Dr Benn Lawrence Steil, director of international economics at the Council on Foreign Relations (CFR), New York spoke to Moneycontrol.com about global markets- equity, commodity and bonds- and where they are headed.
Talks of a hard landing in China rule the roost of news on the Street ever since LTRO-II put to rest the European crisis for the time-being.
The red dragon is showing signs of exhaustion, with the Chinese economy expected to grow slower than estimated. This has repercussions for markets across the globe since China has been one of the major consumers of commodities and a major manufacturer and exporter of goods.
Dr Benn Lawrence Steil, director of international economics at the Council on Foreign Relations (CFR), New York, attributes this slowdown to weakness in the nation’s exports. China’s February monthly trade deficit touched USD 31.5 billion, its weakest performance in more than two decades. Dr Steil however tells Moneycontrol.com that maybe it is good that China is looking to restructure its export-led growth model to a consumption-driven one. China's factory activity has slumped for the fifth consecutive month as weakening domestic demand continues to weigh on growth.
Speaking on the occasion of his visit to attend the FOFM 2012, he says, “Inflation is a major cause for concern in China and therefore, to grow domestic demand is going to be task that requires very significant policy changes.” Nonetheless, he is glad that China has got onto combating inflation right away, before the situation blew up.
Chinese exports have slackened due to weakening demand from the West. Remember that the Euro zone crisis has only be been averted for the time-being. European banks faced a serious liquidity crunch and the only one they could turn to was the ECB. And ECB found no other way than to pump in short-term cheap money through the Long-Term Refinancing Operation (LTRO) into the system. The second tranche of LTRO was 530 billion euro given out to banks for three years at an interest cost of 1%. The injection of cheap money was intended for banks to use it to buy higher-yielding assets and make profits, or to lend more money to businesses and consumers which could help the real economy return to growth as well as potentially yielding returns.
Sadly, there is no evidence of that having happened or happening, says Dr Steil. “A lot of that money has now gone back to the ECB as deposits,” he says. Banks fear that given the situation, they might not be able to repay in three years and have taken a chance with losing the 1% interest, he says. “Another part has found its way to the sovereign bond markets, especially Spain and Italy,” Dr Steil says. Though this is good in the near-term, the LTRO may find itself a failed bailout a few years down the line. In fact, Dr Steil believes that Europe is nowhere near a solution to its problems. “Greece is going to default next year and Portugal may follow,” he says. Markets will be able to stand that, but what it won’t take sitting down is an Italy or France defaulting. “That is a serious threat to the existence of the Euro zone,” he says.
According to Dr Steil, what the LTRO has done is join banks and sovereigns at the hip. “It is a balancing act now. Banks are overly exposed to sovereigns, and sovereigns are being dragged down by banks in their attempt to keep themselves solvent,” he says. This is what is being reflected as the rally at the bond markets. “It is a yield-hungry market,” Dr Steil opines. He says that at this stage, equities are a bad option.
If equities are bad, what do investors look to hold? Commodities, especially gold. Gold has traditionally been the best instrument to hedge against inflation. “With that being the major concern for economies across the globe, it is but obvious that gold will find an uptick in demand,” he says. Then there is of course issue such as slowing demand in China that pushes metal prices up and the sanctions on Iran that is pushing crude to exorbitant levels. Dr Steil expects this thrust in commodities to continue for the while until equities make a come back.
In this game, US seems to now have backed out into cover. With everyone talking of Greece, Italy, France, China and India, the importance that US once commanded over global markets has receded a bit. “It is not that US investors are not interested; they are very much in the game and risk-on,” Dr Steil says. “However, we need to take into cognizance the secular shift in thinking about emerging market equities against the developed market,” he says. He also warns that investors are ever ready to pull out funds if required.
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