Reasons to be worried: Liquidity flood amid economic uncertainty

      Does this mean the worst is over? Are we moving into a secular bull market, where all prices – from stocks and currencies to bonds and commodities – will rise for a sustained period?

Far from it. Look beyond surface and it is not difficult to see that the world economy, the foundation of financial markets, is still full of risk – from the sovereign debt crisis in Europe’s peripheries, to the worrisome situation in the Persian Gulf. And, in my mind at least, the skyrocketing of asset prices also reflects a new threat of bubbles and inflation in emerging market economies. But before spoiling the party, allow me to discuss the reason for the surge in global market confidence. 

Running counter to the gloomy economic projections from international organisations like the World Bank and the IMF, and despite the alarming downward trend of leading global economic indicators, the financial market’s irrational exuberance is due to two main factors: the European Central Bank (ECB)’s liquidity injecting programme, and the recent deal for a second loan to Greece. 

Since December, the ECB has performed an unconventional move called the Long Term Refinancing Operation (LTRO), by lending ¤489 billion to commercial banks at a low interest rate (1 per cent) for up to three years, in exchange for a wide range of collateral. Commercial banks have then used this funds injection to buy government bonds, especially those of Spain and Italy, which give a higher return of around 5-6 per cent. The higher demand for bonds has thus calmed the bond market. Money has also flowed into riskier assets in search of higher returns, causing the rise in prices discussed above.

Market optimism has been reinforced by the approval of a ¤130-billion second bail-out package for debt-stricken Greece by the so-called Troika of the IMF, EU government and the ECB. As part of the deal, private investors holding Greek bonds will take a “haircut” of 53.5 per cent. The bail-out approval came after the Greek parliament agreed to implement tighter austerity measures, including a minimum-wage cut and job cuts for public sector workers.

Admittedly, these two actions – the LTRO and the second bail-out – are the correct way to address the underlying problem. The main purpose of the LTRO is to soothe European commercial banks’ liquidity problems, while the second Greek bail-out is necessary to prevent the default of a European country’s debt. However, these actions came with serious flaws and/or side effects.

In the case of the second bailout and its accompanying harsh conditions, there are three serious flaws. First, the deal comes with an unrealistic assumption that Greek GDP growth will contract only mildly, and grow robustly thereafter. On this forecast, Greek public debt will be sustainable (120 per cent of GDP) by 2020 – which is highly unlikely. Second, the harsh sacrifice borne by the private sector while the public sector bears no loss leads to a loss of confidence in the sovereign debt market. As a consequence, Greece will have to depend on public money for years to come. And third, the deal ignores the political consequences it brings. Street protests, strikes and arson attacks are growing, and given the harsh conditions attached, political instability in Greece is foreseeable.

With the LTRO and the massive liquidity injected by central banks, on the other hand, comes a serious side effect – the distortion of global asset markets and global inflation, especially in emerging market economies. A correlation between the rise in money supply from the West and the appreciation of emerging-market asset prices and currencies is evident. Since the beginning of the year, the MSCI emerging market index has shot up by 16.5 per cent, coinciding with a 2-5 per cent appreciation rate for Asian currencies. The recent increase of the Brent and Dubai oil price, which topped US$120 per barrel for the first time since 2008, is due mainly to the liquidity injection from major central banks. It is this ECB liquidity injection – rather than tensions over Iran or the supply disruption in South Sudan, Syria and Yemen – that has led to speculation in the oil market.

(Anyone who doubts this should consider that sanctions against Iran plus supply disruption elsewhere are forecast to cut global oil supply by no more than 1.3 million barrels per day. OPEC has spare capacity of at least 1.7 million bpd.) 

Looking forward, the risk of a higher oil price, and hence high inflation, is alarming, since geopolitical tension in the Middle East (Iran, Syria and Yemen) is unlikely to ease in the near future. Meanwhile, the threat of stagflation – simultaneous inflation from the high oil price, and deflation caused by Europe’s debt crisis – is greater. 

For a prudent investor, sometimes it is good to be worried.

 

Piyasak Manason is vice president for research and planning at Kiatnakin Bank.