Perspectives

Reading the signs

Published: Jul 2015

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Slowing growth and rising interest rates in the global economy could be important signals for things to come. ECR takes a look at how diverging monetary policies, amongst other factors, across the world’s various regions are having a knock-on effect on each other’s economies – but not always in the best way.

A contracting US economy and weakening Chinese growth over the first quarter of this year have led international institutions to revise down their growth projections for the global economy in the past weeks. The OECD expects 2015 growth of 3.1% (instead of 3.6%) while the World Bank estimates that global growth will be 2.8% (instead of 3%). Simultaneously, bond yields have risen substantially in various countries. This combination of a growth slowdown around the world and rising interest rates bodes ill for equities and corporate bonds, which have seen price drops in recent months.

Addressing the contradiction

At first glance, weaker growth and rising long-term interest rates seem to contradict each other but there is an explanation. The growth expectations for the coming quarters to years are good and the US downturn was mostly caused by temporary factors. Over the coming period, higher consumer income and more borrowing (because consumers are growing in confidence and their net wealth has increased) will likely boost US growth. Expanding consumption will prompt businesses to up investment, as jobless rates fall and wage growth increases. This could generate an upward economic spiral in the US.

In Europe and Japan, too, growth prospects are improving. Akin to developments in the US, the Japanese labour market is tightening. This puts upward pressure on wages while incomes are on the rise. Although yen weakness and last year’s sales tax are affecting purchasing power, rising asset prices are good news for consumers. A cheaper currency benefits Japanese exports.

Chart 1: Total income in the US has risen considerably due to an improved labour market and low inflation rate

Chart 1: Total income in the US has risen considerably due to an improved labour market and low inflation rate

Source: Thomson Reuters Datastream/ECR

Presently (the delayed effects of) euro weakness, lower oil prices, and accommodative ECB policy and low long-term interest rates are boosting the Eurozone economy. Asset prices rose as consumer confidence picked up. Many purchases are being made that had been deferred in the past years as businesses are more willing to invest. At the same time, a tightening labour market is a distant prospect in Europe. Consequently, the upward pressure on wage increases will be limited for the time being (except in countries such as the UK and Germany). The upside is that this will allow the ECB to continue with loose monetary policy for longer, which will stimulate the economy.

Focus on emerging markets

The Chinese authorities are taking measures to counter the growth slowdown. Recent data suggests that this is successful. However, because it would be dangerous to further inflate the credit bubble, they cannot stimulate the economy to maximum effect. This means China is unlikely to further drag down the global economy whereas the Chinese demand for resources and other import products will not increase considerably for now; it could even decline. This does not bode well for the (commodity-exporting) emerging markets (EMs). On top of this, many businesses in the emerging economies have large (dollar) debts. Presently, economic growth is slowing, the dollar is appreciating, and dollar interest rates are rising (in anticipation of Fed tightening). Therefore, borrowing is stagnant in these countries. This is hampering growth.

Chart 2: A further decline in the unemployment rate will push up wage growth (and inflation)

Chart 2: A further decline in the unemployment rate will push up wage growth (and inflation)

Source: Thomson Reuters Datastream/ECR

Monetary policy concerns

For the moment, the EMs are a source of downward pressure on global economic growth, whereas growth prospects are improving in the developed countries. Here, deflation fears have eased while inflation risks are on the increase. This points to less accommodative monetary policy around the world over the long term, for instance:

  • In countries where central banks have immediately pulled out all the stops (the US and the UK), the economies have recovered the most and monetary tightening will start in the not too distant future. By contrast, the authorities in the Eurozone and Japan will wait longer.
  • Owing to the downward pressure on growth and inflation theoretically, central banks in the EMs are in a position to open the liquidity spigots. However, we expect them to exert caution as monetary easing would weaken their currencies against the dollar. If so, dollar debts would become a bigger burden. As debts have already soared in many emerging economies, many are not keen to step up borrowing.

It is not immediately clear what effect this will have on the financial markets. In any case, a positive is that global monetary policy will continue to be loose. The European Central Bank (ECB) and the Bank of Japan will keep the money tap open, while central banks in the EMs will be inclined to ease rather than tighten their policies. As soon as the Fed or the Bank of England (BoE) increases interest rates, the dollar and/or the pound could appreciate substantially. This could act as a drag on growth in these countries. In other words, once the Fed and/or the BoE tighten their policies, they will do so gradually.

Knock-on effects

Also relevant is that weaker growth and overcapacity in the EMs could put ‘the right amount’ of downward pressure on US inflation. In that event, the Fed will not need to substantially tighten its policy – initially, at least. In the West, this will be good for growth and it will create more export opportunities to Western countries in the EMs. If so, the global economic growth will improve due to better growth prospects, low inflation, and accommodative monetary policy.

Chart 3: A tight labour market gives Japan hope on higher wage increases

Chart 3: A tight labour market gives Japan hope on higher wage increases

Source: Thomson Reuters Datastream/ECR

On the downside, ultra loose monetary policy around the world has driven stock prices beyond their equilibrium levels whereas long-term interest rates are far below equilibrium. Under such conditions, a minor deterioration of the monetary climate is often enough to trigger a trend reversal. Especially if further tightening is in the air. Of course, if asset prices plunge and long-term interest rates soar, central banks will refrain from (further) tightening at first. Even if there is upward pressure on inflation. Simultaneously, a large-scale monetary stimulus is unlikely as it would drive up inflation expectations further. In other words, many investors may have unrealistic expectations of future central bank interventions to boost asset prices.

Liquidity also gives cause for concern. Many markets have become more illiquid, due to new regulations. And there is another factor at play. As long as central banks continued to create extra money in order to purchase government bonds – which forced investors to buy more and more risky assets – asset prices kept rising and credit spreads kept dropping. There were always enough investors willing to sell their assets in order to take profit. This will change once one of the most important demand drivers in the asset markets (monetary policy) loses momentum and gradually disappears. Whereas numerous investors will want to sell their overly expensive assets, there will not be enough buyers. As a result, asset prices will plummet and long-term interest rates could spike.

Chart 4: A weaker euro combined with low rates and low oil prices will provide a boost to EMU economies

Chart 4: A weaker euro combined with low rates and low oil prices will provide a boost to EMU economies

Source: Thomson Reuters Datastream/ECR

Lastly, the negative implications of less accommodative monetary policy – first in the US and the UK and then in Japan and the EMU – will come to the fore over the coming quarters. The recent bond yield rally is an initial signal. Diverging monetary policies could stir up volatility in the currency markets, too. Further rising long-term interest rates and a stronger dollar are developments to be reckoned with.

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