March 2, 2018
Andrew Sheng of the Asia Global Institute looks at the year ahead for Asian economies.
All markets function on a heady mix between greed and fear. When the markets are bullish, the investors know no fear and regulators think they walk on water. When fear grips the markets, and everyone is staring at the abyss, all eyes are on the central banks whether they will come and rescue the markets.
2017 was a year of smooth tailwinds, even though everyone was mesmerized by the Trump reality show. Heading into 2018, one issue on everyone’s minds is whether headwinds will finally catch up when the tide goes out.
Last week at a Tokyo conference, Fed Vice Chairman Randy Quarles was visibly confident about the US economy. Real gross domestic product (GDP) growth through the final three quarters of 2017 averaged almost 3 percent, faster than the 2 percent average annual pace recorded over the previous eight years.
The European recovery, barring Brexit, looked just as rosy. Eurozone growth has stepped up to 2.7% in 2017, with inflation at around 1.2% and unemployment down to 8.7%, the lowest level recorded in the Euro area since January 2009.
In Asia, 2017 Chinese GDP grew by 6.9% to RMB59.7 trillion or $9.4 trillion, just under half the size of the US. With per capita GDP reaching $8,836, China is expected to reach advanced country status by 2022. Meanwhile, the Indian economy has recovered from its stumble last year and may overtake China in growth speed in 2018, with an estimated rate of 7.4%.
The tailwinds behind the growth recovery seem so strong that the IMF’s January World Economic Outlook for 2018 sees growth firming up across the board. The IMF’s headline outlook is “brighter prospects, optimistic markets and challenges ahead.” Expressing official prudence, “risks to the global growth forecast appear broadly balanced in the near term, but remain skewed to the downside over the medium term.”
Having climbed almost without pause in most of 2017 to January 2018, the financial markets skidded in the first week of February. On February 5, the Dow plunged 1,175 points, the biggest point drop in history. The boom in 2017 was too good to be true and fear came back with the re-appearance of volatility.
Amazingly, the drop of around 11% from the Dow peak of 26,616 on January 26 to 23,600 on February 12 was followed by a rebound of 9% in the last fortnight. Global stock market indices became highly co-related as losses in Wall Street resulted in profit taking in other markets which then also reacted in the same direction.
Will headwinds disrupt the market this year or will there be tailwinds like the economic forecasts are suggesting?
What makes the reading for 2018 difficult is that the current buoyant stock market (and weakish bond market) is driven less by the real economy, but by the current loose monetary policy of the leading central banks.
With clearer signs of firming real recovery, central banks are beginning to hint at removing their decade long stimulus by cutting back their balance sheet expansion and suggesting that interest rate hikes are in the books.
The projected three hikes for Fed interest rates in 2018 auger negatively on stock markets and worse on bond markets.
The broad central bank readout is as follows. The Bank of England and the Fed are leaning on the hawkish side, the European Central Bank is divided and the Bank of Japan will still be on the quantitative easing stance.
In his first testimony to Congress, the new Fed Chairman Jay Powell was interpreted as hawkish. In his words, “In gauging the appropriate path for monetary policy over the next few years, the FOMC will continue to strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2 percent on a sustained basis…… In the FOMC’s view, further gradual increases in the federal funds rate will best promote attainment of both of our objectives.”
What is more interesting is the divided stance facing the European Central Bank (ECB). In his latest statement to the European Parliament, ECB President Mario Draghi reaffirmed that the euro area economy is expanding robustly. Because inflation appears subdued, despite wage growth has picked up, he argued that “patience and persistence with respect to monetary policy is still needed for inflation to sustainably return to levels of of below, or close to, 2%.”
In an unusually critical and almost unprecedented article published last month by Project Syndicate, the former ECB Board member and Deputy President of the Bundesbank, Jurgen Stark, called the ECB “irresponsible”, suggesting that its refusel to normalize policy faster is drastically increasing the risks to financial stability. In short, the bigger partners in Europe think tightening is the right way to go.
If both central banks begin to reverse their loose monetary policy and unwind their balance sheets, liquidity will become tighter and interest rates will rise. Financial markets have therefore good reason to be nervous on central bank policy risks.
There is ample experience of mishandling of policy reversals.
After the taper tantrum of 2014, when markets fell on the fear of the Fed unwinding too early and too fast, central bankers are particularly aware that they are walking a delicate tightrope. If they reverse too fast, markets will fall and they will be blamed. If they reverse too slow, the economy could overheat and inflation will return with a vengeance, subjecting them to more blame.
In the meantime, trillions of liquid funds are waiting in the sidelines itching to bet on market recovery at the next market dip. But this time round, it is not the market’s invisible hand, but visible central bank policies that may pull the trigger. Man-made policies will always be subject to fickle politics. The raw fear is that once the market drops, it won’t stop unless the central banks bail everyone out again. This means that central bankers are still caught in their own liquidity trap. Blamed if you do tighten, and damned by inflation if you don’t.
There are no clear tailwinds or headwinds in 2018 – only lots of uncertain turbulence and murky central bank tea-leaves. Fear and Greed will dominate the markets in the days ahead.
(Andrew Sheng is Distinguished Fellow, Asia Global Institute at the University of Hong Kong)