Oil prices have tumbled more than 10% in a week, stock markets in Europe, the USA and USA have taken a substantial knock and, to the surprise of many, yields on ten-year government bonds in the USA and Germany have fallen back to only 3.2% of late.
The driving factor behind these changes is fairly obvious: markets have revised their fairly optimistic expectations. This has been prompted by a number of indicators in the USA or the new order figures in Germany. They have rekindled skepticism, even though the indicators provide only a short-term snapshot. The press releases from the US Fed last week and the ECB this week also played a role, fueling expectations that the two central banks would remain in accommodative mode and confirming that they still saw risks for the stability of the upswing. Finally, a slowdown in the emerging markets was looking inevitable as central banks endeavor to get a grip on inflation by ratcheting up interest rates.
To some extent the market reaction of the past few days is a delayed reaction to risks that have been lurking for a while but had to date left markets unruffled. The market cooldown is therefore not unexpected nor unwelcome. But what lies ahead? Is this the start of a longer-term downward correction, possibly stretching over months?
We think this unlikely. The decline in oil prices, along with a host of other commodity prices, removes one of the major headaches for the economy in recent months. Inflation rates will already dip substantially in May if, as is to be expected, the decline in commodity prices persists at least this month. This boosts consumer purchasing power and fuels hope that monetary policy will remain accommodative. The decline in long-term interest rates is also significant and serves as a stabilizing factor. It indicates falling inflation expectations and is a helpful signal in the midst of a heated discussion about the dangers of sovereign debt, especially in Europe and the USA. These welcome corrections on the markets are taking place against a backdrop of what is a stable, if somewhat slower, upward trend in the emerging markets and an as yet incomplete catch-up process in the western industrial countries. While consumption in many industrial countries was weakened by the commodity-fueled rise in prices, investment activity in these countries has bounced back strongly and, overall, looks to be in good shape. An end to the upswing following the overdue correction on a number of markets is not on the cards. To this extent there is no cause for pronounced pessimism about the trend on financial markets. The current economic slowdown could continue in the short term and hence the correction on the financial markets as well, but as the year progresses the Dax is likely to climb back above the 7500 mark it had already brushed. On the commodities front the correction of market excesses is likely to persist a little longer. Bond yields are likely to start to climb again once it is clear that the current slowdown in the economy is to be seen more as a pothole on the road to recovery than as the dawn of a new recession.