Friday, April 14, 2017

Financial Market Snapshot April 2017

Financial Market Snapshot
April 2017
International tensions
Political events continue to overshadow the economy. Acute tensions are on the rise about North Korea’s nuclear program and the conflict in Syria. Although the head of America’s central bank has announced the commencement of a policy aimed at bringing down the overextended central bank balance sheet to begin this year, the central bank may delay the project because of the highly uncertain political environment. This would imply that stock markets, which are already overextended, would likewise delay their correction.
European uncertainties
Political events also tend to overshadow the economy in Europe. There will be elections in France, with a right-wing populist as one of the frontrunners. Later this year, Germany will hold federal elections. The incumbent head of the government faces a strong opponent. Britain has officially triggered its exit from the European Union. Yet no one knows how the terms of separation will play out. To make matters worse, hardly a week goes by without some terrorist event in Europe and other parts of the world. The crisis of immigration remains unresolved.
Europe’s economies march at different paces. While Germany keeps doing well along with some other Northern EU countries, Europe’s South has a hard time getting out of its stagnation. 
Quantitative easing in reverse
In reaction to the global financial crisis of 2008, central banks in the industrialized countries, particularly the US Federal Reserve and the European Central Bank, have practiced a policy of “quantitative easing”, which has led to an unprecedented expansion of the central banks base money. This way, commercial banks could easily obtain funds in order to consolidate their balance sheets. This policy is about to end. The financial sector seems robust enough to support a withdrawal of base money. What lies ahead is quantitative easing in reverse.
Outlook for interest rates
The reversal of the quantitative easing policy will require higher interest rates. A continuation of negative real interest rate would drive up asset prices to unsustainable levels. In the area of monetary policy, the big questions for the rest of the year will be how the major central banks will manage to reduce their balance sheets. For this purpose, the central banks must sell a huge part of their assets, which largely consist in government bonds.
Asset prices
For almost ten years as by now, monetary policy has been extremely expansive. An enormous expansion of central bank money has taken place and interest rates have come down to zero and have turned negative in some cases. Now, as the major central banks prepare for a reversal, the question arises what will happen to the asset prices. As a reflection of the low interest rates, stocks, bonds and real estate are highly priced. In order to find buyers of their bonds, central banks must lower the prices, which will mean higher interest rates. GL
Economic growth
All major economies post relatively solid economic growth in the range of an annual growth rate of the gross domestic product between 1.5 to 2.0 percent. Germany’s export boom continues and private consumption is on the rise. In the United States, consumer confidence is getting stronger propelled by a favorable employment situation. It is doubtful, however, that any higher growth rates could be achieved in the future given low productivity growth in all major industrial countries.
Prices and interest rates
Global inflation remains low. Central banks wanted to get out of the deflationary drag and finally managed to obtain higher inflation rates. Currently, the U.S. inflation rate is close to two percent while in the Euro Area, the rate rose to 2.6 percent. With interest rates below this rate, real interest rate are negative. This constellation stimulates gross fixed capital formation. This should foster further economic growth. Negative real interest impact heavily on the German real estate market where there is no end in sight of the housing boom.
In the United States, Japan, and Germany, employment is surprisingly strong with unemployment rates below five percent. In the overall Euro Area, however, unemployment remains high. Europe’s unemployment rate has not yet fallen below the ten percent level. The highly uneven levels of employment in the Euro Area contributes to the general uncertainty about the future monetary policy actions. The absence of significant wage rises seems to be a major cause of the favorable employment situation. It remains to be seen if this situation can continue.
Current account and exchange rates
The exchange rate between the U.S. dollar and the euro has remained very stable over the past years and continues this way while the dollar has strengthened against many other currencies recently. In terms of purchasing power parity, the US-dollar is highly overvalued against almost all currencies. As a consequence, the U.S. current account deficit remains persistently high and America’s net foreign investment position is worsening. The recent meeting of the Chinese leader with the American president has defused the dispute about China’s exchange rate manipulation – at least for a while.

North Korea
All eyes are on North Korea and how the United States will react when Kim Jong-un should continue with his nuclear program. The fall-out of a military intervention would affect profoundly North Korea’s neighbors such as South Korea, China, and Japan. All three of these countries have close links with the world economy and thus any serious conflict would be strongly felt in the whole world.
President Trump has tried to find help from China in dealing with North Korea. This way, trade tensions between the United States and China have been kept low for a while. Yet the military expansion of China to South China’s seawaters does not bode well for a real d├ętente. China tries to bring down its huge position in U.S. government bonds, which will require a shift in economic strategy from exports to domestic consumption.
Middle East
The importance of the Middle East for the world economy results from its huge oil and gas reserves. Although the West is no longer as dependent on Arab oil as it was in the 1970s, the contribution of the region to the global oil supply is still important enough so that a stop of oil deliveries would severely disrupt the world economy.
Latin America
Latin America is at the fringe of global politics. Various countries in this region have enough domestic trouble to keep them busy for years to come. Different from Asia, almost no Latin American country has shown superior economic growth over the past decades. On the contrary, countries like Argentina and Venezuela are falling back and Brazil, which promised to move ahead, could not maintain its growth pace of the first decade of the new mellenium. 
Africa presents a highly mixed picture. Some African countries move steadily forward, such as the Ivory Coast, Kenya, and Mozambique, while others move backward, such as South Africa and Nigeria. Like some Latin American countries, parts of Africa have become a domain of China’s economic expansion in search of securing raw materials, space and food supplies.

Antony P. Mueller
The Continental Economics Institute
April 15, 2017