The short answer is that we are experiencing divergence in the trajectory of growth and monetary policy among major economies.
U.S., European and Japanese central banks have all been running with easy monetary policies for years and all have engaged in quantitative easing (QE). We are seeing growth in all three countries, with the U.S. doing the best, as a result. However, QE tends to lead to currency depreciation, which is difficult to see when everyone is doing it. For the five years from 6/30/2009 to 6/30/2014 the U.S. dollar index, which measures the general international value of the U.S. dollar by averaging the exchange rates between the U.S. dollar and major world currencies, traded on average at 80 since many of the major currency countries were also doing QE. As the U.S. ended QE, Europe and Japan actually escalated their QE programs, and the dollar began to appreciate. As we moved closer to the time when the Federal Reserve expected to raise the federal funds rate, the appreciation accelerated. From 6/30/14 to mid-March 2015, the dollar index rose from 80 to 100, up 25% in less than a year (see graph). That is a lot of volatility for the currency market.
On the other hand, China’s GDP growth has been slowing from 10% growth down to 6-7% growth as they move from an export-driven economy to a consumption-based economy. Much of the high growth came from rapid investment in building which required high commodity consumption. As their infrastructure building slows, their growth in demand for commodities slowed which has weakened commodity prices. This has also slowed the economies of countries that are big exporters into China, in particular commodity-producing countries such as Australia. Commodities are also bought by investors as an inflation hedge and with the steep decline in commodity prices, concerns about deflation come back as a risk to the markets and central banks.
The stronger dollar has also had its impact on corporate earnings as it’s more difficult to sell to other countries when their currencies are so much weaker. About a year and a half ago when credit spreads (the amount of extra interest an investor requires over the risk free rate to take on credit risk) were at very tight levels and overall yields were low, we started to see companies beginning to increase shareholder friendly activities. This activity, which includes share buybacks, dividend increases, increased leverage and mergers and acquisitions, reduces the protection for bondholders. As a result, we’ve seen domestic credit spreads widen over the last year and a half.
The U.S. economy is still doing ok, but it is growing slower than a typical recovery. Employment and housing are much improved, personal debt burdens are more reasonable and corporations are healthy. However, governments have taken on an enormous amount of debt in order to stimulate this growth and the private sector deleveraging. These enormous debt burdens along with aging populations in the U.S., Japan, Europe and now even in China are reducing potential growth in these major economies. Also, technology allows us to be much more efficient and need less in order to do what we need, which slows demand.
While all of this is happening, we have China going through a major transformation from an investment-led economy to a consumption-based economy. These are big changes for a developing economy, particularly one it its size, and certainly there will be volatility in their growth and consumption rates as these changes take place and the old areas driving the country’s growth such as infrastructure building are replaced with new areas of growth such as services.
With slowing growth in China, the Chinese central banks have been easing policy by lowering rates, expanding the monetary base by reducing bank reserve requirements and increasing their balance sheet at an even faster pace than the U.S. did. China has long pegged its currency, the Yuan, to the dollar. It has made some moves toward a more freely floating currency, but it was kept within fairly tight ranges. Allowing the Yuan to strengthen along with the rapidly strengthening dollar requires China to spend reserves to maintain the peg. Selling reserves effectively acts as policy tightening and undermines their central bank policies so, during the third quarter, China devalued the Yuan. This caused a lot of concern across global markets, as China slowing and a devalued Yuan serves as a disinflationary force to the global economy. We saw some sharp corrections in global stocks, particularly in emerging markets, and in high yield bonds.
In the midst of all this turmoil, the Federal Reserve decided to err on the side of caution and did not raise U.S. interest rates because they were concerned with global growth as well as the lack of inflation.
Since then, markets have recovered a bit and the dollar has weakened but the overall take away, I believe, is that we in for slower global growth, lower inflation and lower interest rates for a longer period.