Financial markets for risky assets are under pressure. Market behaviour in these circumstances can perhaps be described as “sell fast, think later”. The question is whether this is just another correction or whether the current sell-off marks a breaking point. We think this is another correction, not a breaking point, but consider the situation more dangerous than during pervious corrections.
Indicators on economic activity are not the problem
Last week’s indicators confirmed our view that advanced economies are gaining momentum. This was particularly clear in Europe. The European Commission’s Economic Sentiment index continued to edge up in January: 100.9, versus 100.5 in December. It was the ninth consecutive improvement and the highest level since 2011. The January reading was also very close to the long-run average of this series. The German Ifo index measuring German business confidence also rose in February, continuing the upward trajectory started at the end of 2012, though this series has seen a few setbacks along the way. German consumer confidence also improved. We need to go back to 2007 to find data on German consumer confidence that are stronger.
Disappointingly, German retail sales fell 2.5% mom in December and fell 2.4% yoy. It must be said that this is an extremely volatile series and I am inclined not to put too much weight on it. Eurozone inflation fell back to 0.7% in January while the core rate inched up from 0.7% to 0.8%. The bottom line is that inflation is below the ECB’s comfort level and this will trigger it to take further measures to reduce inflation risks. M3 growth in the eurozone eased to 1.0% yoy in December. The underlying data was a little more encouraging, but this pace of money growth is also too low. Finally, the ECB’s bank lending survey showed a continuation of recent trends: a majority of banks are still tightening lending criteria, but this majority continues to shrink and has almost disappeared. Corporate loan demand is also still weakening, but the majority of banks saying this is also falling.
Most US data was also encouraging. GDP growth amounted to 3.2% qoq annualised in Q4. Private consumption was strong as was investment in equipment. Sceptics may argue that GDP was supported by unsustainable strong net exports, but they are ignoring the equally unsustainable drag from sharply lower government consumption. US consumer confidence also improved. Data on the housing market was mixed, reflecting higher borrowing costs since May last year. Durable goods orders and jobless claims were weak, but that may have been caused by the weather. Durable goods shipments were not as soft as the headline orders. That is relevant as shipments go into the GDP calculations. The Q4 GDP report confirmed stronger investment on equipment. While personal income was unchanged in December, spending rose by 0.4% and November’s spending data was revised higher. The savings rate, thus, fell, which is in line with increased net personal wealth.
Elsewhere, industrial production in Japan strengthened considerably. December data showed that output was up by 7.3% yoy, against 3.8% in November. Industrial production growth also strengthened in Korea in December and Taiwan registered an acceleration of GDP growth in Q4: 2.2% yoy, versus 1.5% in the previous quarter.
If not concern over advanced economies’ growth, then what?
The turmoil on financial markets has been triggered by developments in emerging economies. It is clearly not the growth outlook in advanced economies that is the problem. So what is the problem and how will things develop from here?
There is a number of countries with significant financial or political unrest, such as Ukraine, Turkey, Thailand and Argentina. In most cases, the causes of this unrest are purely domestic. More serious are concerns over broader growth prospects, concerns over insufficient reform, over unsustainable growth models and over financial stability in China. In addition, credit growth in many emerging economies has been strong in recent years, but the reversal of US monetary policy will likely make sustained strong credit growth impossible.
In any event, such strong credit growth is unsustainable. It is hard to say what will happen next. Markets are nervous, but we have to keep in mind that markets for risky assets had a great year in 2013 and that a very broad consensus was expecting a continuation of the favourable performance. So a correction was perhaps inevitable.
We also consider the following. The quality of economic management in emerging economies has improved in leaps and bounds over the last 20 years. In addition, many emerging economies have large currency reserves, providing them with a significant defence force. They are also more flexible than in the past as they generally do not follow fixed-exchange rate policies and many of them actually are running surpluses in international trade. The upturn in the business cycle in advanced economies we are expecting will also be a support. As for China, we think that the policymakers are more likely than not to get on top of the credit problems. They are not following a predetermined road map, but are developing and fine-tuning their policies as they go along.
While the growth of credit in recent years in many emerging economies is a concern, we find that many of them are actually in a better position now than they were a year ago. Therefore, we think that when ‘selling fast’ is ended and the actual ‘thinking’ begins, a recovery is most likely.