Normalization Takes Over…

A formidable challenge facing the financial markets is the need to align themselves to the inevitable process of normalization which the major economies are going through in the post-pandemic time. The unprecedented expansion of liquidity was intended to combat the potential negative effects of the pandemic-led disruption. Liquidity which was injected into the financial system by the central banks and the governments, is to leave the shores of the financial system and the markets as soon as normalcy returns. This normalization, which is the process by which the liquidity is withdrawn from the system, is likely to be accompanied by some amount of volatility in the markets. The liquidity glut helped the rise in price earnings ratios and expansion of market capitalization. The ability of the equity markets to rise without fear, and price-in the aggressive earnings expectations, was to a considerable extent facilitated by the liquidity conditions.
The normalization of liquidity in the US is about to start anytime now. The Fed in its last meeting had indicated that the normalization process was going to start soon, and the tapering of liquidity to the tune of US$ 15 billion per month is slated to be initiated, as against the total amount of US$ 120 billion, the monthly asset purchases. This activity continued at an even pace would completely eliminate the special liquidity in the next six months. The Fed statement provides for variable speed depending upon the changing requirements of the economy. The rate of economic growth and the rate of inflation are both high, indicating a recovery in economic activity to the pre-pandemic levels. Inflation in the Fed’s opinion was going to be transitory. But it looks like inflation has stabilized at higher levels, and it may stay there for months. As things stand today, there is agreement that the Fed will start full-fledged normalization, and some rate action too at a date much earlier than expected. Fed may start tightening the rates also as we move into the new year. But the move by the Fed has consequences for the financial market in many different ways. It has consequences for currency rates. As interest rates rise, currency yields go up and this invests currencies having higher interest rates with some strength. This is for the exchange rate. But the fund flows also become relevant here. There may be higher flows from
emerging markets to more developed markets. This affects exchange rates again, and also the market rates. But this need not be a worry for those economies with a relatively stable rate of growth and fundamentally sound economic outlook.
The latest US consumer price inflation spiked to 6.20 % in October of 2021 as against 5.40 % for September, the highest since November of 1990. This is way above the 5.80 % forecast which economists had put out. While many components resulted in this surge, the main factor was the rise in fuel costs and the associated pick up in other costs. Food inflation, medical facilities, housing transport etc. too witnessed a sharp rise in inflation. Inflation expectations are clearly not anchored at an average of 2 % inflation.

This is because the inflation which was expected to be transient is continuing to be transient for a longer time. This may have an impact on consumer confidence in the long run. People are happy about the economic recovery. But they do not feel that this is going to sustain for long time mainly due to elevated levels of inflation. This is going to be a major challenge for policy makers and people in government.
The US consumer confidence is at a 10 Year low. The University of Michigan’s Consumer Sentiment Index fell to 66.80 in its preliminary November number, down from the final October number at 71.70. This is the lowest observations since Nov. 2011.This situation is complicated by other related factors. The number of job vacancies far outnumber the labour force available, and the number of people who quit their jobs to take up better paid jobs is also rising fast. This trend is observed majorly in the sectors where there was a lag in the recovery. As of October, the number of vacancies available was close to 10.50 million, a number the US will be able to fill only over a two-year time period. This reflects the
enormity of the problem at hand. In the UK economic growth is happening but at a slower pace, but recovery in some of the contact sectors like hospitality has been phenomenal. It is expected that there could be a rate action from BOE sooner than expected. But that may not be the case with the rest of Europe. German industrial production continues to decline affected by the supply chain issues which it continues to face and thereby pulling down economic growth. This is not an isolated thing but a global phenomenon, and analysts expect a bounce back later in Q4. GDP number for Japan for Q3 of Cy21 shows a sharp decline, mainly accounted for by the heavy restrictions imposed due to the pandemic during and after the Olympics, GDP declined by 0.80 % on a Q-0n-Q basis as consumer spending slumped and private investments. The forecasts have projected a better performance in Q4 21. This is mainly based on the lifting of most of the restrictions on movements, and also on the basis of the likelihood of strong fiscal measures to push up aggregate demand. The policy of the BOJ is likely to remain unchanged for an extended period of time.
China has been in the news for the surge in the covid cases recently and the cancellation of many flights as part of their attempts to control the surge in the pandemic. The exact situation or the gravity of the developments is not known to the outside world as yet. But the current restrictions may have some impact on business in China over the next two quarters. This assumes greater significance for the global economy given the recent rapid rise in fresh cases in Germany, UK, and Russia. While there are no fresh reports of any regulatory outreach to tech and education companies, China has already stated that these crackdowns are part of the government’s attempt to promote what is good for China and
that it will continue for many years. A third factor and a more tricky situation is the real estate debt problem which many Chinse realtors are facing today. While Evergrande has been able to weather the storm to a certain extent there is no guarantee that there will not be any problems in future. There are many companies which may join the league due to the persistent problems of liquidity and huge repayments. What adds to the gravity of the situation is the observations in the Fed’s Financial Stability Report which states that there could be potential spill overs into the global markets from China.
“Stresses in China’s real estate sector could strain the Chinese financial system, with possible spill overs to the United States,” The impact on other economies stems from the fact that China is the second biggest economy in the world, and it has trade relations with all major countries. The crux of the issue is that the rate of economic growth in China remains under pressure and more so the real estate sector. Therefore, the repayment abilities of the real estate companies may be adversely affected over the next couple of years.


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