2018 will be an extremely exciting year for the capital markets. The central banks will have to prove whether they can find the right degree of monetary tightening under difficult conditions. This is likely to lead to greater volatility in the capital markets.
The global economy has been growing for nearly 10 years. The pace of global growth is in fact so strong at the moment that even structurally weak countries such as Greece and Italy are achieving respectable growth rates. In structurally better placed countries such as Germany or the USA, the number of people in work has now increased so significantly that labour markets there are close to full employment.
However, a very stable economic growth trend is not only a feature of the industrialised countries. Growth is also robust in the emerging countries. Even Latin America has moved out of recession, despite political turbulence.
Generally speaking, political developments can be said to have had only a negligible impact on countries. The best example of this is probably the USA. Serious concerns were evident in the early days of the Donald Trump presidency. Despite a highly unusual style of government, there were no negative economic consequences. The same applies to Germany. The new government, when finally formed, will not be sworn in before Easter. However, this does not seem to be disrupting economic growth.
A particular feature of this lengthy upturn is that no tensions have been evident so far in the goods and commodities markets. Wage growth is moderate, and commodities prices have remained relatively low. Consequently, inflation rates in most countries are still close to targets set by the relevant central bank, even after this prolonged upturn. The only exceptions are countries which have had to absorb a marked depreciation in their currency as a result of political developments, for example the United Kingdom or Turkey.
The cornerstone of this stable economic trend is extremely expansionary central bank policy. Never before has the global economy been stimulated by central bank interest rates of close to 0% over so many years. This extraordinary central bank policy has also been intensified further; in particular, the four major central banks in the USA, the Euro area, the United Kingdom, and Japan have expanded their balance sheets further, thus increasing the money supply. The additional liquidity has been used to purchase substantial volumes of sovereign bonds. This has caused the yields of sovereign bonds and ultimately those of corporate bonds and bank bonds to fall.
Debt has risen sharply as a result of low interest rates and yields. According to figures from the Institute of International Finance (IIF), global debt has increased by 56 trillion to 233 trillion US dollars in the last 10 years. In global terms, debt has risen primarily at government and corporate level. This increasing debt has been an important growth driver. Strong growth has also protected against the creation of a debt bubble, since debt has actually fallen recently as a percentage of GDP.
However, low yields have had other effects. Investors‘ risk appetite has increased massively. As a result, the equity markets have risen sharply and the market for corporate takeovers has gained momentum. However, valuations have not been too expensive so far, since corporate earnings have also shown very positive growth.
From a global perspective, this is therefore a perfect scenario. However, there are unfavourable distortions at country level, for example the development of a pension shortfall in Germany.
The basis of this economic growth has broadened in recent years and has thus also become more stable. However, it is not possible to state with any certainty how dependent the global economy has now become on low interest rates and yields. The lack of inflation does nevertheless suggest that the dependency is greater than might appear from the robust growth rates.
This uncertainty is the biggest problem facing the central banks. If the dependency is underestimated, and interest rates are raised too quickly, the house of cards will collapse and the global economy may move rapidly into recession. If central banks overestimate the dependency, they will act too slowly, triggering strong growth in inflation. To maintain their credibility, the central banks will then have to raise interest rates very rapidly. This will also lead to major risks for growth and the capital markets.
The central banks must therefore get the timing and the scale of interest rate rises right. They will undoubtedly proceed cautiously and, in case of doubt, are likely to err on the side of slightly higher inflation. A certain global division of labour between the central banks also seems to be apparent. The US central bank is attempting to withdraw some stimulus from the global capital market environment, while central banks in the Euro area, Japan and the UK are holding back and are not tightening the monetary reins.
It will become clear over the course of 2018 whether the central banks succeed in finding the right measure of monetary tightening. This could lead to greater volatility in the capital markets. However, the endeavour should ultimately be successful, since the robust pace of global economic growth will also act as a sufficient bulwark against any undesirable effects.