By Peter Wilby
It seems to us that no amount of QE will change fundamental problems which afflict Europe: a lack of common fiscal policy or at least a mechanism for substantial fiscal transfer; over–regulation and a German economic model based on excess savings leading to insufficient consumption.
Interest rates and credit spreads are low in Europe – limiting the domestic channels through which QE can enhance growth. This indicates that the ECB’s version of QE, as in Japan, will work by creating a weaker currency. Euro weakness will likely put upward pressure on inflation through import prices and encourage some degree of substitution away from imports to domestically generated goods. On the other hand, it encourages an export-driven recovery likely benefiting Germany more than other European countries.
Whilst, at this stage, much remains to be seen, we suspect that longer-term progress on the core issues will be slow and complicated by the rise of fringe political parties in many countries. The appetite for meaningful reform just does not appear to exist at this juncture.
A new equilibrium for oil
The recent sharp decline in the price of oil has triggered a broad debate about its primary causes and these factors will play out iteratively as markets establish a new equilibrium price level over time. Weak oil prices will eventually cause a reduction in supply and it can only be a matter of time before new projects are cancelled and eventually, production is cut.
At the same time, there are numerous beneficial effects of low oil prices. Current oil prices will encourage GDP growth in oil importing countries as it simultaneously lowers inflation. Estimates of the impact vary, but in our view, point to an increase in growth in developed economies on the order of 0.3-0.5%. With higher growth will come increased oil demand and the next phase in the price discovery process will commence.
A slowdown in China
We know that China’s population is aging and its trend rate of growth is slowing and that growth has to rebalance towards consumption and away from ineffective over-investment. But we don’t know the exact path that China will follow.
The Chinese leadership is faced with a daunting challenge. To rebalance too slowly is to continue misallocating capital and resources and likely would eventually lead to a sharp slowdown. To rebalance too quickly is to challenge vested political interests.
The strong surge in the stock market over recent months raises concerns as the banking and shadow banking systems are overextended in our view. Each additional unit of credit generates less additional GDP than the prior unit. This portends a rising bad debt problem. But the economy is slowing and to recognise those bad debts risks a collapse in confidence. The rise suggests that we may have reached a stage in China where monetary easing no longer benefits the housing market but rather benefits stocks. If this is so, the management of the economy has just become a lot more difficult.
Prospects for 2015
In conclusion, there are a number of interesting factors influencing the state of the market. The oil market will likely offer great opportunities but defining these is challenging and, whilst China’s economic challenges are clear, its path to success is not. While we remain cautious on the level of government bond yields, we enter 2015 with a more positive view on credit spreads than at any time since late 2011.
Peter Wilby is chief investment officer at Stone Harbor Investment Partners
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