The slowdown of China, and expectation of higher interest rates in the US, is causing increased volatility in global financial markets. We should expect the shake, rattle and roll to continue in the coming months, with markets moving from a position of complacency earlier this year to a period of over-correcting.
Amid the turmoil, we highlight two of our key calls:
First, we don’t believe that the US Federal Reserve (Fed) will take interest rates as high as markets expect.
Second, although concerns about China are justified to some extent, we expect a pick-up in activity in the fourth quarter as policy stimulus begins to take effect, avoiding a hard landing.
A necessary slowdown
China’s deceleration is necessary. If China is to become a high-income country, it needs an economic model that is less dependent on investment, exports, manufacturing and construction, and more dependent on services and consumption.
Also, China responded to the 2008-09 global financial crisis with significant policy stimulus, which has led to high leverage among businesses, banks and local governments (but not households), and a slowdown is now a must.
China has room for moderate policy stimulus to prevent a hard landing of the economy. The People’s Bank of China has already reduced policy rates five times and the reserve requirement ratio (RRR) by 200 basis points (bps) since November.
We expect another 25bps interest rate cut and 100bps of RRR cuts this year. Policy works with a lag, and policy easing is likely to start to lift economic performance in the fourth quarter of this year and into 2016. We expect growth to reach 6.9 per cent in the fourth quarter.
We are not convinced by the widespread view that the CNY is overvalued
It’s also important to put China’s currency devaluation in August in context. The move was seen by some as an attempt to improve the economy by boosting exports. We disagree: China’s authorities want to introduce more currency flexibility in order to have the CNY included in the IMF’s special drawing rights (SDR).
We are also not convinced by the widespread view that the CNY is overvalued. The IMF usually uses internal and external balance models to determine a currency’s fair value. A currency is considered to be at fair value when the economy enjoys both internal (full employment) and external (current account at equilibrium) balance. China still has a significant current account surplus, and its labour market is robust.
Move to normalise rates
As for US rate hikes – the other key concern for financial markets – the Fed has been preparing markets all year for its first interest rate rise since 2006. Interest rates close to 0 per cent and three rounds of quantitative easing were the Fed’s measures to deal with an extraordinary situation: the slow healing after the global financial crisis. Now, with unemployment falling to 5.1 per cent in August from a peak of 10 per cent in October 2009, the Fed’s believes it should move to normalise interest rates.
But there are risks. First, though unemployment has fallen, the participation rate in the US labour market is at the lowest level since 1977. Second, inflation is below the Fed’s inflation target of 2 per cent. Third, the inflation pressure appears to be low, with wages well under control.
The Fed seems eager to move, but also wants to make it clear that the hiking cycle will be very gradual. The risk with this approach, as Japan discovered in 2000 when it hiked prematurely, is that the Fed might find it hard to convince markets of its intended gradual pace. Actions speak louder than words, and markets will note that the Fed decided to hike interest rates when inflation was below target and there were no apparent inflationary pressures.
The two global stories spooking markets will probably continue to dominate in the coming months, but it is important not to lose sight of fundamentals
We expect the Fed to hike in December this year, but for the reasons discussed above, we think interest rates will peak at just 1 per cent by June 2016 and stay there for a prolonged period. Our forecasts are lower than market consensus and Fed projections.
Markets were not pricing for risk earlier this year, but are now in a period of elevated volatility.
The two global stories spooking markets – China’s economic slowdown and the first Fed hike – will probably continue to dominate in the coming months, but it is important not to lose sight of fundamentals.
Despite the prevailing negative sentiment, we expect China to weather the storm, with growth picking up by the end of this year. And we expect the Fed to take rates to a peak of just 1 per cent over two years, lower than the market anticipates. This suggests that beyond the initial period when markets re-price risk, interesting opportunities will arise for investors.