Cash & Currencies: Financial Market Snapshot July 2016

THE CONTINENTAL ECONOMICS INSTITUTE

FINANCIAL MARKET SNAPSHOT

July 2016

- Brexit vote shocks markets

- negative interest rates are here to stay

- macroeconomic policy hits the wall

Brexit vote shocks markets

The result of British referendum about of leaving the European Union (EU) has hit financial markets like a shock. The so-called Brexit has brought market turmoil and will bring uncertainty to the international arena for years to come.

As if the series of other worriers has not already been enough, Brexit will weaken not only the position of the United Kingdom (UK), but the European Union as a whole.

The immediate fallout has been a drastic fall of the British pound (see chart. At the political front, Prime Minister Cameron declared his resignation and the opposition leader in the British Parliament suffered a vote of non-confidence. The independence movement in Scotland is gaining new momentum.

Some of the longer-term consequences for the economy of the United Kingdom are already visible:

- Consumer confidence has started to plunge

- Investment spending is on hold

- Import prices are on the rise

- Real estate prices have begun to contract

- Banks cut hiring and plan to move staff to other locations

Chart 1

British pound/US-dollar December 2015 – July 2016

Are negative interest rates the “new normal”?

Official interest rates in the United States, Japan and the euro area are close to zero or already negative. How long can this go on and what are the effects?

The low interest have come into existence because of the policies of “quantitative easing”, which means that central banks buy financial assets in exchange for money. Asset prices rise and consequently returns tend to fall.

The secondary effect of quantitative easing is an asset bubble. This, in turn, leads to a deterioration of wealth distribution.

Negative rates will exacerbate the situation. Along with accelerating the drive for riskier in search of return, negative rates on government bonds will also motivate the accumulation of more public debt.

An unsustainable situation is in the making.

A return to normality - with interest rates in the industrialized countries at their historical rates of the second half of the 20^th century - would require a massive downward revaluation of financial assets and of property.

Central banks rightly fear the effect of higher interest rates. Yet by postponing any correction, they make matters worse.

Chart 2

Negative interest rates of the German 10-year government bond

Macroeconomic policy hits the wall

With interest rates at historic lows and with public debt at critical levels, the conventional policy measures of monetary and fiscal stimuli have reached their limits. In many countries, private debt, too, is close to becoming unsustainable. Steps to promote more free trade also meet obstacles. The Brexit campaign in Britain and the presidential election process in the United States indicate a surge of populism.

International political tensions are also on the rise. Relations of Western countries with Russia have reached a new low point, while China is on its way of asserting itself not only commercially but also in the monetary area and militarily.

For investors, there are no safe havens. The so-called BRICS-countries, first of all Brazil, have disappointed as the potential new motors of the world economy.

The euro area suffers from the weakness of its countries at the Southern periphery, including Italy. Almost unilaterally is it up to Germany to accumulate the surpluses of the other countries’ trade deficits.

With the proposed exit of the United Kingdom from the European Union, additional factors of concern have come into play. For years to come, uncertainty will tend to hamper any substantial economic recovery – not only in Britain but throughout the European Union.

Economists have begun to talk about the coming of a period of “secular stagnation”. Strong headwinds confront the world economy. Even in the United States, productivity rates have slowed down.

A gigantic mass of international liquidity is desperately on the search of returns. A large part of this financial capital exists in assets of pension funds. Large parts of the population depend on the returns of these assets for their retirement. While low interest rates favor the financing of debt, they represent a huge burden for the savers. As the positive effect of low interest rates on the valuation of stocks may diminish in the time to come, the return of financial market assets will come under even more pressure.

Monetary and fiscal policies have run out of options. As a sign of their desperation, macroeconomic policy authorities have begun to discuss even more extreme measures irrespective of the fact that their earlier unconventional policy measures such as the so-called “quantitative easing” have failed to bring about a solid economic recovery.

With plans to extend the program of central banks of purchasing financial asset on the open market beyond high-quality government bonds, the trust in the present monetary system will continue to erode.