Back on track after Black Monday?

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US and European equities shook off Black Monday to end the week higher, though the mood remained nervous against the background of worries about China and emerging markets. Two key positives are helping to turn the tide. First of all, policymakers are ready to respond.

Investor risk appetite deteriorated sharply and equity markets collapsed around the world Nick Kounis Nick Kounis Head of Macro Research

China eased monetary policy this week and the Fed and ECB have made it clear they are ready to adjust course if need be. Indeed, the risk that the Fed delays hiking rates further, and the ECB steps up QE have increased significantly. In addition, economic fundamentals are more positive than suggested by the extreme worries about the global economy seen earlier in the week.

Black Monday

The week started off with what has been dubbed ‘Black Monday’. Investor risk appetite deteriorated sharply and equity markets collapsed around the world. Emerging market currencies and commodities nose-dived. What happened? The weakness seemed to reflect the fear of a China hard landing and vulnerabilities of emerging markets once the Fed raises interest rates. This combination could provide quite a jolt to global growth. The lack of a response from the Chinese authorities over the weekend seemed to add fuel to the fire.

The rebound

During the course of the week, sentiment improved and equity prices rebounded. US and European equities are above their start of the week levels. Commodities and emerging market currencies have also recovered on the week.

Policymakers ready to respond

What drove the recovery? Policymakers responded. The People’s Bank of China finally eased monetary policy, cutting its lending rate and reserve requirements for banks, and hinting that more would come in its accompanying statement. Indeed, we expect another 50bp cut in reserve requirement ratios and a 25bp reduction in lending rates going forward.

Meanwhile, Fed and ECB policymakers made it clear that they are ready to adjust course if need be. New York Fed President William Dudley suggested that the FOMC could delay the policy rate hike, saying that the market turmoil had reduced the case for a rate hike next month. Furthermore, ECB Chief Economist Peter Praet hinted at the possibility of a stepping up of the central bank’s QE programme if needed. He asserted that downside risks to the central bank’s inflation goal had risen.

Graph: Investor risk sentiment has improved, but still

Better fundamentals

Markets also received strong support from better economic data, which served as a reminder that fundamentals in the run up to the turmoil were not so bad, easing worries about a global downturn. There were no notable reports out of China, but numbers out of the US and eurozone were impressive. The headline grabber was US GDP growth for Q2, which was revised up to 3.7% from 2.3% previously, with the components pointing to broad-based economic growth. Meanwhile, consumer confidence surged in August. This reflected increased optimism on the job outlook, though admittedly it did not cover the most recent period of market weakness.

In the eurozone, the bellwether German Ifo business climate indicator rose in August, against expectations of a small decline. The same was the case for the economic sentiment indicator for the eurozone as a whole. In addition, eurozone money supply and bank lending growth accelerated convincingly in July, which is also consistent with an ongoing economic recovery (see chart below).

Mood still nervous

Given the recovery in financial markets over recent days, it looks like the week that began with Black Monday has had a positive ending. However, it must also be noted that investors still seem to be nervous. For instance, even though equity volatility indexes have come down, they still remain above their long-term historical averages. So it is too early to say that we are out of the woods, though we do expect investor sentiment to receive support from evidence that the global recovery is back on track.

Upturn likely in coming months

There are downside risks to the global economic outlook from a China hard landing and from emerging market growth more widely. However, we continue to think that the global economy will gain pace in the coming months after a weak start to the year. The advanced economies look to be on a good track, with domestic demand firming.

China not waving the white flag

We do not think that the Chinese authorities are waving the white flag in terms of supporting economic growth. Their aim in our view remains to foster a gradual slowdown. Signs that momentum is deteriorating more sharply has always triggered action to support the economy. They also have a lot of ammunition they can fire. We therefore think the Chinese authorities will do what it takes to get economic growth back towards their growth target going forward.

Lower trend

Of course, global trend growth has come down since the financial crisis. So even though we see a cyclical upturn, with economic growth likely to be above trend rates, the overall pace will be nothing to write home about.

Fed: still September but rising risk of a delay

Our base case is that the Fed will hike interest rates next month. However, the risks of a delay have increased further since the market turmoil. Nevertheless, the US economic data continue to be consistent with a rate hike and uncertainty could even be reduced once the first step is out of the way and the world doesn’t end. Fed commentary at Jackson Hole, especially from FOMC Vice Chairman Stanley Fischer this weekend should tell us more.

Graph: Eurozone money supply signals recovery

Risk of ECB stepping up QE rising

At the same time, the risk of the ECB stepping up or extending its QE programmes have risen significantly given the comments of Executive Board member Peter Praet. Usually when a central banker says that downside risks have ‘increased’ it’s a signal that policy action will follow. Nevertheless, we are cautious in this case, as that message has not been repeated by other officials. So we will be watching the tone of ECB Vice President Vitor Constancio’s speech at Jackson Hole with great interest in this respect.

Is more QE really necessary? In our view not at this point. China risks, the drop in commodity prices and somewhat higher euro do point in this direction. However, more importantly, core inflation has bottomed out and the eurozone economic recovery is continuing.

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