Larry Summers, Charles W. Eliot University Professor and President Emeritus, Harvard University, former Secretary, U.S. Treasury and former Director, National Economic Council, speaking at the CITI pension and endowment conference in New York observed that economic austerity can only further stunt weak global economic growth.
“This is the moment for a focus on maintaining the level of demand while at the same time insisting on long-term adjustment,” said Summers, who also was an economic adviser to President Barack Obama.
He further observed a growing sense that a protectionist candidate could soon become the president of the United States and would surely introduce great uncertainty at home and abroad. The resulting increase in risk premiums might well be enough to tip a fragile U.S. economy
into a recession.
He also observed that if Britain exits from the European Union (EU), it can damage the British economy. All in all Europe and the US would slow down in the second quarter and the growth could very likely to be less than 2 percent. Unlike in the past few years, foreign exchange volatility could jump to record levels as the Chinese stock markets plunge and also because of the US elections, Brexit threat and increasing tensions in the Middle East.
According to Morgan Stanley, swings like this will persist after averaging the most in four years in 2015. While Deutsche Bank AG sees a “minor retreat” in volatility, it says more turmoil may come from China and rising US interest rates. Therefore, the second half of 2016 is certainly turning out to be a very difficult period for all foreign exchange managers and for the central banks of emerging markets.
It would be wrong to think that speculation about Brexit will have no impact on foreign exchange (FX) but the impact needs to be put into proper perspective. Low energy prices continue to put pressure on consumer prices in the UK and as a result, the Bank of England revised its inflation outlook downwards in November last year.
Market participants have however drawn their own conclusions and have postponed their expectation of a first rate hike well into 2016. However, it is very possible the Bank of England will follow any Federal Reserve move and hike rates as early as May, pushing the EUR/STG pair lower in the New Year. But an exit from the EU will certainly have a big impact on STG and on FX markets in general.
It is very unlikely, according to currency speculators, that the EUR/USD is likely to depreciate rapidly, despite all arguments in favour of a strong dollar and a weak euro. The Fed would likely react to an overshooting of the dollar, while Mario Draghi and the European Central Bank (ECB) are tempering expectations of larger-scale asset purchasing in 2016.
In light of this, analysts say only a very moderate downtrend in EUR-USD is likely. However, the firmer dollar could draw capital into the US from the EU creating problems for some of the weaker currencies.
The slump in oil prices, stemming from the Organisation of the Petroleum Exporting Countries’ (OPEC) recent reluctance to come to an agreement to cut the output due to Middle East politics, has triggered risk aversion across the world. The Bloomberg Commodity Index has slipped below 80 for the first time in nearly 17 years. As expected, market participants have sold risk assets and bought debt.
Global indices have been severely hit, with many of the majors, including the Standard & Poor’s (S&P), now down on the year. Low crude prices are helping Saudi Arabia’s plan to expand its market share by forcing out the US shale producers and the Russians. Therefore, the lower-for-longer oil prices are here to stay. The decline in the oil price has had a massive impact on the sector and the wider economy. Upstream capital expenditures (capex) have been significantly cut, with many exploration and production projects being put on hold.
However, for the midstream and downstream, investment is continuing, as participants invest for the longer term. The decline in the oil price is causing hardships for some exploration companies but will create opportunities for those with the financial resources to acquire value assets that become available.
The general consensus is that prices will gradually recover by the beginning of 2017. This means the global inflation outlook continues to look subdued, which will complicate the central bank policies of many economies. However, it will help many of the unprofitable airlines the space to restructure.
2016 second half
It is very likely 2016 will see high asset volatility with central-bank-policy divergence, an expensive US dollar becoming even more expensive and political uncertainties acting as the catalyst. According to Hans Redeker, Head of Global Foreign Exchange Strategy at Morgan Stanley in London, “Volatility will be the name of the game, and the very first trading day of this year provides us with a taste of what to expect.”
The Federal Reserve might have finally raised interest rates thanks to lower unemployment but there’s no doubt much of the US public still feels the effects of the long recession the country endured, not to mention the global economic risks, ranging from China’s slowing growth to terrorism threats in the Middle East and beyond.
Given the many risks involved, the world economy ranging from politics to protectionism to oil slumps and cyber attacks, there is a very good chance of another prolonged downturn in the global economy that can certainly have a negative impact on small economies like Sri Lanka.
(Dinesh Weerakkody is a senior company Director)