Slower global growth may be just what the doctor ordered
Another week, another sign that financial markets have entered a period of heightened volatility following nearly two years of remarkable calm.
Last week, the benchmark S&P 500 equity index suffered its biggest weekly decline since January 2016, falling 6 per cent, while the technology-heavy Nasdaq Composite index plunged 7.3 per cent, its steepest fall in three years. The VIX Index, Wall Street’s so-called “fear gauge” which measures the anticipated volatility in the S&P 500, is back above its long-term average of 20 and close to the level at which it stood just after February’s “mini-crash”.
Yet this time round, the precise reason for the sell-off is unclear.
Was it growing fears of a tit-for-tit campaign of escalating trade tariffs between the US and China following President Donald Trump’s decision last Thursday to impose 25 per cent tariffs on US$60bn of imports from China? Or perhaps the bullish picture of the US economy painted by Jerome Powell, the new chair of the Federal Reserve, last Wednesday as a justification for tighter monetary policy in the coming years? Or maybe the sell-off in tech stocks triggered by the data mining scandal at Facebook?
That there is confusion over the catalyst for the latest bout of turmoil shows just how nervy and disoriented international investors have become since volatility erupted at the end of January.
The reaction in government bond markets, however, is revealing.
Earlier this year, fears about a sudden spike in inflation and an earlier-than-anticipated withdrawal of monetary stimulus caused yields on sovereign bonds to rise sharply, with the yield on benchmark 10-year US Treasury bonds surging 60 basis points between early January and late February. Last week, however, US and German 10-year yields fell nearly 10 basis points, suggesting that the inflation scare has abated.
The new bogeyman appears to be a slowdown in global growth, accentuated by concerns about the effects of a trade war.
It is not a coincidence that last week’s sharp falls in stock markets occurred just when IHS Markit, a data provider that publishes the results of closely watched Purchasing Managers’ Index surveys, revealed that the euro-zone economy – the international success story of 2017 – has slowed to its weakest level since January last year. Business confidence in Germany, Europe’s economic powerhouse and the country with the most to lose from trade protectionism due to the dominant role of exports in its economy, has slumped to a five-year low. The Dax, Germany’s main equity index, has plummeted more than 12 per cent since the end of January.
Other signs of slowing global growth have emerged in Japan where manufacturing output has lost momentum. In China, whose economy is expected to slow this year as a result of Beijing’s crackdown on debt, the manufacturing PMI for February suffered its sharpest drop in six years.
To be sure, the global economy is still expanding at a decent pace. The problem, as Citigroup’s Economic Surprise Index makes clear, is that growth is no longer beating expectations, especially in Europe.
While an economic slowdown amid an escalation in trade tensions is troubling, from a market perspective it could be just what the doctor ordered.
Weaker growth helps keep inflation subdued and relieves some of the pressure on the leading central banks, particularly the European Central Bank, to remove stimulus – still the most important source of support for global asset prices.
Headline inflation in the euro zone has already dropped to 1.1 per cent, down from 1.5 per cent as recently as November, while the core rate (which strips out volatile food and energy prices) remains stuck at 1 per cent – half the ECB’s target. In Japan, meanwhile, core inflation stands at just 0.5 per cent, held down by the nearly 7 per cent appreciation of the yen against the dollar this year.
If the deceleration in global growth gathers pace – a likelier prospect if international trade tensions escalate further – divergences in monetary policy will persist, and may even become more pronounced. Fears over an earlier-than-expected end to the quantitative easing programmes in Europe and Japan, which continue to buoy investors’ appetite for so-called “risk assets”, now look overdone.
Even in the US, where the Fed is much more hawkish and expects to raise interest rates at a faster pace in the coming years, bond markets remain sceptical about the scope for tighter policy.
While there are plenty of reasons for investors to be nervous right now, fears about a surge in inflation and a sudden draining of the QE punch bowl are not among them. In the peculiar world of markets, an economic slowdown has its upside.
Nicholas Spiro is a partner at Lauressa Advisory