4th February 2016
Dominic Rossi, global CIO of equities at fund manager Fidelity International looks at the recent market volatility and the role central banks need to play…
The world economy is bearing the brunt of a third deflationary wave in less than a decade, this time emanating from the developing world.
A combined volume and price shock is depressing aggregate demand in nominal terms, guaranteeing that world GDP will continue to operate at a level below potential output.
A painful supply-side adjustment in the developing world is at hand, with a further fall in potential global output unavoidable. A general weakening of inflationary expectations is now visible.
Those investors who had hoped the secular opportunities within the developing world would insulate them from the stagnation across the developed world will need to rethink.
This emerging markets crisis, in essence, joins the developing world with the low nominal framework that has engulfed the developed world since the Great Financial Crisis.
In US nominal dollar terms the Chinese economy is now growing at a mere 1-2%, slower than the US economy, compared with over 10% in 2010. This landing is already hard.
A landscape of low nominal growth, and an ice age of low nominal interest rates, looks more with us than ever.
More than ever monetary policy in the developed world must be clearly communicated in a way that supports aggregate demand to minimise the damage this third wave of the crisis may have on developed economies.
Unfortunately, a series communication errors over policy in recent weeks has unnecessarily contributed to equity market weakness.
The ECB disappointed European capital markets before Christmas. The PBOC mis-managed a shift in foreign exchange policy from a RMB dollar link to a basket of currencies which no one understood.
Finally, after a well flagged interest rate hike, Fed spokesman were too forceful in signalling that money markets were under estimating interest rate rises in 2016.
These signals need to be reversed in order for equity markets to stabilise, fortunately this may be happening. Draghi has set markets up for further QE in March and he cannot afford to disappoint a second time.
The PBOC admitted it made a mistake and, with this admission, will now need to bring more clarity to foreign exchange policy. We must hope the Fed also now pulls back from its rhetoric on four interest rate increases in 2016.
The Fed has featured the strength of the labour market, and expected wage rises, as the basis for future interest rate increases. Tightness in the labour market is undeniable, and there are signs that wages are trending higher.
However there is very little evidence any other market is tight.
The supply of goods and services is ample, with over-capacity in many sectors. Industrial utilisation is below 77% and a wall of cheaper imported goods can stock Walmart’s shelves. With the recent fall in oil, inflationary expectations are failing again. Five year inflation breakevens are now trending down and sit at a substantial discount to the Fed’s own 2% mandate.
It will be sometime before a pick up in wages broadens out to a general price increase.
Yet the Fed has pushed aside this inflation data, convinced the effects of low oil and commodity prices will prove transitory. This view was questionable even before the most recent oil price weakness.
After the 2001-3 recession, it took only two more years for the US inflation rate to reach 2%. We are now in the sixth year of this expansion and the PCE deflator stands at 1.3%.
The Philip’s curve cannot offer us a satisfactory explanation to this conundrum.
A recognition that US dollar strength has had a powerful disinflationary affect would inform monetary policy. The Fed has consistently failed to calibrate the impact of its forward looking statements on the foreign exchange markets. As a consequence, a strong US$ has forged a nexus with weak commodities, emerging market volatility and a tightening of financial conditions generally.
A weak inflation picture has subsequently emerged.
So the Fed needs to step back from communicating four interest rate hikes this year.
If it continues with the current trajectory for the funds rate, it risks a further appreciation of the dollar, which is the present threat to financial market stability. The Fed needs to communicate that it understands this threat and indicate that further dollar strength would be unwelcome. This message alone would immediately ease financial conditions.