The architecture of financial markets has changed and we will soon see the end of the last eight years of economic prosperity, said Stefan Bielmeier, chief economist and head of research at DZ Bank.
While the world has seen dramatic shifts in politics in the last 24 months, the global economy has remained strong.
In a keynote speech at Bellin’s 1TC Treasury Convention, Bielmeier argued that this was because “central banks have helped to emancipate the economy from politics”.
“Central banks are one of the most important players in world financial markets right now. The central banks are responsible for this long-lasting upswing we have observed in recent years – eight years of growth in the US and Europe, with low inflation, rising equity markets.
“Central banks are one of the most important players in world financial markets right now”
“The problem is that this works for a time but when the politics is too bad it will have an impact [on the economy]. But for now, the economic situation around the globe is brilliant,” he said.
Despite economists’ warnings following protectionist politics coming into power in 2016, there are hardly any signs of slower economic growth.
However volatility is back, Bielmeier said. He pointed to income and equity markets as an example.
He also cited strong mergers and acquisition (M&A) activity around the globe.
“This is also an indication of market risk. It is a problem for central banks because if yields and interest rates rise so quickly, many M&A and investment structures will collapse,” Bielmeier argued.
“The architecture of the world and financial markets has changed,” he said.
Regulation is changing the ‘architecture’ of banking
Banks have started to increase their balance sheets to offset the negative effects of heavy regulation that has come into effect following the financial crisis of 2008, he argued.
“The problem is that the channel between central bank balance sheets and the credit channel is linked to commercial banks and the central banks are not linked to the credit channel,” Bielmeier commented.
“This is one of the major changes in the architecture of financial markets in my view because it is still ongoing.
“Regulation is still working, Banks are fast becoming more risk adverse and smaller,” he said.
While central banks have been able to limit any impact on the economy, we are now coming to a period where this comes to an end which will trigger some volatility in the global markets, according to Bielmeier.
Why is inflation so low considering the strong rise in liquidity?
Economists generally believe that inflation and liquidity are closely linked, but in recent years this has not been the case.
Bielmeier argued that it because the liquidity being provided by central banks is only partly put into the real economy.
“A major part of this liquidity is kept in the banking system as base money, not the real economic money supply,” he said.
“This is due to the very gratuitous supply and demand for credit. This could change quickly if corporates start demanding more credit and liquidity, but to date, the central banks have been able to mitigate any impact,”
However, in recent months central banks have started to realise the party will soon be over, according to Bielmeier.
In the US, treasury yields are now close to 3% and the equity markets we have seen a small correction, he noted.
Digtalisation is only just beginning
Another reason for inflation staying low in the US and Europe is automation, Bielmeier said.
“Digitalisation is just starting. All non-reactive workplaces will be replaced in the next few years.
“In Germany, we have a strong lack of skilled workers despite this. Wage growth is ok and relatively low commodity prices helps, but this could quickly change,” Bielmerer argued.
The major threat to financial markets in 2018 is rising inflation rates, he said, adding that “cheap liquidity is the fuel for market performance”.
“Overall, I do not expect a reduction in liquidity in 2018-2019, but I do expect the rise of liquidity to stop. This, in itself, is slightly restrictive,” he said.