There is no shortage of stories for what is affecting global financial markets.
On the 10th of August we witnessed the Peoples Bank of China decision to allow the yuan to depreciate for the first time in two decades. Brazil, the “B” in the sensation that was the BRIC economies tabled a budget this week that roiled the real, its currency, and sparked fears among investors that its debt would be relegated to junk status by credit rating agencies. The North American continent sees investors debating what level of immunity our domestic economies have to slowdowns elsewhere in the world, and the US Fed has to determine whether September 17 would be an appropriate day to raise interest rates for the first time since the financial crisis amidst all of the global instability. August was quite the month. It ended earlier this week, but this saga for the markets is only getting started.
As the US dollar continues its bull market, the pressure on emerging market (EM) economies can only continue. China’s story of a depreciating currency should slowly lose interest as in this period of US dollar strength all other major trading partners of the US have seen their currencies tumble. Other explanations of the move by Chinese regulators have been attributed to internationalizing their currency to gain currency reserve status. As the action by the bank of China seemed to shock markets at the time, it fits in a long list of reforms as they look to liberalize their financial markets. Frankly, the bigger concern for those linked to China’s economy is establishing the magnitude of the link between the financial markets and their economy.
China’s equities continue to be the catalyst for North American equity weakness, and the downside volatility we have witnessed with a greater than 10 per cent correction in the S&P 500. The notion that weakness in Chinese equities will continue to cast a cloud over North American stocks seems stretched; moreover, as the exuberant run in China began last October, it didn’t see our markets participate in the same upside. What is likely though is the souring sentiment in emerging markets could continue to elevate risk premiums worldwide, and Canada and the US are not completely immune.
Former PIMCO CEO Mohammed El-Erian makes a very sound argument that because these catalysts are emanating from overseas, and EM policy makers don’t have the same tools or “circuit breakers” that say the Bank of England, Japan, ECB or Fed has, downside volatility could continue for some time. The most recognizable example of what he is referring to is ‘quantitative easing’. What has to be recognized is that countries like Brazil still have a hard price to play for failing to reform and diversify their economy through their commodity boom years. Running an austerity filled budget that still leads to a deficit of 9 per cent of GDP will see a dark recessionary period with huge social costs.
What does this mean for North America? Well, as one economist put it, it risks making the US Fed look like a kid stuck on a diving board who’s too scared to jump. One threat could be runaway inflation for the US if they don’t stay ahead of it. GDP growth in the US this year is nearing 3 per cent. Inflation is approximately half a percent under target, but on an upward trajectory. The jobless rate, although understated from displacement from the Great Recession, is at 5 per cent, which is what the Fed defines as full employment. That warrants a Fed move. If or when the Fed raises interest rates, they will use every voice they have to let investors and market participants know that they remain highly accommodative. Even with a hike in September and the fed funds rate still below 1 per cent, the punch bowl isn’t going from the party just yet.