of the increase in the workforce plus the increase in productivity).
Chart 1: Global labour productivity growth has been declining steadily over the past decades
Source: Thomson Reuters Datastream/ECR
Ageing populations and insufficient immigration mean that workforce growth is minimal. To lift potential growth to a level where the debt will be sustainable, productivity will need to increase substantially. This can be achieved through structural reforms and higher investment. Unfortunately, loose monetary policy on an ongoing basis is preventing both. Also, because the reforms are very unpopular among voters, politicians prefer to keep the economy ticking over by means of ultra-loose monetary policy instead of implementing reforms that will not pay off until a number of years have passed.
Plus, accommodative monetary policy keeps afloat inefficient and outmoded businesses that produce superseded goods and/or services. For productivity to increase, such companies should make way for modern and efficient businesses.
Monetary easing: the paradox
Another negative is that monetary easing has sent share prices up well above levels that could be justified by economic developments. However, the downside is that businesses do not invest enough, even if they are sitting on huge stacks of cash. The reason is that very few investments yield sufficiently high returns to justify the share price surge.
Paradoxically, although expansionary monetary policy is necessary to stave off economic collapse, it has a downward effect on long-term growth potential. This is particularly true in Europe, where unemployment is high and wage increases are low. More monetary impulses will be required to underpin the economy.
By now, however, loose monetary policy is beginning to look like part of the problem rather than the solution. Also, the financial regulators are imposing more stringent capital requirements on financial institutions, leading to tighter lending conditions. Yet, from a macro-economic perspective, access to credit must improve, or the economy will implode. Central banks need to ease their policies further and drive up asset prices to compensate for all of this.
Chart 2: Emerging market currencies have already depreciated significantly against the US dollar
Source: Thomson Reuters Datastream/ECR
The situation differs around the world. As explained earlier, before long, US economic growth will have to slow to potential (approximately 1.5%). This rate is too low to sustain the huge debt burden. Therefore, share prices will fall as credit spreads widen but once prices fall by over 20% the economy will be hit hard and monetary easing will have to be on the cards again. And even though equity prices will bounce back and credit spreads will narrow, these effects will be short-lived as potential growth will be declining.
However, it will not stop there. If growth is sluggish in Europe and slows to around 1.5% in the US, it will not be high enough in other countries relative to the debt burdens. Most of all in the Asian emerging markets, so monetary easing will be required in these countries, too, eventually. Consequently, even though debts are already high, the debt mountains will continue to grow.
This underlies our forecast that price fluctuations will increase in the future. Share prices will discount the fact that economic growth will continue to be sluggish as the debt burden increases. As a result, credit spreads will widen. However, the economy is too fragile to cope with plunging share prices and widening credit spreads. The best solution would be the rapid implementation of far-reaching structural reforms everywhere. Politically, this is unfeasible.
At best, all we can hope for is a gradual unfolding of this process. This is why (more) monetary easing will be on the cards as soon as share prices plummet and credit spreads widen substantially. In the first week of September, the ECB and several Fed members hinted at this. Following a stimulus, both the stock markets and credit spreads will recover but not for long. They’ll soon change course again. Even more so if monetary policy stays accommodative (because growth is too slow).
These developments will not unfold at the same pace or to the same degree in different areas across the globe. Therefore, currency fluctuations are bound to gain momentum. And this is something which has already started: witness the movements of the euro and the EM currencies against the dollar in the past months, for instance.
In Europe, it will be necessary to pursue very loose monetary policy for quite some time to come. The reasons: high jobless rates, low wage increases, fairly sluggish growth, and minimal inflation. Conditions in the US are different: unemployment has dropped so much that higher wage increases can be expected in the near future. This does not mean that the Fed will be able to really tighten its policy – which would have been better in terms of productivity developments – but at least it can begin to take steps in this direction, long before Europe does the same.
This points to policy divergences between the US and Europe, which will automatically increase the price fluctuations. All the more so if it becomes necessary to apply monetary easing at speed, in case of another stock market rout and/or widening credit spreads and an appreciating dollar. Such a bumpy monetary ride is a recipe for significant gyrations in financial markets.
