Our debt-clogged world is just one shock away from tipping into recession
The risk of global recession has suddenly jumped several notches, as the accumulated damage from Donald Trump’s trade wars and worldwide monetary tightening is taking a bigger toll than hoped.
A mounting weight of evidence suggests we are one shock away from a contractionary vortex that would be extremely hard to control.
In America the Federal Reserve’s instant tracking gauges of GDP growth have halved since late January. They are approaching stall speed.
In China it is becoming clearer that the Communist leadership either cannot or will not engineer another break-neck credit boom to revive an economy slipping into structural stagnation. Stimulus is trickling through but it is a pale image of past reflation cycles.
This is hard to square with the blistering asset boom over the last two months. The MSCI index of world equities has risen 15 per cent. Wall Street’s S&P 500 is up 18 per cent. Bears have been mauled.
Big global banks and funds bought into this relief rally on early evidence of synchronised “policy capitulation” by the G2 economic superpowers: the Fed’s rhetorical retreat after its ill-judged rate rise and hawkish message in December; Beijing’s pledge to avert a hard landing at the Central Economic Working Conference.
This had echoes of the Fed rescue in early 2016, which bought another lease of the global expansion and proved to be a bargain-basement buying moment. Yet the comparison has its limits.
The eurozone was then in the accelerating stage of a V-shaped recovery driven by quantitative easing a l’outrance and the end of austerity. Today it is in a deep industrial slump. It has tightened monetary policy into the downturn by shutting down QE.
Yields on 10-year German bunds have dropped 70 basis points over the last year and are flirting with zero again. Over US$11 trillion (pounds 8.4 trillion) of bonds worldwide are back to negative yields. Large players are battening down the hatches for a deflationary storm.
Morgan Stanley’s Michael Wilson thinks it is time to dismount from the stock market rodeo. “Bulls can be dangerous animals. We struggle to see the upside from hanging on,” he said.
The danger for the world economy is that the sugar rush from Trump’s US$1.5-trillion fiscal package will fade before China comes close to righting the ship. This would push the eurozone over the edge and back into the “sovereign/bank doom-loop” that it has conspicuously failed to resolve.
The central premise of Trumponomics has turned to dust. Cuts in corporate tax rates from 35 per cent to 21 per cent were supposed to set off a virtuous circle of capital investment by companies. Instead they spent the money on dividends and share buybacks.
All that remains of this wasted largesse is a budget deficit near 5 per cent GDP at the top of the cycle, and a public debt ratio rising from 106 per cent of GDP this year to 117 per cent by 2023 (IMF forecast) assuming nothing goes wrong.
Great expectations now ride on China’s gargantuan US$690-billion credit surge in January. But Chinese double counting distorts the headline figures. Rob Subbaraman, from Nomura, said much of the debt is being used to refinance corporate and household liabilities that have reached 206 per cent of GDP. China has reached credit saturation. His “credit impulse” measure has risen just 2.5 percentage points in the latest reflation mini-cycle. This compares with 13.9 points in 2015-6. It was 18.7 points in the cycle before that, and 30.2 points in the post-Lehman blitz of 2008-2009.
Chang Liu and Mark Williams, from Capital Economics, estimate that fiscal stimulus from tax cuts and extra spending amounts to just 1 per cent of GDP so far, compared with 4 per cent after the stock market crash and currency scare in 2015-2016, and 10 per cent a decade ago.
The global impact of the 2008-2009 episode had five times the potency.
The People’s Bank (PBOC) has ostensibly been easing for several months. The required reserve ratio for banks has been cut five times, but this is chiefly in order to stop liquidity drying up. The PBOC has not cut the benchmark lending rate this time. It cannot risk setting off capital outflows.
The short-term repo rate has come down 100 points — half the level of cuts seen in previous rescues — but this is not feeding through to corporate lending where it is most needed.
Capital Economics said spreads on AA- bonds have jumped 150 basis points to 400 over the last year due to credit risk and rising defaults. The transmission mechanism for stimulus is partly broken. The economy may stabilize by the middle of the year at (true) growth rates near 4 per cent but there will be no return to boom.
The new twist is how shockingly weak the U.S. economy suddenly seems. Retail sales fell 1.2 per cent in December, the biggest drop for nine years. The Conference Board’s leading indicator for the economy has hit an eight-year low.
The Philadelphia Fed’s manufacturing survey for February was dire. New orders fell 23.7 points in the steepest one-month drop since October 2008. The broad U6 measure of unemployment has risen from 7.4 per cent to 8.1 per cent since July. This has tell-tale signs of late–cycle exhaustion.
The new twist is how shockingly weak the U.S. economy suddenly seems
The New York Fed’s Nowcast gauge of growth in the first quarter has dived to 1.2 per cent (annualized) since late January, with startling drops for net exports and industry. The Fed waited too long to abandon monetary tightening, which famously operates with “long and variable lags.” Delayed damage from higher rates and bond sales of US$50 billion a month is only now being felt.
Lakshman Achuthan, from the Economic Cycle Research Institute, said it is not enough for the Fed to hit the pause button. Rate cuts are needed. “The Fed may already have left it too late to avert a recession,” he said.
We can see with hindsight that a rise in 10-year “real” borrowing rates to 1.15 per cent in October was all it took to set off an episode of violent global stress.
The rising dollar was torture for an international system with US$11.8 trillion of offshore dollar debt and complex linkages to the U.S. monetary policy through derivatives. European banks have large dollar liabilities on short-term maturities that must be rolled over constantly.
When the Fed kept tightening over the course of 2018 it drained global liquidity and pushed the broad dollar index to a modern-era high of 128.88 — until the world screamed. The global fallout from this protracted squeeze is now blowing back into the U.S. economy with a delay. If the U.S. rolls over before China stabilizes, the eurozone risks a terminal crisis. It is chronically incapable of generating its own internal demand growth. The European Central Bank’s key rate is already minus 0.4 per cent. The political bar to fresh QE is exorbitantly high.
The fiscal machinery of the eurozone makes it impossible to carry out aggressive counter-cyclical stimulus in a crisis. Public debt levels are much higher than before the Lehman crisis and European banks are sitting on euros 1 trillion of non-performing loans. Populist parties are on the rampage.
This is a political and economic construction that cannot withstand a major shock, which is why a no-deal Brexit would be courting fate for the EU. “Europe is a sitting duck in the next global downturn,” says Ian Kearns, director of the European Leadership Network.
It does not require a catalyst to set off global recession. Claudio Borio, from the Bank for International Settlements, says asset markets can “fall under their weight” from exhaustion and then take the economy down with them. This is what happened in the dotcom bust of 2001 and the Great Recession of 2008.
“Rapid increases in credit drive up property and asset prices, which in turn increase collateral values and thus the amount of credit the private sector can obtain until, at some point, the process goes into reverse,” writes Borio in his seminal work The Financial Cycle and Recession Risk.
Donald Trump may keep this asset rally going through the spring if he pulls back from trade wars with China and Europe, and a Brexit deal ices the cake. But deeper economic forces are at work in the world’s debt-stretched system. We may already be uncomfortably close to Borio’s tipping point.
The Daily Telegraph