All posts by tariro mudzamiri

Investment management specialist who writes articles providing analyses on the economy; investing and financial planning

Fed Minutes: A Summarised Version.

Monetary authorities spent their most recent policy meeting agreeing that the economy was improving and no longer needed stimulus tools such as asset purchases, though concerns persisted that inflation expectations may be falling, the minutes of the Federal Reserve’s October policy meeting released last Wednesday revealed.

At its October monetary policy meeting, the Fed left its benchmark interest rate unchanged at 0.00-0.25% and said it was closing its monthly bond-buying program in a move widely expected by markets.

While the economy is improving, some monetary authorities want to be sure recovery remains sustained before raising interest rates, which is seen taking place sometime in 2015, with a few voting members expressing concerns that inflationary pressures remain soft.

“Participants anticipated that inflation would be held down over the near term by the decline in energy prices and other factors, but would move toward the Committee’s 2 percent goal in coming years, although a few expressed concern that inflation might persist below the Committee’s objective for quite some time,” the minutes read.

“Most viewed the risks to the outlook for economic activity and the labor market as nearly balanced. However, a number of participants noted that economic growth over the medium term might be slower than they currently expected if the foreign economic or financial situation deteriorated significantly.”

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The European Crisis and Prospects for Recovery

Introduction

Since the financial crisis of 2008, GDP growth in Europe has been dismal. This could be attributed to the appreciation of the Euro exchange rate, which has strengthened 10% on an effective basis between August 2012 and March 2014. This has led to a loss in competitiveness in export markets as well as business confidence with a resulting negative knock-on effect on manufacturing activity which continues to gradually decline as evidenced by the persistently poor PMI numbers coming out of the Eurozone countries. Effects of the latter phenomenon have been more pronounced in countries that have been slow to take up and implement structural reforms namely, Spain and Germany. To add to the Eurozone woes, rising political tensions in Ukraine are adversely affecting sentiment on the continent.

It has not been all bad though, Europe can still point out to continually and gradually declining bond yields; stabilizing unemployment which in turn has given consumers new found confidence to increase consumption; signs of renewed housing market transactions and rising construction activity as some of the factors that gives the continent and investors alike hope for an improved economic outlook.

Economic recovery: Scenarios

Investment: as driver of growth

In light of the above it is plausible that going forward, external demand from relatively thriving economies like the US and Emerging Markets like the BRIC countries supported by a weaker Euro will form the basis of economic growth in Europe which will be driven by investments.

Consumer spending: as driver of growth

With consumer confidence on the rise as unemployment abates, there is a high degree of probability that consumption will follow suit. To further support consumer spending in order for it to have material effect on economic growth, authorities could relax lending conditions.

Avoiding deflation

It is encouraging to note that in terms of rhetoric and policy action there has been a shift in emphasis from austerity measures which comprises of freezing, capping and or cutting expenditure to accommodative monetary policy- best exemplified by the recently instituted bond buying program by the ECB also known as quantitative easing-meaning that deflation is likely to be avoided. However, given the continuing substantial underutilization of resources in the labour market, the Eurozone may still struggle with very low levels of inflation for long time to come.

Conclusion

As I intimidated earlier, risks to growth forecasts are balanced. Downside risks include impact of US and the European Union (EU) sanctions on the Russian economy and Russia’s retaliatory measures. Upside risks encompass stronger-than-expected earnings growth in Germany and a positive shock to exports boosted by the weaker euro and a stronger world demand.

Impact of the current account deficit on the financial markets

History is littered with examples of countries that have experienced turmoil in financial markets due to large current account deficits. Turmoil in the markets is more pronounced if the deficit is being financed by short term portfolio investments.
The classical textbook definition of a current account deficit is the difference between imports and exports of goods and services. A decline in trade balance caused by either increased demand for imports and or poor export performance, as was the case in the second quarter of 2014 according to the Reserve Bank’s latest quarterly bulletin reported last Tuesday can increase the current account deficit.

A large current account is an imbalance which is always undesirable. However, for investors to navigate the treacherous waters caused by a current account deficit it is important that they establish the source of imbalance and how it has been financed. Because being large in itself may not necessarily lead to turmoil in the markets, case in point- the US has been running huge current account deficits since 2006 without any negative repercussions on the financial markets. Although studies by the IMF have shown that large deficits are ultimately not sustainable as a result of financing problems or a change in investment patterns in a domestic economy.

In the case of South Africa, a stubbornly low savings rate has meant that the country has had to rely on foreign investment to fund the deficit since first quarter of 2006, in particular through “…a combination of direct, portfolio and, to a lesser extent, other investment flows”. This has not been a problem in the past, especially in the wake of the global financial crisis which later morphed into a full blown economic crisis resulting in ultra-loose monetary policy, circa 2008 in the US and Europe making emerging markets attractive investment destinations.
The times are changing though. Whereas in the past 6 years, the only risk to South Africa’s attractiveness as an investment destination was external- from global markets. At the moment South Africa’s macroeconomic environment is weak, implying risk may arise internally as well.

Contrast these prevailing economic conditions in South Africa with recent developments in both the US and the UK where monetary authorities have already made the commitment to put an end to their respective quantitative easing programs and are seriously considering hiking interest rates. A rate hike in the US specifically, will fundamentally alter investment options across the universe posing a threat to the attractiveness of South Africa along other emerging markets as investment destinations.
Given the scenario as described above. Is it time for investors, foreign ones in particular to dispose of their equities in SA stocks? My view is that not yet, not least because returns on capital on the JSE represents income from outside the borders from South Africa but the country despite its economic and social challenges continues to attract capital and investment inflows, the latest bulletin from the Central Bank highlights the fact that foreign direct investment has more than tripled in the second quarter to ZAR 24.6 Billion Rand from ZAR 8 Billion in the first quarter.

Given the ever widening deficit and other disappointing data, it is counterintuitive that investments especially in long term projects have increased. However, it is important to note that these inflows are a vote of confidence in the future of South Africa despite what the credit rating agencies may think. Embedded within this economic data- inflows- is a key political and social message subtly making a positive judgment call about the relative capacity of South Africa’s monetary and fiscal authorities operating within the existing political system to come up with a feasible plan to narrow the current account deficit. And this has and continues to inform my optimistic outlook on the fate of domestic financial markets.