Global growth remains lackluster averaging 3.7% for 2017-18, in the face of rising risks, reflecting persisting trade barriers and the reversal of capital flows to emerging market economies (EMEs) with weakening fundamentals amid higher political uncertainties.
Emerging Asia (led by India and China) was the world’s principal driver, expanding growth at about three times the pace of OECD. The global economic weather has begun to shift, with the outlook dimming as the new year approaches. Sure enough, tariffs are beginning to take their toll as countries have responded to US protectionist measures with matching tariffs of their own. Global trade has suffered. Last year, global trade volume rose 5.2% – the best since the 2010/11 rebound from the global financial crisis.
This year, trade appears on course for a 4.2% gain, lower than the April 2018 IMF forecasts. For most who track the comings and goings, the probability attached to further bad news has gone up. Prospects today seem worse than six months ago, weighed down by EMEs which are facing greater instability and having to contend with a strengthening US dollar, forcing many central banks to raise interest rates in even weak economies.
Still, despite this, the global economy will enter 2019 on a wave of some strength, emanating mainly from the US and BRICS. Global growth will no doubt slowdown but it’s not a disaster.
Risks have been building up,
Beneath the largely benign surface, risks have been building up, with a looming financial crisis being ever present. The long period of super-low interest rates carried risks of excessive leverage and risk-taking, including the building of high debt levels. A chorus of concern came from multiple central bankers, warning that the non-bank financial system has expanded too rapidly and now seemed to be highly leveraged. Policymakers admit they have been short on will and ways to rein-in risks in the shadow banking sector, before they will surely blow-back to the real economy.
The risk that the rising Chinese and Indian debt burden will blow-up at some point simply means that policymakers can never truly relax.
US growth
No doubt, the global economic outlook is less robust in the face of growing turbulence and uncertainties. The past year was marked by strong growth in the US (expected to hit 3% in 2018) stimulated by strong fiscal expansion. That, in turn, has been underpinned by sustained profit growth, despite short-term rate increases. But most expect the pace of growth to slacken as the fiscal impetus begins to wane (and hence, slower profit growth) in the face of rising calls for a breather in Fed rate hikes.
The Fed is looking for inflation to stabilise. Because it is not certain they are there as yet, another rate increase this month is likely, even as the unemployment rate (3.7% in October) sits at near a 50-year low. Economic capacity is already running tight.
Bear in mind in the 1960s, low unemployment was accompanied by a decade-long run towards double-digit inflation, and in the 1990s by an epoch of asset bubbles that ended rather badly. Is this time any different?
Two big uncertainties overhang US prospects: (i) the outlook on fiscal spending is unclear given a looming US$1 trillion budget deficit and exploding debt servicing costs; and (ii) business investment outlook remains uncertain – it has slackened to a modest 2.5% in 3Q18, with oil prices down and confrontational trade, on. The effects are wide ranging. World trade has already slowed down.
In Germany, exports contracted in 3Q18; economic activity is falling in France, Italy, UK and Germany, as well as in China and Japan. US businesses aren’t walled off from this. They are grappling with rising import prices that are hit by tariffs, and uncertain about their global supply chains because of export disruptions. Feeding investors’ anxieties are a range of other threats, including trade spats initiated by the US on EU, Canada and Japan. Also, the uncertainties surrounding Brexit.
The temporary trade truce with China helps. Still, the outlook for 2019 rests heavily on whether the sources of tension can be resolved or instead, allowed to spiral unpredictably into a full trade war.
Business and investors are growing anxious about the prospect of recession in the advanced nations. They are puzzled because the prevailing economic trends don’t fit the patterns that led to previous downturns. True, equities are falling; the gap between short and long-dated US bonds is narrowing; and oil prices are down – all harbingers of past recessions. Also, economic activity in Europe, China and Japan, all engines of global growth, is slackening.
Feeding these anxieties are very visible threats from global trade spats (albeit Trump-made) and from Brexit. Studies I have seen (based on 120 recessions in 40 nations over the past 40 years) suggest a disconnect between data in US, eurozone and Japan over the immediate past years, and the record since 1980: (a) productivity growth and consumer spending have picked-up, instead of falling; (b) US rise in jobs is robust & payrolls much better – so much so, employment is highest on record; (c) models using different assumptions on the growth outlook suggest 21%-36% probability of recession in next 12 months; and (d) where there are strong signs of downturn, they reflect peculiar situations – Italy (because of the budget spat with EU, is now moving into recession); and UK (as a result of Brexit).
The US expansion is already the longest on record. Periods of growth don’t die of old-age (Australia’s have continued for a quarter of a century). But they can and do slow down. Indeed, expansions end because something goes wrong – high inflation sets in; asset bubbles bust; central banks pushing interest rates up too much.
Inverted yield curve
The yield curve, as widely publicised, comes about by plotting US government yields (rate of return) of different maturities on a single graph, with the Fed’s overnight interest rate at one end and the 30-year “long” Treasury bond at the other.
Typically, it costs less to borrow money for one day than for one year or a decade, and 30 years will be the priciest. This is so because things do happen to an investment over time – including inflation that erodes the fixed return on a bond; as a result, investors need to be compensated for taking-on the risk.
That’s why shorter-dated Treasury bonds usually carry a lower yield than longer-dated ones. That means the shape of the yield curve tends to slope upward over time, from left to right.
The different yields demanded by bond investors say a lot about what they think about how the US economy is doing and where it is heading. In the event there is a big difference between short and long-term Treasury yields – that is, if there is a steep upward curve – it suggests investors expect inflation and interest rates to rise markedly in the future. The curve can be particularly steep as the US economy is pulling out of a recession.
But as that difference declines (as the curve flattens, as it is doing now) it indicates that investors expect slower inflation and more tepid economic growth in the future. Initially, this may not be such a terrible thing. The Fed typically raises interest rates when the economy is doing well and inflation is rising.
By increasing short-term yields, the premium for investing in longer-dated yields declines. What investors do not want to see is a negative, or “inverted”, yield curve – i.e. one that (on a graph) has a downward kink or is backward sloping. That suggests that an economic slowdown may be approaching, one in which inflation will fall and the Fed will have to cut rates. An inverted yield curve (IYC) has preceded every economic recession in the US since WWII.
The most telling indicator is the difference between 2-year and 10-year Treasury yields. At its post-2008 financial crisis peak that difference (or spread) was close to 300 basis points, as the economy pulled out of recession. Last week, it slipped below 10bp for the first time since 2007. But other measures have already turned negative; one reason for the stock market sell-off earlier on.
It is unlikely that there would be an imminent US recession. US economic growth in 3Q18 was strong; 4Q18 forecasts look good. Unemployment and wage growth data are still broadly positive. Manufacturing data released last week brought a welcome surprise.
Broadly speaking, US investors and policymakers are upbeat about the state of the US economy. But an IYC is a warning sign, because it tells investors about expectations for the future and not necessarily about the state of things right now.
There are concerns that the economic “sugar rush” provided by tax cuts earlier this year will soon wear off. Uncertainty over trade disputes still looms large. Earnings growth is expected to fall in 2019. Since 1980, the average time lag between the yield curve inverting and the economy falling into recession is 21 months; and it can take up to three years.
Yes, recession not imminent, but is it inevitable? It’s possible, but there’s no guarantee. It is possible for an IYC to become self-fulfilling, exacerbating an economic slowdown and helping push the economy into a recession. It’s particularly acute for the banks which, in practice, make money by lending long at higher rates than they pay out on short-term deposits. An IYC can thus constrain lending, thereby hurting economic growth. Others say there is no causal relationship between an IYC and a recession. It’s just an indicator.
Five things to watch
As financial markets become more challenging at this time, it helps to know where the stresses are. Indicators to watch include:
l The Vix – commonly dubbed the “fear” index, the Chicago Board Options Exchange (CBOE) Volatility Index. A handy proxy for the level of panic on Wall Street – it measures the implied volatility of the US stock market over the next 30 days. Normal is 20 – at the height of the last financial crisis, it rose to 89. It’s now close to 20;
l The Skew – the CBOE Skew Index. It measures the difference between the cost of buying insurance against a market fall and the cost of buying the rights to benefit from a rally; it ranges from 100-150 (100 means expected market gains are normal). It’s now about 120;
l Cross-currency US dollar swap cost banks charge – spikes in demand for US dollar do reflect financial distress;
l Financial conditions indices – the most commonly used being Goldman Sachs’ Financial Condition Index, designed to measure how stressed financial markets are: index rises when markets are stressed, and fall when they are buoyant; and
l Yield curve inversion (IYC). Together they offer a composite reading of how fearful markets can become.
What then are we to do?
Tariffs don’t work – they distort and disrupt. Trump’s trade truce is a start. Still, it looks shaky enough today. In October 2018, the United States recorded its highest trade deficit in 10 years, resulting in part from the untimely tax-cut driven domestic demand and a potentially tariff-related fall in exports. Trump’s trade confrontation is making investments everywhere less attractive – including the US. It’s good that G20 has since vowed to overhaul the international trading system.
WTO falls short in meeting its objectives & is in need of reform. To succeed, there is urgency to bridge the deep & wide gulf between US & other G20 nations in their respective political, economic and strategic interests. Indeed, they need to cede key national priorities to defuse tensions, including those created by climate change.
It’s a pity only 19 of them reaffirmed their commitment to the goals of the Paris climate deal which they now rightly deem as “irreversible.” It’s important there is no back-tracking. As I see it, the trade truce is unlikely to last for long against the backdrop of growing superpower rivalry.
If there ever was a walking, talking embodiment of the “accident theory” of history, it is the unpredictable President Trump with his brazen show of American power. Tensions will continue to be ever present in 2019, reflecting Tina the old Margaret Thatcher dictum: “There Is No Alternative”.
So, plenty can still go wrong for the global economy in the year ahead, including tense trade confrontations amid the looming recession, which economic data aren’t saying it’s happening anytime soon. (Wall Street Journal.)
The writer is a former banker, Harvard educated economist and British Chartered Scientist, Tan Sri Lin See-Yan is the author of The Global Economy in Turbulent Times (Wiley, 2015) and Turbulence in Trying Times (Pearson, 2017).
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