DABERIAM XCVI

18th February 2016

The Year of the Fire Monkey, 2016, has started with stock market turmoil and paralysis in the central banks.  Economic indicators are pointing all over the place and economic commentators, faced with no consistency in the short term indicators, are failing to come up with any cohesive or consensual opinion on what is happening.  The consequence of this confusion seems to be that central banks, with the exception of the Fed, just continue to lean on the same levers as they have been doing for the last seven or eight years, since the financial crisis.

The Fed had a go at moving expectations and raised interest rates by an insignificant quarter point at the end of last year and was then forecasting a continuing rise in interest rates, working towards a more “normal” level, whatever that may be.  This initiative would appear to have stalled as a result of the stock market turmoil.  The problem with stock market turmoil is that it has rattled the public and politicians as well as central bankers, particularly as it has proved difficult to point a finger at a cause.  Without being able to pin the turmoil on a cause, the myth that central bankers are all-powerful is exploded and increases the feeling of uncertainty.  Increasing the general feeling of unease is the political malaise and lack of Western leadership.  The world’s biggest economy by far, the USA, not only has an uninspiring President but the Presidential elections are not as yet throwing up candidates that inspire confidence.

Politics aside, there does not seem to be any particular underlying change in the direction of the world’s economies and it must be noted also that the problems of the banking sectors around the world have by and large remained unresolved since the financial crisis.

The oversupply of commodities is cyclical: the supply of raw materials (copper, steel, oil, and even food) respond to prices.  Food shortages create price increases which encourage farmers to produce more, a slightly shorter cycle than copper and most other commodities, which tend to work in approximately ten year cycles.  Today, with prices on the floor, the exploration boom for raw materials is coming to a halt.  Countries that were benefiting hugely from rising prices and whose politicians were able to claim all the credit for their country’s prosperity are now in trouble.  Countries that did build reserves are starting to spend these reserves.  Countries that did not build reserves are facing economic stagnation and bankruptcy.

For the consuming countries, this is basically good news – cheap energy: oil and gas; cheap raw material: copper and iron etc., will feed through into economic growth as prices decline.  The change from high to low prices in this area causes a disruption in financial markets and this is what we are experiencing.  The aftermath of the financial crisis and central banks’ profligacy caused the banking system to lend to companies and countries that were benefitting from high commodity prices.  There is now a major threat of default on these loans.  Added to the banking worries, countries that ran surpluses and built up reserves have been spending these reserves.  That is, moving stock markets…And the asset bubble created by quantitative easing is being deflated. 

Another disruption to markets is coming from China, where the freeing up of the exchange rate, demanded by the West for many years, is causing money to flow out of the country.  A major policy headache for the Chinese government which is trying to work with western economic systems.

China is also conducting an experiment on a massive scale, of deliberately rebalancing its economy.  A good idea in general, but something that has never been attempted before.  So far the experiment seems to be going relatively well, when one looks at it from within China.  It is, however, having a disruptive effect on the world economy, and exacerbating the problems in the prices of commodities.  If the Chinese government can keep its nerve, its course of action will be enormously beneficial to the people of China and the rest of the world.  It is inevitably going to be a rocky period for the next twelve months or so.

US stock markets have, as I have said, been in turmoil and there seem to be two major factors underlying this.  An enormous outflow of funds, over $30 bn. in January alone, naturally pushed the market down.  The extent of the across the board decline is exacerbated by the new large market in ETFs, where somebody selling is not selling an individual stock, but causing across the board sales.  The market it being heavily constrained by regulation since the financial crisis and the historic pools of funds held by market makers and bankers, which would have smoothed movements in the markets, have largely disappeared.  This makes violent gyrations more likely.  Looking at America as a whole, however, the economy is sound:  unemployment is getting down to historically low levels, Federal tax receipts are up over 5% year on year, house purchases and retail sales are comfortably up.  All basically good news.

Europe still has not adjusted but there are signs of improvement in employment in southern Europe, albeit painfully slow.  The bad news is Germany which is suffering from the Asian slowdown.  The really bad news, however, is that the system of government in Europe is producing sclerosis in the economies.  Bureaucratic overload is stifling industry and commerce, regulations pour out of Brussels but nothing is done to free up market forces.

Further confusion in Europe is being created by the British referendum, and the political expediency of calling a referendum is also creating, I think unnecessary, economic uncertainty.  The difficulty of decision taking in business caused by general unpredictability is being exacerbated.  In the end, Britain probably would benefit from standing alone in the world and not being part of a sclerotic Europe.

We are in confusing times as the world’s economy adjusts from high to low commodity prices.  This adjustment, however, will by the end of 2016 largely have been made and the outcome will be primarily beneficial to western and Asian economies.  Until we get through the current fog and confusion, the ride will be rocky.