Europe’s equity markets are in danger

The threats levelled at Europe and Asia by the USA are becoming increasingly strident. This has already put massive pressure on Asian equity markets. This negative development could now also spill over into Europe. So far investors here in Europe have been little impressed by the verbal attacks. However, the situation could change if world trade is seen to suffer.

US President Trump is thinking out loud about imposing tariffs on all Chinese imports to the USA. The US Treasury Secretary would like to verify whether the euro’s recent depreciation against the US dollar was brought about by currency manipulation. At the same time, the finance ministers and central bank governors of the G20 countries have come together in Argentina to save the global economy – which is actually doing quite well – from permanent damage.

This is the real irony. During the past few years the world economy has been very stable and has slowly overcome the major turmoil caused by the financial crisis. The growing imbalances, which also include Germany’s trade surplus, have been identified as problems and attempts would have been made to mitigate this in the next few years. Instead, protectionism has become a recognised strategy to secure national advantages. At the same time, all are aware that world trade in its entirety fosters affluence and contributes to the stabilization of the world order.

However, stable conditions are very important at the moment. The mounting migration pressure, triggered by war, climate change and economic necessity – which is also often the result of corruption – are pushing western societies to their limits. In Eastern Europe the political leaning towards an anti-European stance is further exacerbated by the divergence between the political interests of Europe and Russia. A look at Asia shows us what could happen if the current escalation strategy is continued and investors’ growth expectations are permanently dampened by it.

In the past few months share prices have come under pressure in China and other Asian countries such as South Korea, Malaysia or Thailand: the Chinese Shanghai Composite Index has fallen by over 20 per cent since the high it charted at the end of January. Peeved investors have sold shares because they were worried Asian companies would suffer increasingly in the future from the trade disputes with the USA.

This was compounded by the yuan’s significant depreciation, which has at times been over six per cent lower against the US dollar since mid-April. In past trade disputes the use of the exchange rate has proven to be at least as effective as the imposition of penal tariffs. Especially for China, whose currency is still only controlled by free market forces to a limited extent and which has a long-standing tradition of state support for its export sector using the exchange rate, it is tempting to weaken the yuan deliberately in order to improve international competitiveness. We believe the yuan is certain to remain under pressure for the time being, including because of the USD’s global strength as well as China’s worsening economic outlook. But those who accuse China of running a reckless yuan devaluation policy should not forget how energy-sapping the battle against capital flight was just two years ago. If the yuan’s weakness were to get out of control it would be poison for the already fragile equity markets as well as the ailing banking sector.

The developments in the Asian financial markets are a good example of what could also happen in Europe. So far investors are unimpressed or hardly impressed by the verbal attacks. But if deeds result and world trade is noticeably affected by them, then the situation would probably change. Growth expectations would then fall significantly, bringing share prices and the euro down in their wake. In such a scenario the American financial markets would probably be less negatively affected because the recently-implemented tax cuts should initially have a positive impact and support growth.

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