Stock markets are trending downward very rapidly everywhere in the world. In France the CAC40 has lost 13.8% of its value since the beginning of the year. At the same time, interest rates converge to 0% or below. In Tokyo, the 10 year government bond yield is now below 0%. According to the FT yesterday, the volume of government bonds that is traded below 0% has now reached USD 6tn close to one third of the market.
How can we understand this phenomena?
Financial markets momentum depends mainly on expectations. Those latter are usually conditioned by economic prospects. But it is not sufficient at this moment. Communication from central banks is key to understand the current financial market behavior.
We first have to go back to mid-December when the Federal Reserve, the US central bank, has decided to increase it interest rate from [0; 0.25%] to [0.25; 0.5%]. Immediately after this move, most investors have predicted four rate hikes in 2016.
The idea behind this prediction is the following: the Fed acting now means that the economy is back to its fundamentals. The business cycle will, in the future, follow its pre-crisis behavior. Therefore the Fed will have to tighten its strategy because economic activity and inflation will creep higher. One idea behind that way of thinking was to say that the US economy was able to play a more important role in the global economic momentum. The rosy scenario was back in the mind of many investors and economists.
Nevertheless, this framework was short-lived. At the beginning of January the message from China was clear. Chinese authorities have accepted a depreciation of the yuan because they need a shock of competitiveness. The implication is that China is no more able to converge to its previous growth pace. The global recovery will not come from China and Asia.
One major consequence of this signal is that the gap between supply and demand in the oil market is here to stay. Demand is increasing but will not accelerate and supply is well above it, leading to lower prices and the accumulation of inventories.
A lower oil price was a negative news for central bankers. At the end of 2015, they all suggest that with an oil price at USD 50, the energy contribution to the inflation rate would be close to 0. In that case the inflation would have converge to the core inflation rate.
With an oil price close to 30 or 35 dollars, the question is totally different. The energy contribution to the inflation rate is negative leading to inflation rate close to 0% in 2016.
This deep change was perceived during the ECB press conference on January the 21st. Mario Draghi had to change his mind about inflation and on monetary policy. Measures that were announced at the previous meeting in December the third were no longer relevant. They were supposed to be relevant in early December but were not enough one month later. That’s why Mario Draghi said that new measures would be presented at the March meeting.
The ECB was the first to change its mind so deeply within the large central banks. But the Federal Reserve, one week later at its FOMC meeting, had lost the enthusiasm it had a month earlier on the growth momentum and on the capacity of the inflation rate to converge to 2% in a finite time. The possibility of a rate hike in March has disappeared.
The Bank of Japan two days later said that growth was a problem and that inflation was too low for long. As a consequence, the BoJ has reduced its main interest rate from +0.1% to -0.1%. Last week the Bank of England has reduced its growth and inflation forecasts for 2016 saying at the same time that its rates would remain unchanged in 2016.
In other words, central banks have been surprised by what has happened. Their message is a clear source of uncertainty for investors because in one month time they have to deeply change their mind. This means that in their process there is a huge uncertainty on the economic growth trend and on the inflation rate profile. Therefore they decide to be more accommodative, just to limit constraints on the economic activity and on economic actors’ behavior. That’s how we can translate the new measures the ECB will announce in March, the reduction in the Japanese rate and the drop in the probability of rate hikes in the US after the last FOMC press release.
The uncertainty increased last week after data published for the US economy. The ISM survey index for the manufacturing sector was below the threshold of 50 for the 4th month in a row, the ISM global which a weighted average of the the ISM index (manufacturing and non manufacturing) dropped rapidly in January and employment figures were in January way below the last five year average.
In other words, the US economy was expected to be strong at the December Fed’s meeting. It’s no longer the case and growth could be lower than 2% in 2016. Recent figures suggest that the business cycle peak is behind us (see here) and that there is no reason for the Federal Reserve to tighten its monetary policy. May be the Fed was wrong in its movement in December as it was the first time since 1986 that the Fed was increasing its rate while the ISM index was below 50. Since the beginning of the great moderation the Fed has followed the business cycle signals except in December 2015 and may be the US central bank made a mistake.
The uncertainty on the market is associated with the following global framework: the global growth momentum is weak and since mid-2011 there is no strong locomotive (see here the analysis I did last summer). The US current recovery is the weakest since WWII and is not able to be a growth driver at the global level. In the current situation, its momentum is lower as oil price dropped to USD30. Investment in the energy sector has been a strong support for growth during the recovery. With a price close to USD30 investment projects dropped to 0 and this has a negative spillover effect on the economy specifically in the capital goods sector. In the employment report, the number of temporary jobs dropped dramatically in January. It’s usually an alert on a lower economic momentum.
China is in transition from an industrial led growth model to a service led growth model. It is no longer the locomotive it used to be since the end of 2001 and its membership of the World Trade Organization (see here). Europe and the Euro Area are followers in this global dynamics.
My analysis is that recent uncertainty from central banks and from the economic environment has created a deep change in investors’ expectations. Because even with an oil price at USD30 there is no strong rebound similar to what was seen in the mid-eighties and at the end of the nineties. The two main locomotive of global growth are no longer strong sources of impulse for the world economy.
At the same time central bankers have told that their analysis was fuzzy and that they were surprised by the way the economy is changing.
Recent movements on financial markets have probably shown an over-reaction due to the fact that the economy was changing. The economy is not back to a kind of classical business cycle as it was expected in mid-December after the Fed’s hike. The crisis has created situations during which the economy shows no capacity to rebound strongly and for an extended period of time that could lead to tensions in the economy.
What can we expect now? The risk is to follow a low growth path for the world economy, lower than what we had recently because growth expectations on China and the US are lower. We can’t expect a strong rebound in the oil price and on inflation rates. Therefore, monetary policies have no other choices than to stay accommodative. The Fed will probably not increase its interest rate this year. Its increase rate cycle will probably be the shortest ever.
One consequence is that interest rates for all maturities will remain low and probably the share with yield below 0 will increase rapidly even in Europe.
In that environment, there is a temptation to increase saving for everyone but it is the contrary that has to be done. Higher saving would create what Keynes called the paradox of thrift. Everyone try to save more but at the end demand addressed to companies is lower, weakening growth prospects. Governments have a strong role to play in this environment. They must be a support for expenditures and economic activity. They mustn’t save but spend on public investment to create support for private investment.
The main risk in this environment is not a collapse of the economy as it has been the case at the end of 2008. Growth will be low for long but there is break that could look like what has happened after Lehman.
The main risk is political. Commodity producing countries have lower revenues and are no more able to finance social peace. We’ve already seen austerity policies in different countries (Saudi Arabia for example) and this could lead to social unrest and political instability. In Europe, lower growth prospects and the refugees crisis are ingredients for discussion on the role of the European Union. Extreme votes that can be associated with this environment could weaken the European construction creating a political crisis in Europe. In the US, presidential election will, for sure, increase uncertainty as republicans and democrats seem to speak of a different country.
Growth prospects appear to be highly uncertain and central bankers do not know how to handle the situation.  That’s the new situation. For sure it will be volatile.