The global economy

There’s never a shortage of things that could go wrong with the global economy. One that’s joined the list in recent months is, worries about the health of some emerging market (EM) economies. In a sign of unease nervous investors have been pulling money out of EM equity and bond funds. What’s happening and why does this matter for the rest of the world?

* EMs are feeling the effects of the unwinding of a decade of cheap money policies in the US. Low American interest rates encouraged investors to move capital into higher yielding emerging markets equities and bonds. Vast amounts of capital flowed into EMs, pushing up asset prices and bolstering growth. The impact of the unwinding of that great experiment in monetary policy is feeding through to EMs.

* The previous Chair of the Fed, Janet Yellen, said that she hoped that the reversal of Quantitative Easing (QE) would be as “dull as watching paint dry”. Yet when QE was being rolled out the effects, especially on asset prices, were anything but dull. And just as buying assets makes money cheap and plentiful so selling those assets should have the reverse effect. Ms Yellen’s hopes for a boring unwinding of QE seem predicated on the process happening very slowly. Like the fabled frog failing to notice the cold water becoming warmer and eventually boiling, the aim seems to be to reverse QE so slowly that markets will hardly notice.

* Yet investors could not have failed to notice what’s been happening. Over the last two and a half years the Federal Reserve has raised interest rates from 0.25% to 2.0% and indicated that there’s more to come. Under its Quantitative Easing programme the Fed expanded its balance sheet from $0.9 trillion to a peak of $4.5 trillion, buying up safer assets, mainly government bonds, to push liquidity into the system and drive down interest rates. Now the Fed is running down its stockpile of assets, effectively selling government bonds back into the market.

* At the same time US government borrowing is rising to cover the costs of President Trump’s tax cuts.  The message is clear: lots more US government bonds are heading to market. That implies lower bond prices which, in turn, means higher interest rates or yields (the yield on a bond moves inversely to its price). It’s not surprising that the yield on US ten year government bonds has risen from 1.4% to close to 3.0% in the last couple of years.

* Tighter US monetary policy means that EM economies are facing higher interest rates, a stronger dollar and a weakening of capital inflows. These were some of the ingredients that made up the Asian Financial Crisis of 1997 (more properly the East Asian crisis, in that it hit Indonesia, South Korea and Thailand the hardest). Economies that had seen rapid, credit-fuelled expansions were hit by a Fed interest rate tightening cycle, suffering capital outflows and a squeeze on credit. Those which had issued dollar denominated debt struggled to service and refinance their borrowing. Asset prices tumbled and economies contracted. Governments turned to the International Monetary Fund and the World Bank for support.

* The Asian Financial Crisis was a big one, but there have been others, before and since. Each have their own causes, often unique to that country. Weak institutions and political risks frequently play a role. What unites most are an exodus of foreign capital, falling currencies and an increase in the liabilities of the government and the corporate sector.

* This all matters for the West because of the risk of contagion, through the financial system, to Western financial markets and the knock-on effect on global demand.  In the aftermath of the global financial crisis, with Western growth running well below par, the global economy has been increasingly reliant on EM growth to support activity.

* Today’s most obvious EM vulnerabilities are exposed to less committed, potentially flighty investors and dependence on dollar denominated debt. The former risks sudden capital flight. The latter becomes harder to manage as US rates rise and national currencies fall against the dollar.

* The risks are real, but are probably less than those 21 years ago, on the eve of the Asian financial crisis, partly because EMs have learned the lessons from previous crises.

* Many EM central banks have built up their dollar assets and are better placed to defend their currencies. Fewer EM economies are running current account deficits than in the 1990s, making them less vulnerable to adverse capital flows. And fewer nations have fixed dollar pegs. All of this reduces the risk of big, traumatic currency devaluations which would leave creditors with dollar liabilities in trouble.

* Previous crises were exacerbated by an indiscriminate sell off which spread across EM markets, even those distant from the source of the problem. Today there is a better understanding of the very different macroeconomic fundamentals of different EM nations. Future sell offs seem likely to be more focussed.  Finally, the pace at which the Fed raises interest rates is, and seems likely to continue, to be far slower than that in the early 1990s.

* Overall, then, the fundamentals for EMs look better than in the past. The IMF is certainly optimistic. It sees EM growth accelerating over the next two years, even as growth in the West slows.

* Yet for all this EM growth faces a headwind from US monetary tightening. Countries with large current account deficits and high levels of debt are more exposed. Like Ms Yellen, I’m hoping for a dull unwinding of US QE. But, as US interest rates head higher, it’s worth keeping an eye on how EM economies are coping.

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The FTSE 100 ended the week up 0.7% at 7,682.

Economics and business
* The Bank of England voted to hold UK interest rates at 0.5% and indicated that it will start selling its £435bn pounds stockpile of UK government bonds once rates reach around 1.5%
* In a week of escalating trade tensions, US President Donald Trump threatened to impose a further 10% tariff on $200bn of Chinese goods
* China responded by announcing it will explore non-tariff measures to cause economic harm to US companies
* The US president also threatened to impose tariffs on European cars in response to the EU’s levies on £200m of US imports
* India implemented retaliatory tariffs on US agricultural products in response to US tariffs on steel and aluminum
* Global equity funds experienced a weekly record outflow of $8.1bn in response to the tariff threats
* This month’s Bank of America Merrill Lynch survey of asset managers noted a record 42% of respondents are worried about overleveraged companies
* The Japanese prime-minister, Shinzō Abe, said that Japan intends to boost it trading with China in order to reduce its vulnerability to US protectionism
* The Chinese Freight Index, a widely watched indicator of economic activity in China, fell to ten-month low in a further sign of a slowdown
* In a further sign of a slowing growth in Germany, the German manufacturing PMI fell to an 18-month low
* The British Chambers of Commerce downgraded its forecast for UK growth in 2018 to 1.3%, which would be the weakest growth rate since 2009
* Transactions on debit cards overtook the use of cash in the UK for the first time in 2017 due to the rising popularity of contactless payments
* The UK government deficit in May fell to its lowest level in 13 years due to strong income tax and VAT receipts
* Amazon’s digital assistant Alexa will be installed in some US Marriott-owned hotels to assist guests with ordering room service and concierge advice
* Instagram will launch a standalone video app to challenge YouTube, as the Facebook-owned social network hits a billion monthly active users
* EU asylum applications dropped by 44% in 2017
* 18.3 million people tuned in to watch England’s opening World Cup game against Tunisia, comfortably beating the number that watched the royal wedding in May
* Goldman Sachs produced an in-depth analysis of the World Cup, noting there was a correlation between the ability of a country to stick to its inflation target and their success in penalty shootouts

Brexit and European politics
* Last week saw two significant steps towards further European integration
* German Chancellor Angela Merkel and French President Emmanuel Macron agreed to reform the European Stability Mechanism to give it the capacity to provide emergency loans to member states with high debt levels
* The Franco-German leaders also agreed in principle to a euro area budget
* The plans for a euro area budget ran into immediate opposition from the Christian Social Union, the sister party to Merkel’s Christian Democrats, over concerns that EU fiscal capacity could expose Germany to further risk
* Angela Merkel’s CSU ally, Markus Soder, head of Bavaria’s CSU, launched a stinging attack on Ms Merkel’s decision to keep Germany’s borders open during the refugee crisis in 2015, branding it a “fundamental error”. In a move that stoked speculation about Ms Merkel’s future, Mr Soder also hinted at ending the CSU’s 70 year alliance with Ms Merkel’s CDU.
* In a move seen to be helpful to the UK government’s Brexit negotiating position, UK MPs rejected the House of Lords’ amendment on a ‘meaningful vote’ for parliament over the final Brexit deal
* The Guardian reports that Theresa May will propose to retain UK/EU free movement of goods under the future trading relationship
* Irish prime minister, Leo Varadkar, called on the UK to “honour its commitments” on avoiding a hard Irish border and warned that “progress has stalled”
* Chancellor Philip Hammond set out post-Brexit plans for “global financial partnerships” with targets including China, India, South Korea and Australia to make the UK the “undisputed gateway to global markets”
* EU’s chief Brexit negotiator, Michel Barnier, warned that the UK will lose access to Europol databases and the Schengen Information System
* The European Parliament’s Brexit coordinator, Guy Verhofstadt, criticised EU27 member states for neglecting the rights and status of UK citizens living in the EU
* In a worse-case ‘no-deal’ Brexit scenario, UK households could be left up to £961 a year worse off, according to the consultancy firm Oliver Wyman

And finally…

* A group of UK school children sent a Bakewell pudding into the stratosphere using a high-altitude balloon. Tracking devices attached to the delicacy, which record its position, temperature and take photographs, showed it had last reached an altitude of 16,000m – space jam

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