As the controversy about raising interest rates slightly continues to dominant the headlines and investors worry about the impact this would have on the markets, little attention is being given to the rapid slowdown in global growth. In the developed world only two countries are making plans to raise interest rates in 2015. Both the United States and the United Kingdom believe it is time to move away from historic low rates, that have created numerous distortions in their domestic economies. Although both countries can point to recent domestic growth as a signal to raise the cost of borrowing, the ongoing international move towards additional devaluation is likely to derail these efforts.
The recent wild swings in global markets and the meltdown in Chinese equities by 50% since the middle of June, has given pause to increasingly cautious investors. In little over two months, the equivalent of $5 trillion USD (United States Dollars) was gone from the Chinese stock market. All the gains for the year were subsequently wiped out.
The panic that began in China spread to the United States and in a period of six days, $2 trillion USD of wealth disappeared as stock valuations took a plunge. The American S&P alone, lost $900 billion USD in three days. The biggest one day point drop in American history occurred on August 24th and although the American Stock Market recovered later in the week with the largest two day increase ever, the increasing volatility is shaking the complacency of many financiers.
On the positive side, the United States can point to the 3.7% surge in the GDP (Gross Domestic Product) in the second quarter. The American Commerce Department had expected a lower rate of 2.3%. An increase in business investment and consumer spending helped to propel the economy to the higher rate of growth. However, this is after a dismal 0.06% economic expansion in the first quarter. It is important to note, that many analysts are still skeptical about the most recent statistics for the second quarter.
Consumer spending increased 3.1% from April through June, up from the far lower rate of 1.8% at the beginning of the year. This sector is the main driver of the United States economy. Business investment increased by 3.2% in the second quarter, the highest level in a year for the month of July. It was spurred on, by the jump in corporate profits of 2.4%. Again, this was in comparison to the 5.8% decline in this indicator for the first quarter.
Businesses will be far less inclined to increase their capital outlays, if the economy fails to grow as fast as anticipated. Growth for the third quarter is already being projected at a far slower pace of 2.8% and that was before the latest wild swings in the stock market.
Inflation had picked up to 2.2% during the summer, but is likely to subside as lower energy prices make their way through the American economy. A further acceleration in growth is likely to be held back by lower productivity, slow wage growth and a generational low in the worker participation rate.
Another drag on growth for the United States is the present strength of the American dollar. The stronger valuation is making exports less competitive in world markets. Goods from the United States when priced in dollars, are just too expensive. Prices for many goods and services are still dropping in many areas of the world, because of the collapse in commodity prices.
The cost of imports for the United States will continue to drop in this environment. This puts increasing pressure on employment expansion and any possible price advances within the country. Domestic producers will find it progressively difficult to raise prices in such a market, regardless of any increases in production outlays. You cannot pass on higher product costs to consumers, when the marketplace is being swamped by cheaper imports. This will negate a further boost in corporate profits for many businesses.
Investors are still divided over whether the Federal Reserve will hike interest rates later this month. The Shanghai Composite took another dive in the last trading session of the month. It is down 12.5% in the month of August alone. The government was finally abandoning the large scale purchases of stock, as a means of support for the market. This partly explains the more recent plunge in stock valuations in China, as investors there continue to lose confidence.
The Chinese government is trying to identify the worst excesses of the market and is using journalists and traders as scapegoats. They have already gone after some 200 individuals, who have been accused of activities that are destabilizing the domestic markets. In reality, it merely marks the increasing desperation of Chinese authorities to maintain some control over the market and to assign blame for the downward trend, they can no longer hold back.
An increasing number of analysts in the West, no longer believe Chinese statistics about growth in the economy there. Even Goldman Sachs has reduced growth expectations by a sizable amount for the next three years. The investment house predicts economic expansion in China will slow to 6.4% in 2016, 6.1% in 2017 and 5.8% in 2018. The Chinese authorities would be very fortunate indeed, if these prognostications were correct. In fact, growth in China will most likely be less than half of that and the economy may well be in recession next year.
In Japan the Nikkei saw the biggest monthly decline in stock valuations this past month, since the beginning of 2014. The 8.2% decline was brought about by a drop in industrial production and weaker demand for Japanese goods abroad. As the third largest economy in the world, the weak condition of the economy of Japan puts a further drag on world growth prospects.
In Europe the central bank there is having an increasingly difficult time in combating the effects of deflation, as prices and wages continue to stagnate. The ECB (European Central Bank) is aiming to revive growth in consumer prices, but the 1% core inflation rate is half of the stated goal. It is providing further evidence that quantitative easing will need to continue for the foreseeable future. The ECB will move forward with the annual purchase of the 1 trillion Euro asset purchasing program. This is the equivalent of $1.12 trillion USD.
European stocks meanwhile, had their worst stock depreciation in the month of August in four years. Even the growth engine of the German economy, can no longer sustain the larger market of Europe in the face of stagnating growth and profits.
In the emerging world, the equivalent of $1 trillion USD has left in the search for better investment opportunities in the more advanced countries in the last year alone. This is twice the rate of withdrawal, that took place during the financial crisis of 2008 and 2009. These countries as a whole are in desperate economic straights, with the near collapse in world commodity prices. This was brought about by the cessation of the previous near insatiable demand from China. The Chinese economy had alone been responsible for nearly 40% of world demand in commodities.
The economies of Latin America, as well as parts of Africa and Asia that are overly dependent on the export of commodities, will be confronting sluggish growth and problems associated with debt well into 2016 and beyond. There is no amount of currency devaluation that these governments can produce, that will change this reality. A number of these currencies for example in Indonesia and Malaysia are approaching valuations, not seen since the financial panic of the late 1990’s in Southeast Asia.
The IMF (International Monetary Fund) has already reduced global GDP growth expectations for 2015 from 3.5% to 3.3%. The last downgrade was in January. One should expect a further downward revision later this year. The 3.8% estimated for next year by the institution, is looking increasing unlikely in the present circumstances.
What will United States policy makers do in this increasing unstable and dour global market? The opportunity to raise interest rates to where it would have any real effect, has already come and gone. The present rate of 0.25% has been in place since the last financial crisis and resulting downturn in 2008 and 2009. Small increases at this point would have a negligible effect, beyond the psychology of what higher rates might mean for the larger economy.
Any increase by the Federal Reserve at this point will be reversed shortly, as the stock market swoons later this year and the American economy heads back into recession in 2016. For some financial analysts that is reason enough to raise interest rates now, so they can be reduced again, when the economy is in a prolonged contraction.
Higher rates on interest will strengthen the United States dollar even more. This of course will make American exports prohibitively more expensive, in a very competitive world market, that is already experiencing declining demand.
The Federal Reserve (Fed) is more likely to embark on very small increases if at all this year, with the stated goal of further increases in 2016. As economic conditions worsen these plans are unlikely to come to fruition.
Policy makers in the United States are in an untenable position. Monetary policy has been the principle tool for stimulating growth in the domestic economy, since the failure of the stimulus program enacted by the Obama Administration in 2009. As interest rates are already close to zero the only other real option available when the economy begins to teeter on recession, will be a return to quantitative easing.
The first round of quantitative easing known as QE1 by the United States was in response to the global financial crisis. The system was near collapse by the estimate of bankers and policymakers at the time. This later led to QE2 in 2010, which was employed in the hope of restoring the American economy to growth. The failure of a major spurt in economic activity gave impetus for the Fed to embark on QE3. This was to be the prescription to deal with a stagnating economy of low inflation and zero wage growth, in addition to staggering government debt.
The massive purchasing of government treasuries and mortgage backed securities to the tune of over $1 trillion USD annually, did finally result in an increase in asset valuation and the stock market. This led the Fed to taper and eventually end QE3, in the last quarter of 2014.
For many financial experts the policies of the Fed which is the equivalent of the central bank in the United States, did provide the monetary stimulus necessary to move the economy back towards growth. However, it did set the precedence that the Fed in addition to safeguarding the currency from the dangers of inflation, now had a new job. That is to provide growth in the economy when the government and the private sector fails in this endeavor.
The expectation of many Americans is that in the next crisis which will arrive soon enough, it will be the responsibility of the Fed to provide the needed tools, to right the economy as quickly as possible. When the stock market takes a tumble later this year and the business cycle moves the economy of the United States into a recession, it has now become the obligation of the Fed to provide the monetary stimulus necessary, to ease the pain of a downturn.
Despite that the upcoming downswing may be caused by factors outside the United States, which is what will be different this time, there will be a widespread demand for action by the Fed. They are then likely to give into the political pressure, to be seen as taking an active role in reversing a major contraction in the United States and the global economy. Say hello to Quantitative Easing Round 4.