Assessing the Downside Risks for the World’s Economy
The final quarter of last year witnessed a significant turning point in market thinking, as a combination of factors – including worries about trade wars and policy tightening – led to a downward revision in growth expectations and a sea-change in thinking about future US Federal Reserve policy and the path of policy rates across the globe.
Equities suffered, bond markets performed well. So much so that by the beginning of this year, fears of a perfect storm had been replaced by the expectation of a perfect policy response for markets; with accommodative monetary policy, a significant stimulus in China and a settlement of trade worries. Add in low inflation and this triggered a rebound in equities, with bond yields, while off their floors, remaining low.
Last week I summarised views about the global economy, taking into account the main messages from two recent global conferences I had participated in. There is considerable uncertainty in views and across the markets. Naturally, the outcome is data dependent, but it is heavily policy dependent, too.
The bearish case for the world economy
While there are many different shades of thinking, let me summarise the bearish case regarding the world economy. This is generally viewed as poor for equities, worrying for corporate debt, and positive for safe havens, such as government bonds and currencies where the country has a current account surplus, such as Japan.
The bearish case is that the rebound in the world economy from 2016 to last summer was unsustainable. Economies were overly dependent on cheap money. Western economies suffered from low productivity, emerging economies had not reformed sufficiently. Some economies, like China, had likewise witnessed an explosion in debt.
Add in the rise in debt across Western economies, and the world economy’s debt-to-GDP ratio soared to about 318% last autumn. Trade wars compounded this problem, the impact of US tax cuts wore off, China slowed as policy was tightened.
In this context, global measures of manufacturing fell sharply; the market focus was on declining Purchasing Managers’ Indices (PMI). This was not helped by the structural problems in the auto industry. Traditionally, falling PMIs in manufacturing reflect weaker world growth and lead to a downturn in service measures of PMIs, too.
The direction of global PMIs highlights an overall decline in activity
Source: Bloomberg. A reading above 50 represents an expansion compared to the previous month, below 50 a contraction.
Being at the late stage of the economic cycle doesn’t help
On top of all of this, there was a general recognition in markets that we were at the late stage in the economic cycle. While cycles vary across countries, it is the US cycle that attracts attention. Measured by the National Bureau of Economic Research (NBER), the current US expansion has lasted 117 months up to the end of March. This is now the second longest expansion on record. The longest is 120 months (from March 1991 to March 2001). The third longest, 106 months, was from February 1961 to December 1969.
Cycles can also be measured in other ways. From the bottom of one business cycle to the next, the longest US trough to trough cycle was 128 months (March 1991 to November 2001). While the longest peak from one cycle to the next was also 128 months (from July 1990 to March 2001). In the US, the most recent peak was just before the financial crisis, in December 2007, just before rampant oil and gasoline prices slowed the economy, and the most recent trough was June 2009, just before policy stimulus kicked in.
Thus, by any measure this is a long cycle. That adds to market nerves. So, too, does the fact that companies have been heavy buyers of their own equity; I have seen this referred to as “private QE”, perhaps to emphasise that this boost is not sustainable.
Given all this, one can understand, if not fully agree with, one of the summary paragraphs from the recent IMF Global Stability Report:
“Risks to the global outlook remain skewed to the downside amid high policy uncertainty. These include a reescalation of trade tensions and disruptions from a no-deal Brexit. Given still-accommodative financial conditions, the global economy also remains susceptible to a sudden shift in market sentiment and associated tightening in financial conditions. Downside risks in systemic economies, if they were to materialize, also weigh on the outlook.”
The influence of economic circumstances and policy
It is important to naturally factor such issues into our thinking. But it is also important to set these alongside a host of other factors before weighing up what may lie ahead. There is a need to differentiate between cyclical and structural influences.
In terms of the cycle, two issues in particular are key. One is whether the present set of economic circumstances will allow economies to grow with sufficient momentum. This includes, for instance, whether healthy jobs markets across many Western economies – notably in the UK where data this week showed employment at an all-time high – and which are now seeing a recovery in wage growth, should underpin consumption across many countries. Solid employment growth has, however, also focused attention on the still low rates of productivity growth and thus about how sustained any increase in wage growth may be.
The other key issue is policy, as we have alluded to for some time. A resolution to the trade dispute between the US and China would radically transform not just sentiment, but also trade flows themselves. In some respects, markets have discounted some of the good news on a de-escalation of the dispute, but seeing this delivered and then translated into a rebound in trade is also important to either sustain sentiment or give it a new lease of life.
Also, with inflation pressures having eased, central banks should have sufficient room to ease if needed, or to delay tightening and policy normalisation until economies and markets are better able to cope. This, though, may reinforce concerns about whether markets may become over-extended on the back of cheap money.
In addition, nominal GDP growth, even if less than last year across many economies, should still be sufficient to allow debt to GDP levels to fall – perhaps significantly as we are seeing in the UK – while also allowing scope for increased fiscal manoeuvre if needed.
The positive and disruptive effects of structural change
There are structural changes to the world economy that continue to unfold. Many of these are positive for the world economy but also disruptive. I have referred to some of these previously as “perspiration” and “inspiration”, including demographic change and innovation from the Fourth Industrial Revolution.
The evolving nature of global growth is also driving changes. The initial temptation is to distinguish between the West and the Rest, with more of global growth coming from what are still misleadingly called the emerging economies. It may, though, be more appropriate to talk of the Indo Pacific as the main driver, from India across east and south-east Asia to the US, which is sharing increasingly in this shift in the world economy.
Moreover, in this changing global environment, central banks across many emerging economies now have scope to ease – as India demonstrated recently – and this should help underpin growth.
Overall, global markets, as well as the world economy, continue to contend with many factors. There is upside momentum in many economies, but they, like markets, are vulnerable to premature tightening or to shocks. As the credit cycle matures, financial vulnerabilities may become more evident.
Yet, for now, financial conditions, despite having tightened, are still accommodative and thus supportive of growth. As previous cycles have shown, there is always the possibility markets may, on the back of policy stimulus, reach levels which leave them vulnerable to setbacks. In the second quarter of 2019 the key focus will be to see how policy and the data evolve.
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