Financial volatility has been steadily moving higher over the past couple of months. We have been expecting a rise in volatility since the last quarter of 2014. Our premise has been based on the friction caused by divergent monetary policies amongst G7 central bankers and gradually deflating and slowing world economy. Financial asset prices have been propped up by the promise of central bankers to suppress the short term interest rates as well as long term interest rates at a very low level. Supply of money, as well as cost of money is the life blood of asset booms. So when central banks deliberately manipulate those two metrics, some spectacular asset reflation cycles can be engineered. However, many a times such excesses reach unsustainable heights from where equally spectacular asset busts occur.
Famed economist Stephen Roach wrote about the waning impact of quantitative easing programs on the world economy (https://www.project-syndicate.org/commentary/ecb-quantitative-easing-experiment-by-stephen-s–roach-2015-01). There he referred to three ways of assessing the effectiveness of a QE. They are:- (i) transmission of such a policy into the real economy, in the form of investment and or consumption (ii) responsiveness of the real economy to such policies (iii) how credible are those policies in achieving the real economic results. We believe that it can be argued that US Fed’s policy of reflation asset booms to trigger consumption boom through increased wealth effect has borne some fruits, evident from the relative outperformance of the US economy. However, on an absolute basis, growth has been slower and quality of jobs weaker than previous recoveries. Dr. Rajan in his speech (https://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=930) referred to the term “secular stagnation” in the west. He pointed out how the peak in debt fuelled consumption boom between 2008-11 coupled with peak in productivity, ageing of population, technological displacement have caused potential growth rates to stagnate at a lower level. Therefore, as US has managed to eke out growth from the fading effect of QE, Euro zone and Japan could struggle. We believe, for both Euro zone and Japan, currency devaluation and through that gaining global export share seems to be the ultimate motive, over wealth effect induced consumption boom. However, it is also a fact that how much such a policy can create a sustainable economic improvement would depend on global economic condition as well as on the fact that how much are their competitors not looking to pursue a similar competitive devaluation. Therefore, it can be said that with some certainty, Euro zone and Japan have much lesser control over the three metrics to which Stephen Roach has referred to in his article.
Meanwhile in the Euro zone, the tension between Greece and rest of the members of the Monetary Union are threatening to boil over. On one hand, Greece wants an end to austerity programs demanded by Troika in return for the bailout of its financial system and they also demand that the holders of Greek debt accept to restructure, but on the other hand, Troika, led by Germany is no mood to relent. ECB has already stopped accepting Greek debt as collateral for funding under the refinancing operation. Therefore, now Greek banks, who face the increased risk of bank runs, are dependent on the emergency liquidity assistance (ELA) program of the ECB, backstopped by the Greek Central bank, at a penal rate of 1.55%, for their funding needs, which seem to be rising by the day. The current bailout program requires the existing government to adhere to the conditions of Troika to secure the next leg of the bailout payments, without which the Greek government may be forced to default on its debt repayments by summer of this year. At the same time, incase ECB closes the ELA window, then Greek government would be pushed closer to default and also to Greece imposing capital controls within its economy, which are all measures which can finally culminate into Greece’s unceremonious exit from the Euro zone. We hope at this point, that an amicable solution is reached between Greece and rest of the Euro zone, before a contagion occurs. Though some policy makers in Germany seems to believe that the fallout from Grexit can be contained but we fear otherwise. Such an event would challenge the narrative that Euro zone is unbreakable and policymakers there would do “whatever it takes” to keep the monetary union intact. In today’s world, where financial asset prices are being greatly driven by faith on central banks, rather than on real economic value, the importance of narratives are immense.
For the Euro zone to prevent a politically forced dissolution of the monetary union, there needs to be a greater sympathy towards the plight of the southern countries. A walk down the history of the Euro zone can outline the causes of the crises and also explain why a collaborative effort is need to resolve it. During the inception of the Euro zone, Germany, who was doing its best to stabilise post-unification, put in place polices to support greater industrialisation. It decided to suppress wages of workers and keep real rates high. Suppressed wages and higher real interest rates in Germany caused household consumption to lag but production to increase. Higher production and lower consumption meant savings rose as a proportion of GDP. Additionally, high real rates ensured that investment in the economy never kept pace with the rising savings. Current account which is nothing but a difference between savings and investment in the economy, swung from a deficit of 1.7% in 2000 to a surplus of 7-8% by 2008-10. At the same time, with the unification, member nations lost independence of their external trade policies, monetary policies and currencies.
Source: AMECO, European Commission.
Southern Euro zone nations, viz., Greece, Ireland, Italy, and Portugal had inflation and interest rates which were much higher than that of Germany. However, after the launch of Euro, interest rates in the southern Euro zone nations fell sharply. At the same time, Germany having surplus savings, had to export those down south. German banks became the transmission duct through which surplus savings moved from up north to down south in the Eurozone. The southern Euro zone countries, faced with influx of massive capital from Germany at low interest rates, embarked on a consumption and investment boom. Lower wages in Germany and lower inflation ensured that German goods outbid the local manufacturing capabilities in southern states. As a result, PIIGS became far more dependent on non-tradable services sector and sectors benefitting from the real estate and stock market boom. Hence, offsetting deficits emerged elsewhere in the Eurozone. By 2008-10, the current account deficit was 15 per cent of GDP in Greece, 10 per cent in Portugal and Spain, and 5 per cent in Ireland. The mal-investment and the consumption binge in down South, sponsored by excess savings from up north, triggered an unsustainable rise in debt levels, which ran into trouble post 2008-10. Therefore, we can say that all parties or countries in Euro zone are responsible for the imbalances that now exists in the monetary union. Therefore, the solution lies in an amicable reduction of debt for the southern countries as well as enacting policies which encourages consumption and or investment to rise in the northern countries. Such a shift in policies would allow Euro zone nations to achieve a sustainable future. However, instead if Euro zone nations continue to pursue the path of forced austerity on the non-core countries, then we are afraid it can fan rise of many such left or right leaning, euro skeptic parties in countries like Portugal, France, Spain and Italy. Currently, barring France and Finland, the rest of the countries in Euro zone have managed to move to a current account surplus. It is expected that over the next 2-3 years, even France can also have a current account surplus. The question that begs to be asked is, with such massive increase in surplus savings in the Euro zone, where will it get utilized. In fact, world over countries after countries are pursuing policies which increase surplus savings in the economy. A combination of such polices, causes domestic demand to remain suppressed and production to rise at a time, when much of that production is being financed by greater loads of debt. A deflation is born that way and that is what causes deflation to grow and spread.
Turning our focus back to markets, we Dollar/Rupee show meaningful strength on the face of increased corporate inflows. A spirited intervention having supported the US Dollar when it needed most, we expect a stronger US Dollar over the near term. We would advise importers to cover their near term imports on declines towards 61.00/61.50 levels and exporters to wait for a rally towards 62.70/63.00 to hedge. Globally, US Dollar made a strong come back on last Friday, as US jobs growth for the month of January beat expectation. A deeper analysis of the non-farm payroll data though indicate positive trend for employment in US, but it is yet not a spectacular one. Hourly wages growth remain stuck between 1.3-2.3% for the past 5 years and labour participation, though stable, is still at a multi-decade low. Over the past three weeks, the weekly jobless claims as well as other industry reports seems to be suggesting that US is losing quite bit of jobs in the oil and gas industry. We would need to keep an eye on that.
US Dollar has rallied by close to 1.5-2% against a whole host of global currencies. Large US corporates, who have operations abroad, have issued profit warning on the back of a stronger US Dollar. In our opinion, US Dollar has diverse effects on the US economy. On one hand, a stronger US Dollar reduces dollar earnings of large corporations and resident US citizens who earn in non-Dollar currencies and also adversely impacts export growth. On the other hand, a stronger US Dollar benefits the domestic consumer and small companies with little no foreign earnings, as cost of goods imported falls. The net effect, whether positive or negative, would depend on how much are the large corporation and or exporters willing to slow hiring or wage growth on account of that. There is no easy answer to that.