NN IP: Global growth momentum appears to be balanced

The most timely and important bellwether of global momentum remains the global output PMI, which has behaved almost in textbook fashion over the past few years. During the dollar and commodity-induced disinflationary shock of H2’14-H1’16, the PMI was on a downward trend, but since the late spring of last year (i.e., after the dollar- and commodities stabilised/recovered) the index has been on an uptrend. Late last year it was fashionable to attribute this uptrend to reflation hopes on the back of the election of Donald Trump and at the time we certainly attributed some credence to the fiscal easing part of this story (even though we also emphasised the risk of protectionism). Currently it seems that the hopes of US potential growth-enhancing policy actions have been deflated big time. In the meantime markets and the economy had to deal with substantial EMU political risks until mid-April but the on a trend basis the risk rally continued and economic momentum remained on an uptrend. Hence with the benefit of hindsight it seems the recovery from the lows of early last year was to a considerable extent a “mechanical” textbook reaction to the improvement in corporate profits topped up by positive animal spirits. The latter may have been supported by Trump reflation hopes last year but it is increasingly difficult to see this as the main driver at this point in time.

The May PMI more or less moved sideways at a level consistent with a little above 3% global growth. The data flow over the past few months suggests that global growth momentum is more robust than it seemed at the start of the year. In March it still appeared that global IP momentum was running far ahead of final goods demand momentum while, within the latter, capex momentum was very strong and retail sales momentum was pretty weak. This implied two risks: First of all, the risk that momentum was driven to a large extent by a build-up in inventories which is by nature temporary and, secondly, the risk that consumers had become structurally more cautious. We never worried too much about the second risk because we believed that the inflation hump was the most likely explanation for the consumer soft patch while labour markets, net wealth gains and consumer confidence readings pointed to further strength. Still, it is reassuring to see that the momentum in global consumer spending has improved markedly even if this has been accompanied by a moderate decrease in the momentum of global capex. The latter surged to a pretty high level early this year and now seems to be settling on a more sustainable and still robust pace. The pick-up in consumer outlays is especially reassuring in the US where backward revisions to real PCE growth have narrowed the gap between confidence and real spending indicators. On the global level we note that the improvement in consumer spending has not been confined to the goods sector as the service sector output PMI has also improved a lot since last summer. Finally, the realignment of global IP momentum and global goods demand suggests limited risk of an inventory drag going forward even though this may still happen in some regions. There is some evidence that producers in EM Asia and Japan are reducing inventories. The US by contrast should see a moderately positive inventory contribution this quarter.

All in all, on the global level we have a pretty solid positive feedback loop between income and spending growth which is more balanced than it has been for a long time. This even extends regionally as EM growth momentum is also improving. The latest set of high frequency data does suggest some cooling in export growth and regional IP momentum but that could be partly related to the aforementioned normalisation of capex momentum and drawing-down of inventories as well as specific cycles in tech products. Against this it seems that EM consumer and to a lesser extent business confidence are improving somewhat while EM retail sales were pretty strong in Q1. The latter may have been partly triggered by the fact that many EM countries subsidize fuel and agricultural products because of which consumer spending is relatively insulated from fluctuations in global commodity prices. Besides all this it seems the pace at which EM banks are tightening lending standards has come down a little in the past quarter, which is supportive for the notion that the worst of the EM deleveraging cycle may be behind us. To be sure EM debt to GDP ratios still need to come down but this could also be driven by an improvement in the denominator (nominal GDP) in which case the deleveraging drag on growth will be a lot lower than it was.

Will global growth break the ceiling?

The big question is whether or not growth will break the ceiling that has been in place since 2010. Unfortunately it is impossible to be confident about this. What we can say is that growth tried to do this on two occasions since 2008 and on both counts it failed because post-crisis imbalances or policy mistakes. The first attempt was in 2011 when DM economies recovered strongly on the back of combined monetary and fiscal stimulus while the EM credit boom was still boosting EM growth. The big mistake back then was concerted DM fiscal tightening, which caused a relapse in DM aggregate demand. The Euro crisis in 2011/12 (which was also to a large extent a policy mistake as policymakers failed to short-circuit self-fulfilling detrimental market dynamics in time) added insult to this injury. The second attempt was in 2013/early 2014 and it was essentially aborted because of the confluence of various imbalances. Divergent DM business cycles were translated into diverging monetary policy cycles which resulted in sharp dollar appreciation. The latter then interacted in a negative way with both the EM deleveraging cycle and the downturn in the commodity cycle (which itself was partly the result of sluggish EM demand but also due to a positive commodity supply shock).

To lift the global economy towards a growth equilibrium that is sustainably higher than the 2010-2016 range, we thus seem to need a combination of the following factors: the imbalances in the global economy and the interaction between them must be limited so that they do not form an impediment to sustained robust private sector demand growth. The trouble is that no one really knows how to quantify “limited”, i.e., where the threshold is beyond which the set of imbalances prevents growth momentum from rising towards a permanently higher path. This threshold is probably state-dependent in the sense that it varies with the other two factors: the constructiveness of the policy response and the state of private sector confidence. An increase in either of these two can compensate for increased imbalances. The good news is that the imbalances have indeed decreased over the past few years even though they have not completely vanished. The most important imbalance is still the high degree of EM private sector leverage even though we believe that this need no longer necessarily act as a drag on growth. This mostly holds for EM-ex-China, but then of course in real life you cannot make a clean separation between China and EM-ex-China because both parts of the world are intimately connected via trade, capital flow/risk appetite and private confidence channels.

Now it just so happens that the biggest imbalance in the global economy is hidden within the Chinese financial sector and that the Chinese authorities are taking measures to reduce the growth of the shadow banking system. These measures are long overdue and it is better to take them now than later because the larger the pile of financial sector debt gets, the bigger the risk of a really big accident becomes. Having said that, a wide range of historical experience (including the US in the late 1920s and in the previous decade) shows that trying to reduce rampant credit growth while ensuring a soft landing in the real economy is very tricky business indeed. In the case of the US the main instrument was the policy rate which pushed the whole risk free yield curve eventually higher. This in turn triggered widespread “margin calls” in the real economy and the financial sector resulting in a cascade of fire sales in various asset classes. The Chinese authorities use a whole range of regulatory instruments and have the means to ensure liquidity and solvency of the traditional banking system. What’s more, due to capital controls a wide spread margin call by foreign investors cannot happen. Despite all this, tightening efforts could all too easily lead to sharp asset price fluctuations, a reduction in credit supply in the real economy and a collapse in the real estate market.

Of course, there are other imbalances we can worry about: intra-EMU current account imbalances, EMU institutional deficiencies, US corporate sector leverage, the Japanese corporate savings glut, high and rising levels of DM sovereign debt etc. Still, given the robust cyclical momentum we have seen in G3 space we believe it is safe to argue that these imbalances no longer form an insurmountable impediment. This then brings us to the constructiveness of the policy response. A lot of progress was made here over the past five years with the turn away from concerted fiscal tightening towards a neutral or even somewhat expansionary DM fiscal stance. What’s more, central banks engaged in a trial-and-error process which eventually led to an asymmetric reaction function: “Display a vastly underwhelming response to improvement in the date to foster a positive feedback loop between rising nominal growth expectations and falling real rates. However, react forcefully to any sign of a potential negative feedback loop between the real economy and financial conditions to prevent a secular stagnation like equilibrium from becoming more strongly cemented in the private sector’s collective psyche”. At various speeds DM central banks are now tiptoeing away from this reaction function towards a more normal symmetric pre-crisis version. However, because they are so deep in unconventional territory it is really anybody’s guess what the exact effects on risk appetite and the real economy will be.

The third factor we mentioned is private sector confidence, which in DM space and increasingly also in EM space is on an upward trend. To some extent the rise in confidence is a reflection of improvements in the real economy and financial conditions but given the gap between confidence and spending it is probably also driven by positive animal spirits. To the extent that this is true we should see this gap close in favour of the confidence data. It is very important to watch this animal because we believe that depressed self-fulfilling expectations have been an important factor which kept growth below the aforementioned ceiling. The corporate sector has been very cautious in its investment decisions until fairly recently while being much more willing to increase labour demand in response to rising output demand. A large degree of uncertainty probably played a very big role here: investment spending requires a big upfront lump-sum cost, which cannot easily be recouped while labour can be varied more flexibly. This behaviour seemed to change in favour of a better capex momentum in 2013/early 2014 but this trend was aborted due to the sharp fall in profit growth on the back of the disinflationary dollar/commodity shock. However, now that profit growth and business confidence are rebounding in the face of easy financial conditions businesses are responding in textbook fashion by increasing capex. In short, corporate caution seems to be a lot less than it was before 2013. Whether or not this also holds for the consumer is not entirely clear. The gap between confidence and spending is bigger here. One expression of this gap is the behaviour of the savings rate especially in the US where it is still higher than the level one would normally expect given net wealth and the risk free real rate. The flip side of this is that US consumers have delevered pretty strongly in the first few years following 2009 and have seen only a marginal increase in leverage from the lows. To the extent that positive animal spirits are really present in the US consumer one would at least expect to see some decline in the savings rate.

Emerging markets: EM exports, Mexico, Qatar

Korea is always one of the first emerging economies to report its monthly trade numbers. After a weakish first-21-days-of-the-month print, Korean export growth for the whole of May was surprisingly strong, with 13% year-on-year. Volume growth is estimated to have been 2% month-on-month. Export growth to EM was considerably stronger than to DM. This suggests that domestic demand growth in the emerging world is gradually gaining strength.

If we look at export growth for the whole emerging world, we expect that May will not be as good as it was for Korea alone. While EM manufacturing exporters are benefiting from the pick-up in global demand, EM commodity exporters are suffering from lower raw-material prices. Headline EM export growth for May is likely to be a low single-digit number, after four consecutive months of double-digit growth.

The May manufacturing PMIs suggest that global trade growth might have peaked in April. It is still early days, but the PMIs were clearly softer in Asia. Most countries are still above the neutral 50 mark, but with a smaller margin than in April.

In Mexico, President Peña Nieto’s PRI party won the State of Mexico’s gubernatorial election last weekend by a margin of only 3 percentage points over the left-wing Morena party (34% vs. 31% of the votes). In the past decades, the PRI used to win this election with 60% of the votes. Nevertheless, this win takes away some market concerns about Morena’s Andrés Manuel López Obrador possibly winning next year’s presidential elections.

In the Persian Gulf, a new diplomatic crisis broke out between Qatar and a coalition of Saudi Arabia, UAE, Bahrain and Egypt. The latter four suspended all ties with Qatar to punish the Qatari government for its support for the Egyptian Muslim Brotherhood, Hamas and Iran. Land borders have been closed and all flights suspended. At the same time, Qatari citizens will have to leave the other Gulf countries in 14 days. Risks of the curbs are mainly for the Qatari banking sector, which has large loan books in the other Gulf countries and Egypt. The economy as a whole has big financial buffers, but the blockade should not last much longer than in 2014, when a similar situation took eight months to be solved.