Global economic update
The month of July saw a marked increase in volatility in financial markets as the growing specter of deflation continues to looms large over the global economy. The month started off with yet another new debt rescue deal which essentially placed another Band-Aid on the sucking chest wound that is Greece and the untenable Eurozone debt situation. July also saw a continuation of China’s equity market collapse, which has so far erased more the three trillion dollars in market capitalization from the Shanghai Composite index. Asian investors luckily experienced a brief pause amid the panic selling mid-month as Chinese government efforts, combined with the People’s Bank of China (PBOC), were temporarily successful in stemming the avalanche of selling. However, by the end of the month, China’s equity markets looks as though it has effectively resumed its decline as the Shanghai Composite closed down over 8% on Monday, July 27th as over 1600 stocks on that exchange traded locked limit (10%) down. Despite unprecedented levels of intervention exhibited by the Chinese government and the PBOC, equity prices continued to fall this week amidst a new torrent of selling.
Recent price action in Asia may offer a clues to potential market dynamics Western investors are likely to experience in the future. It is important to understand that China’s equity markets were indeed in bubble territory earlier this year as the their share-markets experience over a 150% ramp up in just the last two years as they retested the pre-financial crisis highs of 2007. Technically speaking, the Chinese equity market looks like has experienced a classic “Blow-off top” after an exponential rise. Blow-off tops usually revert back to where the advance started, which in the case of the Shanghai Composite is SIGNIFICANTLY lower. Currently the U.S. stock market does not appear anywhere near as susceptible to a decline of the same magnitude as China. However the recent market behavior within Asia is already creating shockwaves that are reverberating throughout the financial system.
Perhaps the most under-reported aspect of the Chinese slowdown is the effect it is likely to have on the demand for oil. China is the 2nd largest economy in the world and has been largely accountable for the majority of new energy demand in the 21st century as its economy has boomed. The recent slowdown in China represents a major headwind for the price of oil. Additionally, with all the forced liquidations occurring within the Chinese equity market, one has to wonder what other assets might the Chinese begin to sell in their mad dash to generate cash?
The most attractive resource that the Chinese have at their disposal with the ability to generate desperately needed cash, is the $1.3 trillion worth of U.S. Treasury bonds they collectively hold. Reports have recently surfaced that the Chinese have begun to unwind their massive positions in U.S. fixed income market. This development combined with the existing low levels of liquidity in the U.S. bond market presents a dangerous combination that may lead to sharply lower bond prices later this year. GFC imagines there aren’t going be a lot of investors willing to step in and place a bid against the prospect of the largest holder of U.S. treasuries unloading their positions on the open market. Add in the fact that this scenario could develop simultaneously with the prospect of a Federal Reserve beginning to raise interest rates for the first time in 9 years later this fall and you have a strong recipe for a significant sell-off in bond prices.
With China’s bull market experiencing a significant setback, the prospect for healthy global economic growth appears extremely dim. The GDP growth rates for the United States and the Eurozone have been anemic as they’ve considerably lagged growth rates in emerging markets. Additionally, U.S. inflation has consistently been recorded beneath the Fed’s inflation target of 2% since the financial crisis began. Additionally, whatever inflation the economy has registered in the last 6+ years has largely been due to “cost-push” inflation where prices rose as a side-effect of increased taxes and a more burdensome regulatory environment. This is in direct contrast to the healthy “demand-pull” type of inflation the fed is desperately hoping to achieve where prices rise naturally due to increased economic activity.
The next several years is likely to shed a bright light on the failure of central banks as well as sovereign governments in regards to their abilities to stimulate and manage the global economy and implement effective monetary policy. The perceived omnipotence of governments and central banks in regards to economics and monetary policy is long overdue to be forcefully challenged, and rightfully so. We at GFC will do our best to help our readers navigate the volatility which we fully expecting to encompass the global investment landscape.