2018 has been an interesting year for the global economy. To begin with, the markets have taken a tumble across the world. The sharp movement in the bond market has been just as remarkable, but for a different reason.
What has changed all of a sudden?
For a long, long time, the West was marked by low inflation rates and low interest rates. This has been the case in the United States, Australia, Canada, Germany and the UK.
But the events of the past few months suggest that this is not going to be the same for much longer. Let’s start with the United States. The U.S. Treasury bonds have gone up by 3 percent recently, for the first time in 4 years. This was 2 percent last year.
In Germany too, 10-year bond yields have doubled in just a year. What’s happening is that Central Bankers in the West are trying to get the inflation to the 2 percent level. The Central Bankers want to get away from the low interest rate – low inflation regime.
The reason for that is that low interest rates are generally a sign of economic weakness. Governments nudge the central bankers to keep the interest rates low to encourage investment.
For the interest rates to be moderately low is very healthy, but when they are so low that they are negative, as has been the case in Japan – that points out to stagflation – economic stagnation combined with inflation.
What does this mean – are higher interest rates/higher inflation good for the world economy?
Well, that depends on which country you’re talking about. For a country like India, which has historically struggled with high inflation, any increase in inflation beyond the present 4% can be dangerous. For Japan, where the inflation has been negative for a while, a rise in inflation could help boost the economy.
What you want is the right balance between economic growth and inflation. This is not so easy to find. But many countries are moving towards this direction.
Regardless of the sharp fall in the global stock markets, it has been clear for a while that most of the large economies around the world were doing very well over the last few years. The economic growth rates are up, not only in the United States, but across Europe, Australia and Asia.
There is hence a strong demand for raw materials, oil and other commodities. The imposition of tax cuts in the United States and a possible trade war in the making between the U.S. and China will mean only one thing – higher inflation. And to tackle the higher inflation, we expect the central banks to increase the interest rates.
This is good for the bond market, but what does it mean for you if you have a sizeable investment in stocks?
Well, high interest rates/high inflation means higher volatility in the stock market. Stock markets never do well in an environment of high interest rates.
One of the reasons why interest rates have been kept down in the United States for so long was to encourage stock market investment. That could change with more money going out of stocks and into bonds.
This will not only affect the stock markets in the United States, but also in emerging economies such as India, Brazil, China and Turkey, as the smart money moves from stocks to bonds, leading to further volatility. Interesting times are ahead!