Plan B

Global and US equity markets are hitting new all-time highs at an almost metronomic rate while the VIX continues to hover around a historically-low 11. Moreover, major currencies have remained within narrow ranges in the past couple of months.

Rising global economic activity, still accommodative central bank monetary policy, a historically average crude oil price and increasingly realistic prospect of US tax cuts, among others, continue to buoy global financial markets and tame asset price volatility.

Financial markets have seemingly largely ignored macro, political and geopolitical risks which include 1) monetary policy uncertainty and risk of central banks “getting it wrong”, 2) the impact on emerging markets from higher rates and stronger funding currencies, 3) the shaky underpinnings of global economic growth and 4) political uncertainty in Europe.

The question is whether governments and central banks have a Plan B to reflate their economies and/or support financial markets in the event of an exogenous shock to global growth and/or sharp correction in global financial markets.

The willingness of the private sector in developed markets to borrow more in order to fund economic activity would likely be greatly tested given already high levels of indebtedness and I would not expect corporates or households to be the main source of reflation.

Similarly, the ability and willingness of developed central banks to cut policy rates further and re-start QE programs would be limited in my view.

Precedent suggests that central banks in emerging markets, including China, would likely use considerable FX reserves of around $8trn to slow, if not stop, any shock-induced, rapid and/or sustained depreciation in their currencies.

However, aggregate data mask significant country-side variations while large percentage changes in FX reserves tell us little about their absolute size.

Governments in developed economies could ultimately take over from central banks in a more pivotal role while the governments of China and other Asian economies have repeatedly shown their willingness and scope to use a broad arsenal of measures.

Read the article in full on my blog.

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