Falling into place

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Less than a year ago, financial markets got preoccupied with the risk of a hard landing in China. A little later the Chinese authorities changed their exchange rate policy leading to fears that they were going to push their currency aggressively lower. Very significant capital outflows did little to provide comfort that the policymakers were in control.

Late last year and early this year, people started fretting over the growth prospects for advanced economies, speculating that a recession might occur this year Han de Jong Han de Jong Chief Economist

  • A number of worries have scared financial markets over the last 12 months or so
  • As the dust is settling it is becoming clear that in none of these cases the worst case scenario is coming through…quite the opposite
  • Unfortunately, a new set of concerns – geopolitical in nature – is coming to the fore. Life is never boring.

Today, the world looks different. Targeted stimulus has stabilised the economy. The most recent data actually suggest that things are picking up. GDP growth in the first quarter was reported as 6.7% yoy, only a whisker below the 6.8% registered in the previous quarter. A sharp acceleration of growth is visible on the monetary side of the economy. Aggregate financing was very strong in March and M1 growth has accelerated to 22.1% yoy, the highest since 2010. Cement sales have also picked up strongly. As a result, business confidence is improving, the alleged need for currency depreciation has become less obvious and the sharp drop in foreign-exchange reserves has recently turned into a small increase.

This is all positive for the short term and it confirms our view that Chinese policymakers tend to deal with challenges even if it takes them a while. Having said that, it remains to be seen whether the improvement in economic conditions is sustainable in the longer term or what new problems it may create. High debt levels is one of the challenges in China and the sharp increase in lending does not help the deleveraging process much. It also seems as though an increase in infrastructure spending has been the latest measure to support growth. Nothing wrong with that (advanced economies should follow suit), but that is really falling back to 'old-school' stimulus, while China was meant to be in transition to some 'new school'. Despite these qualifications, I think we must conclude that the concern over the hard landing that spooked financial markets last year is turning out to be exaggerated. And, if I may add, things are panning out the way we thought they eventually would, even though our patience has been tested to the extreme.

Crashing oil prices

The sharp drop of oil prices raised concern over their impact on the global economy as the negatives related to a sharp drop of oil prices (investment slump, solvency issues over energy companies and their financiers, sovereign wealth funds running down investments) seemed to dominate the positives (lower inflation, more real spending power for consumers). When oil prices fell through USD 30, some were talking about USD 20 and suggesting the price might stay there for a while.

There was actually a wider concern over commodity prices. Emerging countries were hurting. Their currencies depreciated strongly, leading to a significant tightening of financial conditions in these countries, making the outlook very murky at best.

Today, the world looks different. Oil is trading over USD 40, easing the worst fears, while the wider commodity price gauge, the CRB index, is up over 10% since the start of the year. People are now talking about a reduction of the imbalance between global oil demand and supply in the course of the year. As oil producers have lowered their cost base (either through technological progress or through currency depreciation) the fear for the solvency of producers has eased, though it has not gone away completely, of course. And at the higher price, the need for sovereign wealth funds to sell assets is clearly less.

The improvement in oil prices is also seen in other commodities. This is relieving the pressure on many emerging economies exporting commodities. In turn, this has lessened the need for currency depreciation. Indeed, emerging currencies have shown a meaningful bounce in recent months, taking away the pressure in their financial systems.

It is early days yet. Supply of oil is still exceeding demand and inventories are very large. So the bounce in oil prices we have seen in recent weeks may reverse at some stage, at least for a while. Nevertheless, I think we must conclude that the concern over the crashing oil price that spooked financial markets last year is turning out to be exaggerated. And, if I may add, things are panning out the way we thought they eventually would, even though we did not get the timing spot on.

Recession in advanced economies

Late last year and early this year, people started fretting over the growth prospects for advanced economies, speculating that a recession might occur this year. A significant drop in business confidence in the US manufacturing sector, combined with a contraction of industrial output fed these fears. The services sector in most countries held up much better, but the industrial sector leads the cycle. The appreciation of the dollar since the middle of 2014 was adding to pressure on US businesses.

Today, the world looks different. The industrial sector seems to be strengthening. Industrial production data is improving and business confidence in the sector has edged up in many countries. It is early days yet. The improvement in industrial activity is relatively recent and given high inventory levels, it may be a flash in the pan. But other economic indicators are supportive of the view that the US and the eurozone are not falling into recession. Perhaps the key variable to watch is corporate profits. They are under pressure in the US. The big question is to what extent that has been caused by the energy sector and the strong dollar. As these factors are now changing, the outlook may improve a little, though rising wage costs may be the next challenge for profits. Despite these qualifications, I think we must conclude that the concern over recession threats in the US and the eurozone that have spooked financial markets during the last six months or so is turning out to be exaggerated. And, if I may add, things are panning out the way we thought they eventually would, even though we have lowered our growth forecasts.

Fed tightening

It is hard to assess to what extent financial market participants actually worry over monetary policy, but last year saw a wide divergence between what money futures were pricing in for US monetary policy and what the Fed was communicating about their plans. As recent as December, the Fed was saying that four rate hikes were in store for 2016. The market was thinking two at most. And the hike that actually materialised in December may have fed fears that the Fed would be more aggressive than the world economy could bear.

Today, the world looks different. Some soft spots in the US economy, continued modest inflation and concern over the consequences US rate hikes might have on global economic and financial conditions have pushed out expected rate hikes. In March, the Fed said it now only expects to hike twice this year, while money futures are suggesting that only one of these will actually happen.

It is early days yet. As global economic conditions improve, the Fed may change its mind again and become more hawkish in its communication. Nevertheless, I think we must conclude that the concern over aggressive, premature monetary tightening in the US that may have spooked financial markets last year is turning out to be exaggerated. And, if I may add, things are panning out the way we thought they eventually would, even though we have adjusted our Fed view as economic conditions and the outlook changed.

Out of bullets

Since the financial crisis started, central banks in many advanced economies have pulled out all stops to prevent disaster. They ventured onto the path of unconventional monetary policy and took an impressive number of steps on this path. I often say that this is the biggest experiment of monetary policy mankind has ever seen. The outcome is uncertain. Last year, the ECB started a large-scale QE programme and has been cutting rates deeper into negative territory, as has the Bank of Japan. Some smaller central banks were already experimenting with negative rates.

The negative interest rates in particular caused quite a debate in a number of countries. The Dutch parliament even organised a day-long hearing as they invited a large number of experts to provide views on ECB policy. Nobody knows how all these measure will work out, not how negative interest rates can become. But the idea that central banks, in particular the ECB, had more or less run out of bullets gave financial markets a very uncomfortable feeling. What can be done if an unexpected shock occurs and policy stimulus is required?

ECB chief economist, Peter Praet, recently raised the issue of helicopter money. I do not think the ECB seriously thinks it must engage in such an extreme policy any time soon. But I do think that raising it as an option was particularly cleverly timed. In my view, Praet had three things in mind when he talked about helicopter money. First, he probably does not welcome a further appreciation of the euro and is hoping that helicopter-money-talk will be helpful (when Bernanke implicitly raised such a strategy in 2002 -'we have the technology'- the dollar weakened significantly). A second reason Praet might have had is that he simply wanted to tell markets that a central bank is, at least theoretically, never out of bullets. While the ECB's policy has become increasingly controversial and even in our own organisation, views on the issue diverge at times, we fully agree that a central bank is never out of bullets. Third, Praet may have considered that he needed to prepare the world at large for such an extreme policy should it become necessary.

Helped, of course, by improving global economic and financial conditions, I think Praet's little plan is working quite well, although it is, of course, early days yet. Nevertheless, I think we must conclude that the concern over the lack of central bank ammunition that may have spooked financial markets around the turn of the year is turning out to be exaggerated. And, if I may add, things are panning out the way we thought they eventually would, even though we did not forecast the size of each of the ECB’s measures correctly.

Abating fear, new fears

The key concerns that have plagued markets last year and earlier this year are abating. But tomorrow, the world may look different. A new list of things people can worry about can be compiled. Such a list would certainly include: The UK referendum on Brexit; the likely downgrading of Portugal's credit rating, making its government paper no longer eligible as collateral for drawing on ECB liquidity facilities; Greece's economic and policy performance; Spain's inability to form a government; NPLs at Italian banks; the European refugee crisis; terrorist attacks; the war in Syria; general elections in France and Germany next year and the rise of populism; and, last but not least, the US elections and the chances of a Trump presidency. Never a dull moment...

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