On February 25 and 26, the finance ministers and central bankers of the world’s 19 largest developed countries and the European Union will meet in Shanghai at a moment of turmoil for global markets. After some seven years of support, the Federal Reserve’s step back from extraordinary monetary policy leaves many wondering which swimmers will be seen to be naked as the tide goes out. Other central banks, particularly the Bank of Japan (BoJ) and the European Central Bank (ECB), are still in easing mode, but the global rout in currencies, commodities, and stocks has market participants wondering again if central bank action can save the day, especially when they survey the anemic GDP growth that has characterized the recovery from the Great Recession -- and ask if another recession is on the horizon. (We think the chances are low, and that we are currently experiencing a correction, not the onset of a recession. Of course, we continue to monitor the data.)
The ECB’s Mario Draghi tried to calm markets on Jan 21 with assurances of the ECB’s determination and capability; the Euro Stoxx 50 index is down about 7 percent since his announcement. On January 29, BOJ governor Haruhiko Kuroda announced the arrival of negative interest rates, and said the Bank’s arsenal was “unlimited” in scope; the Nikkei 225 is down some 8 percent since then. These events are simply reinforcing market participants’ fears that central bankers have lost control and that some sort of unraveling is underway.
G20 Finance Ministers’ Summit: An Opportunity For Bold Action That Probably Won’t Be Taken
We’re intrigued by the possibility that the G20 finance ministers’ summit could be an occasion for the announcement of some decisive policy coordination, particularly from the U.S. Federal Reserve, perhaps focusing on currencies. One complaint of observers during the recovery from the Great Recession has been the outsized role played by central banks and stimulative monetary policy; it would be encouraging also to see a commitment to a greater role for fiscal stimulus, and for recapitalization of European banks (as we’ll note below).
1985’s Plaza Accord Weakened the Dollar Against the Yen and the Deutschmark
We don’t have high hopes that this will occur (though if it did, it would resemble the Plaza Accord of 1985, which also boosted U.S. industry by bringing an end to a half decade of U.S. dollar appreciation).
Capital Looks For Good Regulatory Regimes, and Good Business Climates
Nevertheless, the prospect reminds us of the decisive influence that such agreements and coordinated reform efforts can have on markets and on global capital flows.
We’ve often commented on the significance of the rule of law for markets, even to the point of saying that “democracy” as such is not necessary for dynamic markets and economic growth: what matters is a credible, reliable, transparent, and business-friendly regulatory structure. When reforms move in this direction, capital flows follow.
It’s not always a steady pace; often ambitious reform efforts are greeted with market enthusiasm which fades as the difficulty of those reforms, and the inertia of bureaucratic corruption, become more apparent. (The market’s response to the election of Narendra Modi in 2014 and its endorsement of his reform drive was a case in point.)
In spite of that volatility, though, it’s true that incremental progress towards credible goals that draws capital. Greater regulatory consistency and transparency are one factor; others include:
- Reliable corporate governance rather than cronyism;• Reliable and accurate accounting practices;
- Controlled deficits and sober and responsible fiscal policy (including stimulative policy when called for);
- A generally moderate regulatory burden for business and foreign investment; and
- Financial reforms that don’t overshoot their goals and hamstring market makers.
On some of these fronts, the post-crisis response of western countries has not been ideal -- and such weaknesses begin to feature more prominently in market psychology during corrections such as the present.
Post-Crisis Issues in the U.S.
Particularly, regulatory burdens in the U.S. have been in a steady upward trend -- and as we observed in our letter of January 21, this may be one of the key reasons that business dynamism is declining in the U.S. Regulatory burdens favor established players… and spell trouble for innovative and transformational entrepreneurs.
Another aspect of regulatory overhaul in the post-crisis era that may produce unforeseen problems is overreaching financial reform -- especially if it prevents big firms from playing the stabilizing and market-making roles that they played in the past.
Investment implications: Market turmoil of the kind we’re currently experiencing comes and goes -- but the regulatory frameworks and reform regimes that rise and fall are much longer determinants of where capital goes to find safe returns. That’s the tide -- market corrections are just waves on the surface.