The fourth quarter is shaping up to be a critical quarter for financial markets. The tone may have been set by last month’s US employment report, which cast doubt on the likelihood of an interest rate hike by the US Federal Reserve this year, but news from other parts of the world have also been disappointing, reflected in a downbeat message from the IMF’s World Economic Outlook this month.
Nonetheless, it is still possible to construct a more favourable end to the year, with the key elements to watch being developments in China, the nascent recovery in risk assets including oil, and ultimately the Fed.
Certainly the balance of data at the start of the fourth quarter has been disappointing. The Fed funds futures market now expects the Fed to make its first rate move next March, with the IMF saying that “six years after the world economy emerged from its broadest and deepest post-war recession, the holy grail of robust and global expansion remains elusive”.
For emerging market economies, the IMF predicts a fifth straight year of slowing growth, also forecasting a significant slowdown in world trade. Against this background, global monetary easing continues to dominate the policy landscape. Singapore’s central bank eased policy slightly last week, saying it will reduce the pace of the Singapore dollar’s appreciation.
The Bank of Japan is expected to add to its quantitative easing programme this month, while China may also loosen monetary policy further and the European Central Bank is sounding more prepared to act again.
However, there is still enough time between now and the end of the year for the circumstances to start looking better. The key issues for global markets to focus on in the next three months will be the data out of China, the ability of risk assets to build on recent gains, and the Fed.
The latest Chinese data was mixed, but with the positives slightly outweighing the negatives. Last month’s consumer price index admittedly slowed to a 1.6 per cent year on year pace, from 2 per cent year-on-year in August, matching July’s rate, but apart from seasonal factors and volatile food prices they were basically stable.
However, it was the trade data that was the source of conflicting opinions. Stronger than expected export data hinted at recovering overseas demand and of improved competitiveness on the back of China’s devaluation of the yuan in August. On the other hand, import growth was weaker than expected, causing alarm about the state of Chinese demand.
However, this weakness was driven in large part by the weakness of commodities prices, reducing the value of imports, whereas the volume of imports actually held up better. In fact, China imported considerably more barrels of oil per day last month than it did in August, rising 8.6 per cent month on month. It may be early but there were some signals to support the notion that the Chinese economy is beginning to stabilise a little, if not actually improve slightly.
The issue of China gives way to the broader issue of the recent rally in risk assets, with its headwind being only one factor impeding further progress.
In terms of the commodities markets which have led the sell-off in risk, there is the broader issue of the gap between supply and demand to contend with. It will clearly take a while for these imbalances to adjust, depending on recovering demand (where China does play a part) as well as reductions in supply. In terms of the latter, there have been encouraging signs that oversupply, especially in oil markets, is finally beginning to react to lower prices.
So far, markets are holding on to recent gains, or at least no longer plunging, with emerging market currencies continuing to benefit from the dollar’s recent turnaround.
Both China and financial market volatility will be issues that the Fed will have to calibrate carefully when it comes to deciding whether to normalise its interest rate policy in December. With the possibility that both are more stable, the decision will then come down to the domestic US economy and whether it has improved sufficiently to warrant a move in rates. For the moment at least it looks as if most members of the Federal Open Market Committee still believe that the economy will justify a first rate move by the end of the year.
Certainly there is enough time between now and then for the data to prove them right.
Tim Fox is the head of research and chief economist at Emirates NBD