The last-minute and tortuous agreement between the euro credit institutions and the Greek government has taken the likelihood of a debt default and a Greek exit from the eurozone off the agenda – at least for a while. Now markets can concentrate on the main issues likely to affect the value of financial assets and the larger economies over the next year.
There remain wide mismatches in monetary policy. The Federal Reserve in the US and, following the Fed, the Bank of England, having ended their programmes of quantitative easing, are preparing to normalise interest rates with hikes by the turn of this year. On the other hand, the Bank of Japan is continuing with a QE programme of bond purchases through next year that will take the BoJ balance sheet to over 120% of GDP. The European Central Bank is also conducting a similar asset purchase programme of eurozone government bonds through to September 2016.
All this implies a pro-US dollar world, as the US economy will be stronger than both Europe’s and Japan’s. However, I doubt that sterling will benefit from any anticipation of BoE tightening. Sure, the narrowing output gap and rising real wages dictate tightening sooner than the market anticipates. But once that’s reflected in the price of sterling, attention will switch to the UK’s chronic 6% of GDP external deficit and abysmal productivity and secular growth. The upcoming referendum on the UK’s EU membership will also add to uncertainty about sterling.
Ironically, it will probably be a pro-yen world too. As a large creditor nation, Japan gets capital inflows as crises of over-leverage (the main catalyst of instability) strike other nations. BoJ monetary easing will not reverse that. The BoJ will do little extra on QE for two reasons. The Japanese government has failed to deliver on its side of the restructuring bargain. There is no fiscal reform and precious little third arrow reform, (except in agriculture and corporate governance). So the BoJ will go on believing it’s on target for inflation and stay put.
Indeed, I reckon the focus will switch to Asia for the next global currency moves. Most emerging economies in the region have structural problems that dictate weak currencies. They suffer from over-leverage (with large US dollar exposures), poor total factor productivity, weak capital and labour productivity growth, declining real-wage growth and a broken manufacturing and trade cycle – their previous engine of growth.
And their economies are increasingly linked to China, where secular real GDP growth is going to be only 4% or 5% a year. Chinese reform is piecemeal. Leverage is still exploding. And growth will suffer from the impact of the collapse in the government-inspired equity bubble, made worse by silly government actions to stop markets doing their job.
There is only one way for these Asian currencies to go: down. Falling investment ratios and low domestic yields mean savings surpluses will be exported. Real exchange rates will be allowed to fall to get growth from net exports. Global capital repricing will cause leverage crises to occur in these countries and spark capital outflows.
As I argued in last month’s column, stock markets globally are seriously over-valued and over-leveraged. And corporations themselves are over-leveraged. In many markets they are the same entities, as corporations are the main buyers of equity. So this is the asset class that’ll be hit the most by capital repricing. Higher interest rates will cause multiple contraction. Multiple expansion accounted for the bulk of equity returns in recent years. Higher interest rates will also reduce future profits because, once capital is re-priced, the economic cycle is back and the peak will be perceived as being behind us.
There is little sign of a return to inflation. That’s mainly because of continued deflation in commodity prices. The agreement between the US and Iran over its nuclear programme will free up a huge stock of crude oil for the market. That only adds to cyclical and secular over-supply. Energy prices are likely to go lower rather than higher. With industrial output in many economies slowing down, industrial metal prices will remain weak. And it is not clear yet what the changes in El Nino and the much foretold and totally absent Indian monsoon will do for food prices.
So this is a world of a strong dollar, weak commodity prices and capital flows into creditor economies like Japan.