28 February 2017
Although the uncertainties about President Trump’s administration and policies continue to dominate the news, they are by no means the only factors that will drive markets in future. Here are some of the other key risks we’re facing in 2017.
The core issue of too much debt, which lay behind the global financial crisis, has not been resolved. Central banks have tried to offset the deflationary impact of this debt with ultra-low rates and quantitative easing. This has helped support economic growth. But it has also pushed up risk asset prices, and valuations are high for both bonds and shares. This creates an obvious vulnerability to falls in prices when policy reverses, as it is starting to do.
Over the past year, the power of monetary policy to manipulate share prices higher seems to have lessened and this is one reason, along with social discontent, for more emphasis on fiscal policies. But fiscal stimulus increases inflation risk and that’s particularly an issue in the US. The US is already more or less back to full employment and wage pressures are already building. Fiscal stimulus increases demand for labour, which would tighten the labour market further and increase inflationary pressures. Higher wages mean lower company earnings. In recent years, company profits have risen to unusually high levels compared with workers’ wages. This lack of wage growth has been an important source of social discontent.
Paradoxically, that discontent has resulted in political change in both the US and UK just at the time when wages are starting to rise. The US economy, in particular, is performing robustly and has already consumed much surplus capacity. There’s a risk that increased fiscal spending will spill over more into inflation than real growth.
Outside the US, there is the possibility of further expressions of popular discontent this year. In particular, there are a series of elections in the euro zone, with some strong anti-euro protectionist candidates. 2017’s presidential election in France, for which there is a strong anti-euro far right candidate, is an obvious source of potential dislocation. And of course the uncertainty around Brexit is an ongoing issue.
After the financial crisis, Chinese banks made massive loans to local companies to prop up growth. China now has a huge debt overhang. As the world’s second-biggest economy, there could be global consequences if the credit bubble bursts. But rather than focussing on debt control and reform the focus has been more on economic growth as President Xi Jinping seeks to concentrate power before the 19th Party Congress later this year.
Stability of the economy and the currency is critical this year. With housing construction slowing and raw materials stockpiles rising, there are clearly risks. In addition, with limited attractive investment opportunities in China, and a 49% savings rate, there is risk that too much cash is chasing too few assets. Increasing concern about this has led Chinese investors to try to circumvent capital controls and seek overseas investments. This in turn puts downward pressure on the Yuan, prompting the authorities to introduce more controls to reduce capital outflows.
Australia stands out internationally by having avoided two financial crises. First, despite being heavily indebted, we largely escaped the global financial crisis. Infrastructure stimulus in China provided the commodity boom that was key to Australia sailing through the financial crisis. Then, when the commodity boom turned to bust, interest rate cuts provided an offset by boosting the housing sector.
However, the interest rate cuts have increased Australian household debt further – it’s among the highest in the world – and house prices have risen steeply. Australia also remains reliant on China both for buying our exports and providing capital, but China has its own debt problems and is trying to stem capital outflows.
This combination of issues makes our share market and economy vulnerable and we don’t believe share market pricing adequately reflects this. These factors also put downward pressure on the Australian dollar. However, our dollar may not yet be low enough to increase Australia’s competitiveness to the extent that sustainably changes the current account deficit and associated capital financing needs.
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