SINGAPORE (May 28): Financial markets have become highly volatile of late, with oil prices, bond yields and currencies swinging wildly and equities enduring many a turbulent turn. Investors have had much to worry about. Global economic growth has been looking shakier, especially in Europe and Japan. Oil prices are at a four-year high. Trade disputes among the major economies could damage world trade. Where geopolitics is concerned, not only are the risks proliferating but the unpredictability in so many of these hotspots also makes it difficult for investors to formulate a clear view on risks and rewards.
We suspect that the next few months will not be benign for markets. First, we expect global growth to regain momentum — good for Asian exports, economic growth and corporate earnings, but the financial consequences could be troubling. Second, while compromises among the big countries should prevent an immediate descent into trade wars, protectionism is going to worsen. Finally, we see a rising likelihood of political upsets, which investors may be underpricing.
Upside for growth sounds good…
Economic activity in the first half slowed all over the world. While things now seem to be looking up in the US, prospects for growth in Europe and Japan seem clouded. The latest Purchasing Managers’ Index survey for Japan, for example, was disappointing, with new orders falling to a nine-month low while the eurozone PMI slumped to its weakest level in more than a year. Sentiment indicators in Europe have also weakened considerably.
However, we believe that global economic activity was simply taking a pause in the early months of 2018 and should re-accelerate in the coming months as two additional engines of growth, capital spending and fiscal spending, kick in.
• Capital spending: In the US, for example, the latest industrial production data showed capacity utilisation in manufacturing at 75.8%, inching closer to its pre-crisis peak of 79.3%. As capacity tightens, businesses will be more incentivised to spend on new plant and equipment. Higher oil prices are already stirring spending on oil-related capital spending. Indicators for technology spending continue to soar as well, with the Fed Tech Pulse rising to its highest level in 10 years, suggesting that the multiple technological revolutions are reaching a point where businesses have little choice but to invest more in order to maintain their competitive position.
• Fiscal spending: The US economy is set to receive an energising boost from tax cuts and stepped-up spending over the coming year. The new German government will be cautiously expanding social spending as well. In Italy, the coalition of two populist parties is determined to introduce a flat tax as well as a universal basic income for poor people. Infrastructure spending by governments in developing countries is also picking up momentum. The tendency towards the fiscal austerity of recent years is being reversed quite fundamentally.
…but could mean downside for markets
Consequently, global economic growth will rebound in the second quarter and sustain at robust levels over the coming year. This could raise expectations of earnings growth, but could also hurt valuations in asset markets for a number of reasons:
• First, the bountiful liquidity that sustained high valuations will recede, whatever central banks do or don’t do. The very fact that economic growth is rebounding will be enough to divert liquidity from financial uses to the real economy. This is especially the case if one major driver of growth is rising expenditure on capital goods, which usually results in more bank lending to the real economy and more bond and equity issuance to fund capacity expansion.
• Second, confidence in stronger growth has already persuaded central bankers in the US to commit to raising rates in a judicious manner. In the UK, the central bank appears to feel that despite signs of slower growth, rising inflationary risks mean that it has to tighten policy. In fact, once monetary policymakers feel confident that economic growth is not at risk, they will focus on the risks posed by inflation and financial stability.
Both these risks are being underestimated by policymakers, but that is set to change:
• Purchasing manager surveys show price pressures intensifying even in countries such as Japan and Taiwan, which have endured a long period of deflation. For example, the latest PMI survey for May shows input price pressures at their highest in four years in Japan. It is premature to talk of an inflationary surge, but inflation is almost certainly set to accelerate modestly.
• More and more analysts are also raising concerns over two sets of financial risks in particular — corporate debt in the US and non-financial corporations’ borrowings in emerging economies. The Bank for International Settlements has raised the alarm on the latter — their numbers show non-bank borrowers in emerging economies tripling the size of such borrowings between 2007 and 2017 to US$3.67 trillion ($4.93 trillion). As rates rise, the growing volumes of debt due for repayment will impose strains on emerging economies.
As competition for liquidity intensifies and as unquantifiable risks (such as geopolitical ones) proliferate, investors will become more rigorous in the way they price risk. As they become more risk-averse, they will become quicker to change their asset allocation whenever risks increase. This is one reason emerging-market currencies are now under pressure. The Turkish lira has been falling sharply in recent weeks. So has the Argentine peso and the South African rand. Closer to home, the result has been that the Philippine peso and the Indonesian rupiah have fallen as well.
Trade tensions: Look beyond near-term compromises
The overhang of rising trade tensions has hurt investor sentiment as well. For now, the US and China seem to be edging towards a compromise on trade. President Donald Trump seems reluctant to push China too hard despite his initial threats, while China has indicated — through unilateral concessions on things such as reducing protection for its own carmakers — that it is prepared to make some policy changes to placate the US. So, we are not likely to see a descent into a trade war in the immediate future.
But any relief will be temporary, and protectionism will get worse for Asian exporters. The pattern of trade negotiations — and the politics around them — is not encouraging. Where China is concerned, Trump’s rhetoric has galvanised anti-Chinese sentiment within the political and business elite so much that when he wanted to backtrack on sanctions against China’s ZTE Corp, there was a strong backlash that would limit further concessions to China in future. A permanent resolution of their trade disputes will be very difficult — US demands on China strike at the very heart of the Chinese economic development model, which the Chinese leadership cannot easily give up.
The uncompromising manner in which the US has conducted the review of the North American Free Trade Agreement is also a concern for Asia — Asian countries with large surpluses with the US can expect similar treatment; it is only a matter of time. The US is also adopting a harsh line on trade with its key strategic allies, Europe and Japan, confident that its large market is so important to everyone that the rest of the world will eventually cave in to US pressure. It will take time to convince the hardliners in Trump’s trade team that their calculation is wrong. In the meantime, the world trade regime will have to endure more undermining — and that is bad for Asia.
Investors can no longer be complacent about geopolitical risks
There are several areas where political risks are likely to surprise markets.
• First, there is so much dry tinder in the Middle East and so many agents willing to light matches that it is only a matter of time before the current pattern of episodic flare-ups escalates into wider conflicts. Israel has stepped up direct attacks on Iranian forces in Syria, no longer content with just attacking Iranian proxies. The US has pulled out of the agreement with Iran to limit its nuclear programme, clearly hoping to engineer regime change in Iran by destabilising its economy. Arab nations that fear the rise of Iran are backing the US and may even be cooperating with their long-time foe, Israel, in order to pressure Iran. The killings of Palestinian protesters in Gaza have also aroused intense anger that will find an outlet.
Asia is affected in two ways. The immediate effect is that a higher political risk premium has caused oil prices to spike up. That will eventually slow global growth and raise inflationary pressures. But, the seething resentments in that region are also spreading to Southeast Asia and inflaming passions in our region. After a long period of quiet, terrorism is back in Indonesia with multiple terrorist outrages committed. Worryingly, these incidents involved more sophisticated planning and higher-level bomb-making skills than before, probably reflecting the return of battle-hardened jihadists from the Middle East.
• Second, we believe that the relief over reduced risks in the Korean peninsula will be temporary. North Korea has changed its tune; after a series of concessions, it is now playing hard ball with the US and South Korea. It is still possible that a summit meeting will take place between Trump and North Korean leader Kim Jong-un, but it is unlikely that that summit will resolve the tensions in the region, as the minimum that the US will need is much more than the maximum that the North Koreans are prepared to concede.
• Third, the political pressures on Trump are likely to reach a critical point in the coming months. The noose has been tightening around people once close to his election campaign, and Trump himself will soon have to face questioning by prosecutors. Prosecutors are likely to be sensitive to the informal requirement that they avoid actions against political leaders too close to an election. With the mid-term elections due in early November, that essentially means that prosecutors will want to take action on areas they can by around July. Things are going to get very interesting in US politics.
Conclusion: a turning point in market behaviour
In other words, while we see a nice upside in global economic growth, the other factors that shape the investment landscape are likely to produce unpleasant surprises. Financial and political risks are likely to intensify just as global liquidity tightens and makes investors more risk-averse. Recent corrections in emerging-economy currencies are thus just the initial signs of a new and more troubling phase in global markets.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy