Share prices have declined sharply virtually everywhere over the last 48 hours. For example, the S&P 500 index has declined by approximately 5%, while it has been the strongest market so far. The question is therefore whether it concerns a correction in the bull market or a shift to a bear market. We believe the latter is the case, but on balance we still anticipate a gradual price decline rather than a collapse:
We believe the general reason for the turnaround should be sought in liquidity provision. Following the credit crunch, most central banks have created far more surplus money than the real economy was able to absorb. A large proportion of the surplus money flowed to the financial market and has driven up prices there. This process is increasingly turned upside down in a situation where many economies are operating at high capacity utilisation, as a result of which wage increases and inflation threaten to increase to higher levels.
It looks as though the trade war between the US and China will only worsen for the time being. The IMF has made it clear that this is negative for the global economy. In addition, it drives up inflation, as a result of which the central banks – the Fed in particular – have to hit the monetary decelerator even harder.
Because fiscal stimulus has forced the Fed to hit the monetary decelerator the hardest since the beginning of this year, the dollar exchange rate is inclined to go up. This is very unpleasant for the emerging markets, which have incurred massive dollar debts in the past. As a result, they end up in a self-sustaining spiral of an ailing currency, a higher debt burden, an even weaker currency, and so on. This negative spiral is reinforced by the decline in the Chinese yuan. Beijing allows the yuan to decline in order to compensate for the import tariffs imposed by the US.
Italy is ‘blackmailing’ the rest of Europe by driving up its public deficit to high levels. Brussels is unable to adopt a tough stance in response without risking a crisis within the EMU. The latter could spell the end of the euro. The other side of this coin is that Italian government debts soar to ever higher levels. This renders the situation increasingly unstable.
We have explained in great detail in previous reports that the real problem the West faces is a continuous decline in the competitive position. This problem should be solved by taking all sorts of measures that could restore competitiveness. However, these measures are a difficult sell from a political perspective. Hence, growth is kept at current levels with macroeconomic instruments to an ever greater extent. This comes down to debt accumulation. Hence, total debt/GDP ratios have reached record levels virtually everywhere. This renders most economies vulnerable to the slightest setback. This is the case in a situation where there is limited scope for monetary and/or fiscal stimulus – and therefore there is limited scope to absorb a setback.
Trump’s policy with respect to Iran results in higher oil prices. Apart from the additional upward pressure this places on inflation, it should also be considered that all post-1960 recessions were accompanied by higher oil prices.
It is quite likely that wage increases will shortly progress to higher levels in the West. Not only would this drive up interest rates, but it would also place downward pressure on profits.
In short, there are enough factors that are likely to push down share prices, all the more so because the enormous money creation over the last decade has driven up shares far above their real underlying economic value. On the face of it, there seems to be enough reason to expect prices to rapidly decline further. Yet we believe this will proceed gradually on balance.
Once share prices decline by more than 15%, Western economic growth – US economic growth in particular – will be at risk. In this case, the Fed would stop hiking its rates or would even start lowering them. This process would also be accompanied by less upward pressure on the dollar and an improvement in the situation in the emerging markets. This reaction is actually evident now:
Long-term interest rates have fallen back somewhat as markets expect less monetary policy tightening by the Fed.
The dollar exchange rate has fallen back.
At this point, however, the greatest risk is the fact that the US economy is expected to continue to grow at a fairly high pace for the time being. This is why it is almost certain that the Fed will continue to hit the monetary decelerator. Hence, we believe the following scenario is the most likely at this point.
Shares are strongly oversold, viewed over the short term. A sharp increase could therefore occur at any time.
If share prices start rising again, so will concerns about a tighter Fed policy. The increase in share prices would therefore ‘kill’ itself.
We believe this process will continue until the S&P 500 index has reached approximately 2,450. In this case, the Fed would actually have to take a long break from hiking its rates. Hence, we believe the dollar will weaken over a prolonged period of time (EUR/USD could decline further to 1.10-1.13 in the shorter term, but we believe the pair would rise to 1.20 or slightly higher if share prices drop further). We also expect the S&P 500 index to recover to approximately 2,750 in this case.
Once this phase is over, we expect the process to start all over again. In other words, the US economy would stay strong on balance, as a result of which interest rates and the dollar exchange rate would go up, while share prices would come under downward pressure again.