The International Financial Crisis
The extent and magnitude of the correction in equities at the global stock markets has taken many by surprise and shocked others, and maybe is this just the beginning!
Economic weakness in emerging economies
For some time, there has been mounting evidence of economic weakness in the emerging world, along with persistent low growth in Europe and Japan. The biggest economies have tried to increase the monetary base: it goes for the US, Europe, Japan as well as China and India. The focus was never really on improving basic economic conditions but simply on driving up demand by a flow of liquidity. The easy money policies had led global investors to search for higher-yielding securities, which they found in many faster-growing emerging markets. Money gushed into these countries in search of better returns, driving up asset prices.
With interest rates so low around the world, falling oil and commodity prices, the stock markets almost appeared to be the only choice and resulting – that we know now – in bubbles and inflated assets.
Central banks has depleted arsenals
The last day’s selloff originated in China following information on reduced growth and the subsequent limited devaluation of the Yuan. The selloff accelerated as fears spread that policy makers would not be able to respond sufficiently quickly and effectively. Part of this worry had to do with the extent to which central banks have used up all ammunition after years of monetary quantitative easing. However, a more significant concern arose from the correct realization that the primary response would have to come from the emerging economies that are the source of financial concerns this time, and not from the Federal Reserve and the European Central Bank.
The Fed has actually, since mid-2013 informed that its program of quantitative easing could come to a halt. The Fed has also signaled its intention to raise interest rates in the fall of 2015. If US-interests are raised dollars invested abroad will return and the effect on the value of equities in China, emerging economies and Europe could be devastating.
China is key
China is too big and too powerful to ignore. With an annual GDP of $12000 billion, it is by all standards a huge economic power. China is the largest exporter as well as the largest importer of oil and commodities. Obviously, its impact on the world economy is immense. When China devalues the Yuan, most currencies around the world suffer.
At the stock exchange in Shanghai the Shanghai Composite Index fell again Tuesday, 25 August 2015. China then announced that the central bank lowers its one-year lending rate by 0.25 percentage points to 4.6 per cent. The announcement was received very positively at most stock exchanges and most of the losses from Monday 24 August were regained, but followed Wednesday by new losses.
The problem is that problems are not confined to China. Other emerging economies, stretching from Malaysia to Mexico, are also affected. Their currencies and stock and bond prices have fallen sharply over the last week as foreign investments are withdrawn and seeking a safe haven in US Treasury Bonds. Brazil and Russia are having their own problems and economic growth stimuli are not to be expected. Only India is economically in good shape, but as usual fully occupied by domestic issues.
I am afraid that the global economy and shareowners have a lot to be worried about, as this crisis could get deeper and scarier than what we have seen before. The question is really, whether it is possible to restore longer-term stability with the policy tools available.
What will then happen in the coming months?
In the optimistic scenario, even with the absence of positive impacts from emerging economies, the typical market selloff-cycle after some time exhausts itself once prices come down sufficiently to be attractive for investible funds. This tends to happen first for the well-managed and resilient companies, and then it spreads to the market as a whole. In this scenario, there is cash in the hands of households and companies that could be placed in stocks, or funds hitherto parked in bonds whose yields have fallen and that will look for higher-return opportunities. The problem is that in best case it will take a while.
Sustainable solutions needed from emerging economies
This time, however, genuine and durable stabilization will not materialize unless a good part of the sustainable solution come from the emerging world.
Given the economic and political challenges in many of the systemically important emerging economies, maybe it will never happen – at least it will take time for growth to come back strongly and for comprehensive policy solutions to emerge, as these solutions necessarily must include politically painful structural reforms.
Unfortunately, today we are seeing every emerging market currency weakening. Portfolio outflows will follow, as there will be a flight to safety. Then the domestic problems like earnings downgrades, margin calls, promoters’ pledge selling etc. will happen before the market stabilizes.
The consequences of monetary quantitative easing
If the Federal Reserve, the European Central Bank and other central banks continue to pursue monetary quantitative easing instead of real economic growth investors in equities should be prepared for much more volatility and frequent corrections in markets.
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