Ifs, buts & mibbes
It’s a truism that markets hate uncertainty. Flat calm brings its own complications – certainly for those who need volatility for margin and volumes. However, it’s hard to imagine many welcoming this week’s uncertainty play. The Federal Reserve and Scotland top the bill and the Fed isn’t even the main event. That’s partly due to expectations of Fed subtlety – if it changes tack at all; but its upstaging is also due to the growing import and unpredictability of the Scottish question.
At the time of posting, the Scottish independence referendum outcome is too close to call. But, whatever the result, nothing will be the same for the UK body politic again. Each outcome is loaded with further negotiations and each has its own complications. Furthermore, a Pandora’s Box of nationalism has been open – with repercussions for the rest of the UK and beyond. Friday is by no means the end of the journey.
The Scottish referendum, alongside conflict in Ukraine and the Middle East, monetary tightening and the Eurozone’s woes constitutes the OECD’s latest uncertainty list and the key drivers for its latest growth downgrades. Just one major economy – India – is upgraded in its latest round of forecasts. Although, there remain concerns over the sustainability of the undoubted Indian revival and – in common with other emerging markets – India’s ability to weather the Fed’s next move. I doubt that Janet Yellen et al will be upstaged for long.
It’s only words…
The Fed will take centre stage on Wednesday – at least for 36 hours – with the audience holding their breath in anticipation of a changed word or two in the now familiar script. Rates will be held, the taper will likely come to an end in October, but then it’ll be thesauruses at the ready as the Fed indicates how long overnight rates are likely to remain at their record low. There’s high anticipation that they may change the wording from “considerable time” – believed to be 6-10 months – to something shorter sounding. According to Capital Economics, the last time the Fed tightened, the next shift was to “being patient” on policy when rate rises were thought to be 2-5 months away.
There are reasonable grounds to believe a change is coming. The US economy is certainly picking up – as indicated by improved service and retail figures. However, where the Fed says it matters – employment and inflation – the picture is less certain. ‘Noisy’ inflation has moderated. Monthly job figures have disappointed. This suggests market slack – enough for the Fed to be accommodating for a while yet.
If Fed wants to maintain credibility and raise rates gradually, it needs to acknowledge the improvement in the economy and signal well ahead – if not this month, then certainly in December. The market clearly expects the change in wording and a tighter timetable this month, with US 2-year yields touching 11 month highs. However, the Fed won’t be rushed and previous actions suggest that any change in wording – when it comes – will be slight and tempered.
Slowing dragon, rising tiger?
Emerging markets will be hoping for a smoother transition than last summer. They’ve benefited considerably from the Fed’s becalming language after the initial taper shock, but familiar structural problems remain and jitters are returning in anticipation of real action. As of today – 16 September – the FT reports that emerging markets are heading for their ninth straight day of losses, the longest streak of declines since September 2001. In part it’s due to the ongoing Fed watch, but also concerns over China’s economic outlook following poor August indicators and doubts that it will hit its 7.5% growth target this year. This isn’t just an issue for China; the country is a major driver of growth across emerging markets, particularly as a major consumer of commodities.
In contrast, India is the only major economy upgraded by the OECD in its latest forecasts, and how! Forecast GDP growth for 2014 is up from 4.9% expected in May to 5.7%. It’s a reflection of India’s remarkable turnaround, from taper turmoil to the highest level of growth in two years in Q2. Previous levels of 8% annual growth look unreachable, but 6-7% seems possible by 2016. This would put India amongst the fastest growing developing nations. It could make it the fastest growing BRIC, given troubles elsewhere.
Credit for this recovery is a moot point. Raghuram Rajan, governor of the Reserve Bank of India has been largely responsible in the last year for curbing inflation – emerging market enemy number one. This now sits at its lowest level since 2009. The previous government took some belated action to cut spending. Global central bank actions have becalmed global capital markets. The general election came midway through Q2’s GDP revival, although pre-election hopes and post-election enthusiasm helped rouse animal spirits. However, what matters is how the government maintains this momentum and readies itself for a tougher external backdrop. Deutsche Bank believes that by 2020, Prime Minister Modi could create an investment and exports-led economy for India. However, this will require greater use of his government’s significant majority to push through radical policy change.
Changes to FDI limits and the revival of stalled infrastructure projects were a good start. However, to sustain the recent rise in investment spending the government will need to show increasing reforming zeal. Not least in India’s banking sector, where, as The Economist notes: “Recapitalising state-run lenders will cost up to 5% of GDP and will involve taking on the bureaucracies that run them and the powerful industrialists who are sitting on bankrupt projects that need to be written off.” If banks were more confident in their ability to enforce debts, India could begin a new era of lending and investment.
Elsewhere in the B and B of BRIC, these are troubled economic times. The OECD now expects Brazil’s economy to grow by just 0.3%, down from its forecast of 1.8% in May. Investment has fallen due to election uncertainties and tighter monetary policy, needed to curb inflation., Meanwhile, Russia’s currency sits at a new record low of 38.767 against the US dollar this morning, down by 14% since the start of July. Only the Argentina Peso is less loved. The capital flight, on the back of sanctions, is driving the fall and Moody’s has warned this week that expanded sanctions risk undermining long term growth. Russia has considerable reserves to draw upon and most companies have raised money without incident thus far, but a currency flight could diminish how long Russia could remain in isolation.