Central banks’ options, and Q2’s biggest risks
The International Monetary Fund (IMF) recently pointed out that the global economy risked stagnating as a result of its prolonged period of slow growth. We, however, think this forecast has captured a lot of the worries we had at the beginning of Q1. In some ways the IMF is a lagging indicator and is looking in the rear view mirror. Those worries we had at the start of the year are starting to fade as there is a bit more stability in China, the US and rest of the world.
Are central banks out of ammo?
Central banks are in a very difficult position. They have to behave as if they have more tools in their toolkit, but if you read between the lines, there is very little more they can do in terms of delivering stimulus. In addition, the negative interest rates they have introduced actually have lots of adverse effects, particularly on the banking system and its profitability.
We do not think central banks alone can do anything further to stimulate the economy – aside from extreme measures like so-called "helicopter money" (effectively printing money to hand out to citizens) or monetising debt (whereby a government directly issues new debt to the central bank, thus increasing the monetary base).
As such, their next focus needs to be fiscal, and we expect them to be reaching out to governments asking for fiscal stimulus.
Should we be optimistic on emerging markets?
Emerging market currencies surged in the first quarter, which was the result of a "virtuous circle" of rising commodities, a weakening dollar and China improvement. There are signs on the ground that export orders and manufacturing activity are beginning to improve in parts of emerging markets. These are helped by the stability and rally in commodity prices, but also by a turn in the global inventory cycle. We have seen manufacturing and trade subdued as companies have tried to work off this excess inventory. It looks like this is now beginning to happen, and will help emerging markets as we go forward.
In addition, we believe a more stable environment for emerging markets could make the Fed more likely to raise rates again, as the global market volatility caused by such a move is likely to be reduced.
Where next for the Fed?
We think the Fed needs to hike again soon. It is clear interest rates overall are very, very low, at -1% in real terms. The Fed will have to move rates up gradually, but they are also mindful in an election year in the U.S. that there is a limited window, so they really need to go in the next few months.
Who will benefit from oil price gains?
The recovery of oil this year has been one of the biggest drivers of the market rally. If prices continue to rise, Europe will begin to feel the negative impact but at the same time it will be welcomed in some European countries. For example, lower oil prices have been driving consumer spending in Germany, and it has been a boon for the Germany economy. Rising oil prices will unwind some of that and push up headline inflation, helping Europe move away from a deflationary environment.
Are investors overestimating China’s impact on the global economy?
China remains an important focus for investors globally, although people maybe overestimating its impact on the rest of the world as its dynamics have changed.
Ten, or even five, years ago, Chinese headline growth levels were important for the rest of the world because they had a lot of infrastructure spending, used a lot of commodities and drove global growth. But the balance of growth in China is moving from the industrial to service sector, which has a far lower effect on the rest of the global economy. Now it comes from companies like Alibaba with goods produced in China, from a website in China and with its profits in China. It has far less impact on the rest of the world.
What are the biggest risks facing investors in Q2?
There are major risks for the quarter ahead.
The first is the upcoming referendum on the UK’s membership of the EU. We think the near term impact on GDP growth could be quite severe in the event of a Brexit – about 0.9% lower in the following year. This is because you would have a hit on investment growth and consumption, so you would see a bit of a pause in the UK economy. The real focus will be the pound and whether it could fall further. We think it could fall further, and this would eventually help the economy, but in the near term would affect inflation.
The second main risk for the quarter concerns currencies. They are more stable at the moment but we have seen a big move in the yen. The Bank of Japan does not want that and it might act, which could result in the currency wars kicking off again.
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