26 July 2015
In this week’s market update, we will first start by reviewing the current positions of key Central Banks around interest rates, starting with the American Federal Reserve:
The Federal Reserve remains on course to raise interest rates this year according to Fed Chairwoman Janet Yellen. She made it quite clear during her testimony to Congress that due to robust labour markets and early signs of wage inflation, it may be necessary to increase interest rates. However due to the turbulence in China’s equity markets and the Greek crisis, a rise in interest rates would have to wait.
Janet Yellen’s counterpart, Governor of the Bank of England, Mark Carney also reiterated the same message as Britain prepares to raise their interest rates. In the UK the economy is growing faster than historical trends. Additionally, average pay and bonuses have jumped 2.8% annually which is the fastest growth in wage inflation since early 2009. Surprisingly, annual inflation in the UK dropped in June to zero percent. April was a negative -0.1% which points out to deflationary pressures.
The Bank of Canada is going in the opposite direction. Main interest rates were cut by the Central Bank. Weakness in the overall business climate was cited along with the fact that western Canada and in fact Canada itself has entered into a recessionary climate.
Let’s examine what are the main drivers of the current unrest in world markets. First and foremost the EU’s unwillingness to deal with Greece’s overspending which exposed the ineffectiveness of the ECB’s fiscal policy has come to a close with both the EU leadership and the ECB standing firmly in dealing with Greece and the threat of a Grexit. Greece has no choice but to reform.
The commodity hoarding of the Chinese over the last 30 years put metals and resources on a super cycle of continual appreciation for which all came to a collapse in 2014. China has lost its main edge which was the “makers of all goods at the lowest cost”. Today, places like Vietnam and Malaysia are very aggressive and produce higher quality of goods for less. The component which has eroded the Chinese value proposition is a general move by manufacturers to seek production close to the markets for which they serve. Such a move has not only cut transportation and logistic costs but has also made real time manufacturing quite effective by reducing the need to warehouse unnecessary inventory.
Oil has been the most recent and lasting effect contributing to global deflation. Since the recent collapse of oil prices to $45.00 a barrel, all expectations were that its price would rise relatively quickly due to demand as a result of higher corporate output and profit margins. However, as talks with Iran on becoming nuclear compliant have been successful and progressing, oil prices have rolled back. If and when sanctions are all lifted from Iran expect to see investment dollars flooding into that country specifically in the oil fields. Iran has the capacity to sell approximately 50,000 barrels of oil a day which will have a strong deflationary impact on oil. How low could we see oil prices go? Some analysts are calling for $35.00 a barrel at the WTI (Cushing’s) index. Such an event would prolong the recovery of the energy sector in Canada and America. South of the border, the number of active oil rigs drilling for oil or gas continues to fall in preparation for further price drops in oil. A quick and steady rise of oil prices back to $70 will not happen anytime soon.
For Canada, it would deepen the recession in western Canada which would push the Bank of Canada to further cut interest rates. Remember that Canada has not needed to implement any quantitative easing as a result of the great recession of 2008-2009. The last two interest rate cuts reflect that the Bank of Canada is ready and willing to do more in the way of quantitative easing to keep our economy moving forward and stave of a full blown recession. A lack of being in sync with American monetary policy has cost Canada dearly with the victim being our Loonie. Our dollar has gone from all time highs to an 11 year low all within a 5 year window. If oil prices drop, western Canada will weaken which will force the Bank of Canada to respond with more quantitative easing causing our Loonie to fall further.
The silver lining in all of this is that manufacturing numbers are rising for North America along with infrastructure spending and inflows of investment capital.
At this point in time, all eyes are on oil and our Loonie. Our Loonie has been infected by the “Dutch currency disease.” Such an event is common in countries that are oil and gas rich where exports reach all time highs forcing the currency to record highs also. When export levels sharply fall so does the currency. A failing China would have limited effects on North America and Europe as the commodity super cycle and rapid fall in resource and energy prices is already upon us.
Despite having a stronger than expected second quarter GDP of 7%, China’s stock market fell sharply which points out that efforts by government regulation to curb leverage, short selling and over excessive speculation are not enough. If the government fails to reduce the turmoil, the magnitude of an economic collapse of markets would dwarf the financial crisis of 2008-2009. China already has a collapsed real estate market. A collapsed stock market would see wealth evaporate from the hands of most Chinese citizens.