On Friday, stock markets in the West and commodities rallied strongly. Most of us are still trying to understand it. The proximate cause was the confusion and contradiction-riddled employment report put out by the US labour department. On the face of it, the non-farm economy in the US added 163,000 jobs in July. However, the bulk of the job creation came in professional and business services (49,000) and education and health services (38,000). The Institute of Supply Management (ISM) told us that non-manufacturing employment index came in below 50 meaning that employment, on balance, declined in non-manufacturing sectors in July. ISM also reported that manufacturing employment declined in July, but the labour department said that the manufacturing sector added 25,000 jobs. The extended unemployment rate went up to 15.0% in July from 14.9% in June. The household employment survey showed full-time jobs declining in three of the last four months including in July.
It is hard to justify the furious rise in stocks and in commodities on the back of this tepid labour market report. However, when half the trades in stock markets in the US are driven by high-frequency trading algorithms, we should realize that the pursuit of rational explanations for stock price movements is more futile than it has ever been.
Alternatively, one could say that financial markets were belatedly acknowledging the printing power of the European Central Bank (ECB). On Thursday, in his monthly press conference, the president of the European Central Bank did not offer specific follow-through timetable on his promise made about 10 days ago. Stock markets in Europe and in North America fell. Perhaps, they concluded that they had erred on Thursday and ended up overcompensating on Friday.
Two weeks ago, the president of ECB promised to do whatever it took to save the eurozone and preserve the single currency. Governments of Italy and Spain were finding that their costs of raising fresh debt were rising. The yield on the 10-year Spanish bond approached nearly 8%. In other words, for Spain to borrow for 10 years, financial markets were demanding an annual interest rate of around 7.7% some three weeks ago. In stepped Mario Draghi with his brave words of reassurance. It is possible for ECB, with adequate and necessary political backing from member-governments, to print money and buy up the debt that Italy and Spain issue, at a cost that does not hurt them.
Globally, bond markets are bigger than stock markets. Hence, it is not difficult for borrowers to find willing lenders as long as the interest rate on the loan is deemed adequate compensation for inflation and default risks. The fact that financial markets are unwilling to lend to them at rates that are acceptable to the borrowers suggests a breakdown due to the lack of faith in their promise and ability to repay. “One cannot live beyond one’s means for ever” applies to individuals and to sovereigns. The latter can keep this rule at bay a little longer than individuals can because they have the ability to tax. But tax can be levied and collected only when economies grow, generating income for individuals and businesses. Economic growth can only happen when there is sufficient destruction of previously created excess capacity. A container filled to the brim cannot be topped up any further. It has to be emptied first. The logic is no different for debt and industrial capacity.
These processes are not accomplished in a matter of few quarters. In the meantime, countries have to adapt to the situation through a combination of targeted support to the underprivileged and vulnerable while seeking growth through lower costs and prices—wage and benefit reductions and exchange rate competitiveness. A depreciating currency—if they have one of their own—will help them attract investment and make their exports incrementally attractive. Spanish exports have held up reasonably well post-2008 crisis. Support from a cheap currency will reinforce that positive trend and offset domestic contraction necessitated by belt-tightening.
Instead, the president of ECB is ready to meddle with bond markets, distort price signals and continue to reward speculators at the expense of investors and savers. Further, monies created by these central banks would inevitably show up as higher cost of living around the world as the deflationary impulses from excess supply in commodities and globalization faded away long ago. The price (in Indian rupees) per barrel of the Indian imported crude oil basket is up 14% from its lows in June.
As John Hussman presciently notes in his weekly market comment on 30th July (http://www.hussmanfunds.com/wmc/wmc120730.htm), “both a global recession and severe market downturn are closer at hand than investors assume, partly despite, and partly because, they have so fully embraced the illusory salvation of monetary intervention.” The West is destroying the world to save it.
V. Anantha Nageswaran is an independent financial consultant based in Singapore. Comments are welcome at firstname.lastname@example.org
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