FYI | Oct 15 2014
By Anatole Kaletsky of Gavekal Dragonomics
Why are stock markets around the world falling? The surest explanation is one that works whenever the markets move in a big way: there are more sellers than buyers after a long period without a meaningful correction (it is three years since the 20% decline that ended in October 2011). A more sophisticated account of the correction might point to the collapse of oil prices and its impact on natural resource shares. While falling oil prices are obviously beneficial for most other sectors, it will take time for the money pulled out of resource stocks to be recycled into other shares, including into airlines which have collapsed in response to the Ebola scare. Until this rotation happens, broad indexes are likely to fall. There are, however, two much more worrying possibilities. The first, proposed by Charles, is that the US-led policy of zero interest rates is proving counter-productive and pulling the world into a deflationary spiral. My explanation takes almost the opposite view: the US economy is finally achieving a sustained expansion; but Europe, instead of learning from the success of US monetary and fiscal policies, is taking the opposite course.
While the US is now enjoying an ideal ‘Goldilocks’ combination of strong economic recovery and dovish reassurance from the Fed, the news from Europe is dire—and this seems a plausible explanation for the sudden stock market correction. For the past five years, Europe’s miserable performance did not seem to frighten investors as long as the US economy was doing all right. But suddenly it appears bad news from Europe is being taken more seriously than glad tidings from the US. Why is this happening? In the past I have explained the link between a robust US economy and robust global stock markets by the demonstration effects of US monetary and fiscal policy. Whenever the US economy suffered a growth setback, as it did last winter and in every previous summer, investors around the world would turn bearish because they concluded that quantitative easing, zero interest rates and fiscal stimulus were failing.
If the US was unable to pull convincingly out of recession after US$3trn of QE, five years of ZIRP and budget deficits at 10% of GDP, what hope would there be for other economies attempting half-hearted versions of similar policies? But when each of these US growth scares turned out to be just a temporary ‘soft patch’, bullish sentiment quickly returned in Europe and emerging markets, as well as on Wall Street. If QE, ZIRP and fiscal laxity finally did the job in the US, despite all the disappointments, false starts and delays, then it seemed a safe bet that other economies would eventually follow similar policies and achieve similar results. Thus whenever the US economy seemed to be accelerating and moving towards ‘escape velocity’, a risk-on mentality also took hold in Europe, Japan and emerging markets. So why has this linkage suddenly broken down?
A plausible answer is that investors have concluded that Europe is either unwilling or unable to imitate the policies of monetary and fiscal stimulus that finally seem to have worked in the US. If the ECB refuses to launch QE and the German government continues to enforce fiscal austerity in France and Italy, then a robust US recovery can no longer be viewed as a leading indicator of what will happen to Europe a year or so later. Instead, many investors now assume that even if the US economy moves into a self-sustaining expansion, Europe will be stuck in long-term stagnation. To make matters worse, European policymakers are not the only ones refusing to emulate US expansionary policies: Japan is tightening fiscal policy and China is holding back on economic stimulus. Under these circumstances, it is hardly surprising that global growth prospects and profit forecasts for globally-exposed companies now look much weaker than they did a few months ago, when Europe was still expected to follow a version of the US policy game plan.
But is the newfound scepticism about global policy stimulus really justified? It is likely that the ECB will take more aggressive monetary action at its November meeting and it is almost certain that Europe will see some easing of fiscal policies next year (see Europe: Apocalypse Postponed). It is also possible that China will see some modest stimulus and that Japan will increase QE. If Europe and Asia adopt more expansionary policies, then the present stock market correction will turn out to be a great buying opportunity, offering investors better valuations in an even more benign monetary environment. But if Europe really proves unable or unwilling to deliver any fiscal or monetary stimulus, then global stock markets are likely to go on falling, almost regardless of US economic strength or the Fed’s monetary reassurance.
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