1. Strong dollar
We know that the strong performance of the dollar crimps American exports and earnings overseas. Fragility in emerging markets influences companies in the technology, aerospace, consumer products, and luxury products industries. Devaluation of currencies together with excess capacity, caused by an abundance of investment in China, increases the possibility of deflation, which decreases pricing power. Lower oil prices have a negative influence on earnings and the value of energy producers’ assets.
At the same time, incomes and liquidity pressures cut activity in mergers and stock buybacks that supported values of equity. American stocks drop, and this negatively affects the world’s equity markets.
2. Debt markets
Energy companies with huge liabilities and emerging market borrowers see higher financial risk. Basically, the focus will be on the U.S. oil and gas industry, being significantly leveraged with debts that are more than three times higher than gross operating profits.
3. Shift in liquidity
We are experiencing an era of asynchronous monetary policy. The Federal Reserve diminished its operations, stopping buys of government bonds and securities backed by mortgage, which brought more than $1 trillion per year at their highest level.
The need for U.S. dollar liquidity is explained by the large volume of foreign currency liabilities, especially those issued by borrowers from emerging markets, being denominated in dollars. According to information from the Bank of International Settlements, dollar credit to non-bank borrowers overseas amounted to over $9 trillion in debt securities and bank loans.
Tightening of current dollar liquidity together with a more solid dollar would bring losses on such borrowings. The risk is escalated by the volatility of a number of emerging markets. Low prices on main commodities also contribute to the problems. It decreases the dollar-denominated earnings available to meet obligations on the liabilities of exporters, strengthening the possibility of currency instability.
U.S. dollar liquidity on global markets is impacted also by altered capital flows. Since the first oil crisis, the surplus earnings from oil exporters have been a vital part of the world’s capital flows, financing, increasing the prices of assets, and keeping interest rates low. A continued period of decreasing oil prices will cut petrodollar liquidity and may force sales of overseas investments.
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Foreign currency reserves are also going down in emerging markets, led by significant drops in Chinese reserves caused by a mix of weak trading conditions and capital movements to support the Chinese economy.
4. World economic activity
Let’s concentrate on the energy sector. The expectations that lower prices for oil will lead to growth may be wrong, with the troubles of producers offsetting the benefits for their customers. About $1 trillion of new investment won’t be reasonable considering the low oil prices. Mixed with the drop in forecasted investment in resource sectors, the adverse influence on economies will be huge. Currency fluctuations will also put pressure on growth.
Problems will grow in emerging markets also. Growth is slowing as result of weak demand from developed countries and unaddressed structural problems. For countries producing commodities, lower earnings will also bring a re-rating.
The fifth trigger is that slow growth, dropping inflation, and financial troubles will draw attention to sovereign debt. The public debt issues of the U.S. and Japan will bring about the renewed scrutiny of investor. In the EU, sovereign debt issues will influence important members like Italy and France.
The sixth and final trigger is that investors will negatively appraise government policies. Financial stability supported by low rates and QE is broken by the issue of the influence of these policies.
These financial troubles could bring in a new global financial crisis. The situation is really similar to 1997 with dropping commodity prices and the strong performance of the dollar, increasing U.S. interest rates, emerging-market debt problems leading to monetary crisis in Asia, and default in Russia.