2014 will be another year in which it is manifest that government decisions are critically important for economies and markets around the globe. There was a period of a decade or more leading up to the financial crisis in which markets stopped focusing so much on governments, because the business cycle was apparently permanently muted by wise central bank policies and the governments of most leading economies were pursuing increasingly laissez faire policies that involved minimal intervention in the economy. The global financial crisis returned us, with a vengeance, to a period in which markets need to watch governments closely, and vice versa. So here is a short list of key policy areas to watch in the world’s three largest national economies. (I will leave the European Union for another time, given the complexities on that continent.)
U.S. Tapering. Everyone knows that the move by the Fed to back off from asset purchases, and eventually to raise interest rates, will have major economic impacts here and abroad. The problem is in predicting what those will be and, especially, the magnitude of the effects. One source of uncertainty is the transition from a Bernanke Fed to a Yellen Fed, but it would be easy to over-estimate the importance of that factor. In reality, there is quite of lot of common ground between the outgoing and incoming Chairs. The more important issues revolve around the fact that we are simply in uncharted territory.
We know that extremely easy monetary policies by the Fed and other central banks have encouraged investors and businesses to take more risk, as was intended. What we do not know is how far investors may have moved from their long-term comfort zone. There are certainly indications in market reactions to the first signs of impending tapering that investors had made very large bets based on extremely easy money continuing. This is likely to cause the Fed to move in a start-and-stop fashion, as significant taperingsteps are amplified by market moves back towards more balanced investments, causing a temporary overshoot in interest rates and asset prices. Unless the economy develops very differently than expected, the Fed cannot really walk away from tapering – if anything, the signs of such large, risky bets point to the need to normalize monetary policy to minimize economic distortions. But, the Fed’s leaders also do not want to set off a market panic.
As last week showed again, one of the most obvious places where tapering will have an impact is on emerging markets. Quite a lot of money flowed from the U.S., where interest rates were very low, to the emerging markets, in order to pick up a few points of yield or the benefits of stock prices tied to rapidly growing economies. However, we still do not know the extent of this. Nor do we know how effectively leaders in other nations will respond to the market pressures. Emerging markets stabilized considerably on Monday after a bad few days, in substantial part due to aggressive responses by some key central banks.
Overall, I expect a great deal of volatility around the world, but believe that the Fed and the other central banks and governments will be mostly successful in managing the process of adjusting U.S. and world interest rates to an environment in which we recover from the hangover of the Great Recession.
Chinese reforms. China has developed serious economic imbalances that will inevitably have to be reversed by increasing consumption and putting less investment in the economy. (A problem dramatically different from our own.) Sensible reforms would allow this to happen without dramatic slowing of its heretofore rapidly growing economy. Failure to reform, or inept implementation, could cause a sharp drop in growth, which could then cause panicked leaders to respond with a very large stimulus program. Such a sequence of sharp slowdown followed by massive stimulus would create huge volatility that would whipsaw markets and potentially bankrupt many businesses in a country that relies on high financial leverage. Further, the stimulus would exacerbate the underlying imbalances, leading to still more pain when the government is compelled to try again to tackle them.
The signs regarding reforms are fairly favorable. President Xi Jinping has taken some big steps to set the stage for major reforms. He has gained the assent of key leaders and is creating new institutions that will leverage his power to force change through. The leadership of the Communist Party of China has demonstrated over a period of decades their ability to do what must be done to keep economic growth strong. Betting against them would be a risky strategy. At the same time, there are many ways this could all go wrong, including the insidious death of a thousand cuts that could occur as vested interests throughout the system fight back against the practical implementation of the reforms. Another key risk is simply the complexity of constructing the reform program and ensuring that all pieces mesh together.
So, count me as an optimist on China, but with the recognition that serious tail risks do exist as the economic transition unfolds.
Japanese experiments. Japan is a vivid illustration of how government policies matter. Shinzo Abe, who took over as prime minister a bit over a year ago, has engineered a dramatic change in macroeconomic policy. Monetary policy is providing a massive stimulus, partly by lowering the exchange rate of the yen. The next step is to tighten fiscal policy to help bring down Japan’s massive debt burden, primarily by increasing consumption taxes (the rough U.S. equivalent of sales taxes). Abe also promises to push through critical structural reforms of the Japanese economy and government.
Here, I am something of a pessimist. Calibrating the combination of monetary and fiscal policy is extremely complex and easy to get wrong. Further, implementation of higher taxes and, even more so, structural reforms could fail due to entrenched interests or public concern. Currently, Abe is still enjoying a honeymoon. Confidence levels in Japan were very low, so the economy has gotten a considerable boost simply from the increase in optimism brought on by Abe’s activism. Monetary stimulus has pumped further life into the economy; it is almost always popular to spread money around. The longer-term problems that may result from extremely loose monetary policy are not yet evident. And, of course, the hardest part politically, the structural reforms, have been put off until the near future. Without structural reforms to raise longer-term growth potential, the monetary and fiscal actions will fail to decisively change Japan’s situation. So, Abe may not succeed in pushing his full plan through and, even if he does, there are real risks that it will not work.
In sum, U.S. and Chinese authorities are likely to help their economies through difficult transitions, but even these positive actions will create uncertainty and volatility. In Japan, the volatility may be suffered without an overall positive result. Volatility is opportunity, though. It may be a very good year to be a trader, if one can get the general direction of movements in these countries right and move nimbly.