Monthly Wrap: A welcome correction

While the recent rise in volatility was inevitable, we need to be mindful of potential pitfalls. We examine the impact of rising rates and a stronger greenback, as well as the implications of a Petro-...
Taimur Baig, Gundy Cahyadi23 Feb 2018
  • The recent rise in market volatility was inevitable and constitutes a welcome return to realism
  • Simultaneous spikes in bond and equity markets are, however, rare…
  • … likely reflecting an unusual late-cycle stimulus in the US
  • Inflation still largely benign, which means real bond yields are rising…
  • … which in turn, could put a brake on monetary policy normalisation
Photo credit: AFP Photo

The recent rise in market volatility was inevitable. In our meetings with policy makers in Asia, Europe, and the UK since the sell-off began, we have detected no sign of concern from the equity market correction and increased volatility. It has, in fact, been welcomed in some quarters as a return to realism. The relentless one-way move of the markets was hardly justifiable, so some correction – no matter how small the trigger – was overdue, as per the policy makers, a view we fully endorse.

Simultaneous spikes in bond and equity markets are, however, rare, likely reflecting an unusual late-cycle stimulus in the US. Equity markets are at once supported by strong earnings and held in check by the risk of policy makers falling behind the curve. Bond markets keep looking for inflation risks to materialise, seizing on every strong wage or CPI print. A fiscal stimulus out of the US when labour market conditions are tight is seen as a potential driver of a wage-price jump. This expectation is being increasingly priced in by various markers of inflation expectation. Recent upside surprises in wages in Germany and the US have reinforced this dynamic.

Global demand, as seen through the lens of production and trade, remains strong and broad, underscoring a phase of remarkably synchronised economic expansion. This should continue for the rest of the year, in our view.

All in all, concurrent and leading indicators remain consistent with above-trend growth in Europe, Japan, and the US. China, having decelerated in recent years, is presently characterised by flat momentum, with strong trade offsetting liquidity tightening and pollution curbs.

In the rest of Asia, open, trade-oriented economies continue to report robust exports, while even those not substantially reliant on trade are enjoying positive spillover. One exception is India, which has run into a series of difficulties lately, with fiscal slippage, widening trade deficit, and bank governance problems dominating headlines. We don’t see any quick-fixes to these problems, unfortunately.

Inflation is still largely benign, which means real bond yields are rising which, in turn, could put a brake on monetary policy normalisation. While the rise in bond yields and the pick-up in the price of inflation indexed securities may suggest considerable pipeline inflation, prevailing price dynamic comes across to us as fairly well behaved. Energy prices have been either stable or declining lately, food price inflation is muted, and core inflation is still well-anchored worldwide. Given the numerous times central banks have gotten their forecasts wrong in recent years (always over-predicting), we would expect them to be particularly cautious about premature or excessive hiking, notwithstanding the pressure from financial markets.

We look at two special topics this month. First, we examine the potential pitfalls of a scenario under which rates keep rising and the dollar rallies. This scenario could cause stress in several economies and markets, as per our analysis. We approach this issue from the perspective of external funding needs among key Asian economies. Second, we consider the scope and implication of the establishment of a Petro-CNY system backed by gold and bonds. China’s evolving economic needs and geopolitical imperative may well hasten this dynamic.

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  Taimur Baig, Ph.D.
Chief Economist - G3 & Asia

  Gundy Cahyadi
Economist - Indonesia, Thailand, & Philippines