At M3 we’re always focused on investing with the market and having a long-term outlook. That said, it’s good to be aware of what’s going on overseas and even in emerging markets to give you a wide lens and balanced approach.
So let’s dive in.
We’ll take a tour through some essential happenings you should be aware of.
Euro Area and UK: Fresh Stimulus and Lingering Uncertainty
On Thursday September 12th the ECB revealed the much-anticipated easing measures it had signaled over the summer. After the previous meeting of the Governing Council of the ECB in late July, policymakers had begun to signal a change in forward guidance, prompted by persistently soft inflation readings and rising recession fears.
In August, Olli Rehn, governor of the bank of Finland, had disclosed preparations for a “substantial and sufficient” bond purchasing program in addition to a cut to the key interest rate. In the latest meeting that promise came true, with ECB President Mario Draghi announcing a new asset-purchase program ($22.1 billion a month), a cut to the key interest rate (from -0. 4% to -0. 05%), new measures to support banks in the negative rate environment and a fresh batch of cheaper long term loans for banking institutions (Targeted Long-Term Refinancing Operation, or TLTRO III).
However, the biggest surprise came from forward guidance: Mr. Draghi announced that accommodative monetary policy would continue until inflation “robustly converges” to the target level of just below 2% to ensure “ongoing buildup of domestic price pressure”. Annual inflation in the Euro Area came in at 1% in August, unchanged from the previous month and in line with market consensus, a preliminary estimate showed. The slowdown in inflationary pressures to the slowest rate since November 2016 combined with the open-ended forward guidance from the ECB effectively means looser monetary policy can be expected over the medium term.
What is less clear is what tools the ECB still has at its disposal if economic conditions were to sour further, with an ever-growing balance sheet and discussions about the effectiveness of negative rates. Pressure on EU Governments (Germany first and foremost) to loosen fiscal spending and prop up the economy has been increasing given the limitations of monetary policy at the moment. This is being championed by ECB President-elect Christine Lagarde. Political consensus for increased fiscal stimulus however is unlikely in the immediate future.
In the second quarter of 2019 GDP slowed to 1. 4% in the Euro Area, the slowest reading since the third quarter of 2013. And growth has been consistently trending lower after the acceleration of 2017 due to slowing international trade and uncertainty relating to Brexit. In July economic sentiment dropped to a three-year low, but in August the composite PMI rebounded slightly to 51. 9 from 51. 5.
The composite PMI (Purchasing Manager Index) measures optimism in business conditions for the service and the manufacturing sectors, and any reading above 50 signal economic expansion. The manufacturing PMI in the Eurozone has remained below 50 since the beginning of the year, highlighting a two-speed economy, with the services sector growing while manufacturing activity remains subdued. Concerns of a slowdown spillover to the service sector however are increasing.
The Euro Area slowdown is being driven mainly by the global trade slowdown and it is not yet clear if the new monetary policy stimulus will be enough to support the economy, especially with the looming threat of a messy Brexit. Further loosening of monetary policy would likely devalue the Euro, possibly eliciting the anger of President Trump. This in turn could lead to increased uncertainty relating to trade. The specter of a messy split of the UK from the Union is ever-present, and the recent developments from London do not offer much clarity on future developments, with Prime Minister Johnson suspending Parliament and MPs passing legislation mandating an extension to the exit date to bar a no-deal scenario. The prospects of the last ECB stimulus package signed by Draghi being “substantial and sufficient” to avoid a souring of economic conditions hinge primarily on uncertainty relating to trade and Brexit being resolved – and not worsening.
Both risks are however out of the scope of monetary policy.
China: Slowing Growth and Olive Branches
China’s economic growth slowed to an annualized rate of 6. 2% in the second quarter, from 6. 4% in the previous six months, which marked a 27-year low and was driven by weaker investment growth, disappointing sales growth and a near to-decade low in the expansion of industrial production.
Uncertainty linked to the trade war with the US is weighing on growth, however fiscal stimulus and accommodative monetary policy should offer some support to the economy and make the 6% government target attainable. In fact, on September 6th China’s central bank moved to jolt the economy by lowering the reserve requirement ratio by 50 basis points starting September 16th. Still, the step was a relatively modest one given the yearlong dispute with the US and the size of the Chinese economy. Growth is expected to continue to slow in 2019, in 2020 and further, as reliance on government sponsored debt becomes less sustainable and aging population issues increasingly affect productivity.
After a 3. 3% increase in July, exports missed market estimates and dropped 1% in August year over year in the wake of new announced retaliatory tariffs by the US and persistently weak global demand Exports to the US dropped 16%, hover exports to other countries increased slightly (+3% to the EU, +11. 2% to ASEAN, +24. 6% to Taiwan, +1. 4% to Japan and +1. 9% to South Korea). The uncertainty relating to global slowing demand and the trade war has so far inflicted considerable damage to the Chinese economy.
The current decoupling of the world’s two largest economies does not seem to be a process that can be reversed given the geopolitical implications of it, and investors seem to agree that even after a potential ceasefire in the trade war, some degree of animosity and rivalry should be priced in for the long run. President Trump announced a two-week delay of the latest round of tariffs on $250 billion of Chinese goods and the Chinese have signaled openness to sparing purchases of pork and soybeans from the US from tariffs as a potential bargaining chip.
In any event, while negotiations continue, it seems clear that there are three tiers of issue: increased purchases of goods and tariff alleviation are the simplest to solve, and perhaps there might already be some agreement there; market reform and intellectual property laws are the second tier, less likely to be appealing to the Chinese government, but nonetheless compromise may be possible; lastly, there are geopolitical points of contention, among which Huawei’s status as a national security threat, that do not seem easily fixable unless there is a broad-ranging deal. An olive branch might have been offered this month for a smaller deal, something that could subdue some tensions and allow both Chairman Xi Jinping and President Trump to claim success in the negotiations.
A stabilization of the Chinese economy is of paramount importance because of its role as a major trading partner for many developed and developing economies and because financial imbalances may have already been building up for quite some time. China’s shadow banking system now stands at reportedly more than $10 trillion, marking an intricate web of unregulated lending connecting banks, firms and governmental organizations. Over the past two years China had made a focus out of cracking down on reckless borrowing and on the opaque shadow banking system to try to curb what were perceived as risks to the broader economy.
As the trade war worsened, the effort pivoted to focusing on supporting overall growth, once again turning a blind eye to the debt fueled gyrations of the hazy banking sector. The risk of financial instability is most acute in the Chinese Money-Market. After a government takeover of Baoshang Bank Co. a struggling bank in Mongolia, the system experienced a tightening of credit standards for smaller institutions, that led to a spike in interest rates in the money-market . These fears abated only after authorities urged clam and successfully reassured the markets.
The Wall Street Journal reported some market participants having concerns of a repeat of a severe liquidity crunch six years ago that spiraled into a liquidity crisis, and given the high levels of debt in the Chinese economy, the lack of clarity in the realm of informal lending and the slowing real economy there are concerns that more aggressive government intervention might be needed in a panic scenario in the money market. Given the risks faced at home and the tensions in Hong Kong, it is possible that Chinese leadership may be growing more open to an interim deal to at least make sure the trade war with the US does not worsen.
Japan and Korea: Trade war 2. 0?
Japan has so far posted surprisingly strong GDP growth.
After first quarter GDP growth came in at 2. 8% (partially stemming from statistical adjustments), second quarter also surprised positively at 1. 8%. Overall, consumers are spending and businesses are investing, however there is uncertainty clouding the outlook and monetary policy is already employing an all hands on deck approach, with negative rates (currently at -0. 1%) and a balance sheet larger than the country’s own GDP.
Despite years of loose monetary policy by the Bank of Japan and fiscal support (Debt to GDP ratio is 240%) from president Abe and his Abenomics plan, inflation has remained stubbornly low, failing to reach the central bank’s 2% target ever since 2015. In July inflation year over year slowed to 0. 5%. Persistently soft inflation readings, especially at a time of very favorable monetary policy, raise the threat of deflation. The risk of deflation is accentuated by the looming VAT increase due in October, which some analysts fear might push the country into a recession. Japan is also heavily reliant of demand from China, but as the next-door neighbor’s growth cools, Japan is at risk of suffering too. Furthermore, rising trade tensions, namely with South Korea, are already weighing on growth and might deteriorate the outlook considerably.
While still short of an all-out trade war, trade tensions have flared up between the two countries, leading to Tokyo imposing new restrictions on exports that would harm South Korea’s tech industry and South Koreans calling for a boycott on Japanese goods. Both countries have downgraded each other’s preferential trade status as a tit-for-tat escalation of the trade tensions, initiated by a dispute over wartime reparations. This adds to the existing trade uncertainty and might lead to a further souring of exports from both countries.
South Korea’s economy surprisingly contracted in the first quarter of 2019 from the previous quarter and the second quarter showed only a modest rebound, with GDP expanding only at 1. 1%. This has prompted downward revisions of overall expected growth for the year, with analysts now forecasting growth to slow below 2% – the slowest in a decade – from 2. 7% in 2018 and expectations of weak inflation set to continue. The trade tensions with Japan have only exacerbated an already slowing economy, which was suffering from the Chinese slowdown and weakening global demand. Sluggish exports and chilled investment have acted as a drag on an economy that otherwise showed strong fundamentals and combined with the Japanese feud led to the Bank of Korea to cut the base rate KROCRT=ECI by 25 basis points to 1. 50% in July and keep it firm in August.
Given recent economy data another cut in October is likely.
Slowing growth in the major Asian economies spells trouble for countries heavily reliant on international trade. Whether a coordinated monetary stimulus is sufficient to revert the downward trend is to be seen and hopes of success largely hinge on the prospects of the largest economy, China, and its trade war with the US.
Emerging markets: King dollar
In September, the Trade Weighted Dollar Index reached a high last seen in 2002, in spite of the Federal Reserve’s rate cut in July (Exhibit 10). The dollar’s strength has negative effects on emerging markets, since these often depend on dollar denominated debt to fuel growth. As local currencies devalue against the greenback, debtors see their real repayment costs rise, wiping out the higher yields often associated with the faster growth of emerging markets.
A stronger dollar makes commodities more expensive for buyers, depressing demand and thus leading to lower prices. Since the sale of commodities is often a key source of revenue in many developing markets, the historically strong dollar of 2019 is effectively acting as a drag on growth. With the dollar as the reserve global currency and treasuries as a preferred safe-asset, a devaluation of the currency is unlikely, even with additional cuts to the Federal Funds Rate.
The strong greenback combined with slowing global demand, trade tensions and local issues has lowered growth prospects of many emerging countries, among which India, the third Asian economy by GDP. The country in fact is experiencing a growth recession, with GDP growth slowing to a six year low of 5% in the first quarter of 2019. Pessimism regarding the automobile sector, the rising number of non-performing assets, sluggish consumer demand and the failing manufacturing sector have made the outlook increasingly uncertain. Moreover, Turkey’s economy – the largest of the Middle East – is expected to either contract modestly or not grow at all in 2019 after having contracted by 2. 9% in the last quarter of 2018, and Latin America continues to face headwinds.
The global slowdown is not sparing emerging markets by any means.
Trade tensions have hampered growth in nearly all world economies, increasing uncertainty and depressing investment levels.
As the slowdown spread from the second half of 2018 to the beginning of 2019, optimism around a solution to the US-China trade war waned, and the breakdown of trade talks in May led to increasing skepticism for a quick resolution of the tensions. In the first half of 2019 central banks in Asia started a monetary policy easing cycle that was quickly adopted by other central banks around the world, marking the first globally coordinated policy loosening since the Great Recession. At a time of bloated central bank balance sheets and already historically low interest rates it is unclear if the latest actions will be sufficient to arrest the slowdown. Most likely, as long as trade uncertainty continues to depress prospects of all major economies, the need for stimulus will remain.
Furthermore, as central banks cut interest rates, currencies devalue: continuous cuts across many economies may lead to a “race to the bottom” without any benefits of weakening currency on exports. Overall, monetary policy alone is unlikely to stabilize growth, especially since the causes of the slowdown are political and outside of the purview of monetary policy.
We hope this roundup has been educational and thought provoking. We live in a big and nuanced global economies. Our day to day will be impacted by major players, and emerging markets – though remember, we invest in the long haul. Whatever happens in 2019 happens, our outlook goes 10, 20, 30 years beyond to help you pursue your goals.