Global financial markets have been in consolidation since May. We believe this is a healthy correction and the underlying tone is still positive. Developed markets will outperform the emerging markets with a firmer US dollar, in our opinion.
The global economy is still operating below its full capacity and we are still in a low inflationary or even deflationary expansion phase. Core inflation rates in most economies have been steady or coming down. The headline inflation rate currently stands at 1.4% in the US and the euro-zone area. The producer price inflation in China is deflating and in negative territory.
The recent sell off in bonds has caused some concern about the US Federal Reserve (Fed) tempering its bond purchases. However, we believe the rise in real bond yields in tandem with falling inflation expectations is sending a positive signal to the global economy with signs of recovery. The surge in stock prices since late last year and the recent sell off in bond prices are signalling a potential positive growth surprise in the coming months.
The US economy should see firmer growth prospects as the negative fiscal impulse starts to fade as we get into the second half and 2014. The headline non-farm payroll number for June (195,000) as well as the upward revisions to previous months paint a promising picture on the labour market.
The euro zone is still weak but we believe the worst is already past. There are indications that growth in Europe is beginning to stabilise, though the recovery still remains weak. The sharp fall in borrowing costs and recovering monetary aggregates have reduced the pain and helped to ease the catastrophic situation.
In Japan, there are signs that show Abenomics is beginning to bear fruit with aggressive monetary reflation having a positive impact on the Japanese economy. Money and loan growth have accelerated, consumer confidence has risen and the Tankan business survey has moved to positive territory. For the first time in many years, inflation expectations in Japan have risen to over 1%. As long as the authorities keep reflating and expanding the Bank of Japan's (BOJ's) balance sheet, the yen should remain weak against the USD. Corporate profits should see the benefits in a weak yen environment.
The credit crunch situation in June has again raised the bearishness in the Chinese markets. The sharp increase in the Shanghai Interbank Offered Rate (Shibor) is not an indication of what happened in the subprime fallout in the US. Nevertheless, there has been a lot of talk about the Chinese economy going into a crash landing. While the risk of seeing China experience slower growth in the coming months has increased, we still believe the Chinese government has enough tools to manage the economy into a soft landing. It should also be pointed out that the Chinese banking system is pretty liquid as nearly 40% of the funds of Chinese banks go towards either the purchase of government bonds or to meet reserve needs. The loan-to-deposit ratio for the banking system is 75% and there is a 20% reserve requirement to be satisfied with the People's Bank of China (PBOC).
Beijing has sent very strong signals to the market that it would like to address some of the structural problems in the economic system. The outbreak of the interbank liquidity crisis in June is indicative of a change within the new government toward credit expansion and economic growth at large. The authorities are concerned about the runaway growth of shadow banking activity and the rapid build up of unsecured provincial government debt. The Chinese government is determined to bite the bullet to bear short-term pain for long-run gain. The task is undoubtedly very challenging as it requires finding the right balance between growth and risk.
The Shibor crunch was engineered by the PBOC, which wanted to send a message to state-owned banks of its own intentions to squeeze shadow activity. The new government in the meantime is trying to break up state monopolies and re-orient the economy toward a growth model that is more dependent on small and medium enterprises and domestic consumption.
President Xi Jinping recently argued that China should not just focus on gross domestic product (GDP) growth but also pay attention to livelihood improvement, social progress, ecological benefits and effectiveness. This should help ease the pressure on provincial and municipal leaders to strive for GDP growth in their regions. Meanwhile, Premier Li Keqiang's "reform dividend" idea has started his battle with the banks over the credit squeeze.
The key concerns for China have focused on the rapid surge in credit/GDP and the ballooning shadow banking system. There is no question that a part of China's domestic savings is misallocated, resulting in overcapacity in certain sectors and wasteful investment. Local government borrowing is also problematic. The Chinese government's official estimate is that local government debt amounts to USD 2 trillion, or about 20% of GDP. No doubt some trust companies will be forced to go under and some local governments will default on their liabilities. However, we do not believe there is a systematic crisis here. China saves close to 50% of its output and its equity and fixed income markets are limited in scale. As a result, the large pool of domestic savings has to be allocated via banks and other forms of borrowing activity, leading to a high level of debt.
In addition, the household sector in China is underleveraged and the same applies to the corporate sector. State-owned companies have been the main borrowers from banks. However, the country has run current account surpluses and the government sits on a large amount of reserve assets.
As far as the emerging markets are concerned, growth momentum is still tilted to the downside. The latest purchasing managers index readings in July for new orders were below 50 in Korea and Taiwan. The latest June data suggest that Korean exports continued to stagnate. Shipments to developed economies (both the US and Europe) are performing reasonably well, but exports to commodity-producing regions, including Latin America, Africa and Australia, are contracting. In addition, credit-driven consumer spending in developing countries surprised on the downside as credit growth, including household credit, further decelerates. Some of these countries have been running current account deficits and foreign funding for the accounts has been reduced.
Overall, we believe the developed markets will continue to perform better than their emerging counterparts until we see the latter enter a trough cycle.