Economist Willem Verhagen looks at the changing phases of the global economic cycle, and Strategist M.J. Bakkum examines how international trade worries might be impacting the world’s emerging economies.
10.04.2018 | 10:15 Uhr
Over the past year and a half, the real side of the global economy made our lives pretty easy. Barring some minor perturbations, it seemed like “the only way was up”, which is arguably the phase of the cycle with which markets feel most comfortable. Once the disinflationary waves stemming from the H2’14 dollar appreciation and sharp decline in oil prices had died out, the global economy was resilient enough to embark on a steep acceleration.
At the most fundamental level, the drivers were a reduction in imbalances in EM space and a more supportive global policy mix. The EM-ex-China private credit-to-GDP ratio peaked out, which often marks the transition to a phase in the credit cycle where deleveraging is mostly achieved via growth in nominal GDP rather than a decline in the growth rate of the stock of credit. Such a decline tends to be the first part of the deleveraging phase, which weighs considerably on growth because it is the change in the flow of credit that matters for growth. The analogy of a car is useful here. If less petrol finds its way to the engine, the car will slow down.
On top of this, EM corporate margins were on a declining trend between 2011 and 2015 as the credit boom in the previous years meant that EM corporates had to rely less on improving efficiency to maintain revenues. On top of that, margins in some countries were squeezed by rising unit labour cost growth. These imbalances had also been digested to a considerable extent in early 2016, which allowed EM profit margins to embark on another uptrend. As for the policy mix, the most important development was that DM central banks provided an effective put option against downside risks during the disinflation shock while fiscal policy makers avoided detrimental austerity efforts.
All this allowed a pretty strong feedback loop to develop between rising confidence, easing financial conditions and strong growth momentum. One of the most important consequences of this on the real side of the equation was a strong capex recovery, which made the global expansion more balanced as labour markets continued to tighten simultaneously. In the face of an increasing trend in net wealth and robust levels of confidence consumers had little difficulty in spending a larger part of their increased incomes.
Early in the year we discussed three potential “party poopers” which could stop the expansion: hard supply side constraints, rising imbalances and (political) uncertainty. Our conclusion was that none of these was likely to spoil the party in the foreseeable future. The party stops when the lights go on, fatigue and vulnerabilities become more obvious and everyone heads for the exit, i.e., the economy and the markets undergo a substantial downturn.
We also concluded that in DM space the US is most vulnerable in this respect. If and when the US party stops, the rest of the world will feel it. Of course there are also examples in EM space where a sudden stop to the party could have global repercussions. China springs to mind here. Indeed there is much diversity within EM space but for the region as a whole we would say that it is still relatively early in the cycle with reduced imbalances and some slack to be absorbed.
There are many shades of grey between a journey during which where your car accelerates smoothly on a straight road under calm weather conditions and a storm that forces the car to slow down or even stop. Between these extremes, the journey can also become less comfortable if the weather becomes less bright or the road becomes more bumpy.
Just as a car cannot accelerate forever, the economy will also stop accelerating at some point and reach a cruising speed. In a vacuum, a constant flow of petrol to the engine (which generates a constant force that moves the car forward) would cause the car to accelerate forever. However, the conditions on planet earth are always such that countervailing forces (resistance exerted by the air and the road, for instance) become strong enough to stop the acceleration at some point. The acceleration phase in the economy usually depends to a considerable extent on the additional fuel being provided by factors such as a lift in confidence, easing financial conditions, an upturn in the credit pulse or an improvement in the fiscal pulse. This will trigger an investment upswing that is usually enhanced by stronger employment growth and falling savings rates.
All the pulses mentioned have a natural tendency to revert to neutral unless they get more fuel. Confidence will reach some plateau; structural deficits, monetary policy stances and financial conditions will stabilize; credit supply will stop expanding at an accelerated phase, etc. What’s more, in the real economy, pent-up investment demand will slow down at some point, which is when businesses come close to their desired capital-to-labour ratios and/or the desired level of technology embodied in capital goods. And at some point savings rate will hit a natural bottom in view of consumers’ life cycle consumption planning.
When the year started we still had the impression that we were in the late stages of the acceleration phase, but the data that came out since then seem to suggest that the global economy is reaching a cruising altitude. At the same time we are seeing some clouds on the horizon, which suggests that weather conditions may become less favourable and the ride could become bumpier. Markets had gotten used to the easy ride in the sun, so this transition (even though it is far from a disaster) is obviously not always easy for them to digest.
We know that markets trade by and large on the second derivative. To be more precise, they will trade in perceived shifts in the probability distribution of future economic outcomes, “perceived” and “shifts” being the operative words here. As we argued a few weeks ago it is actually the perception of the average investor about how the average investor perceives the fundamentals that drives markets. This opens up the door for many stories and deviations from the fundamentals, which to some extent become self-fulfilling.
For now let us abstract from all this and focus on the shifts in the probability distribution of economic outcomes. There are numerous inputs that affect changes in this distribution and the drivers mentioned earlier (pulses exerted by confidence, fiscal policy, credit, monetary policy, financial conditions) are an important part of this story. Markets will also look at the size, shape and interaction between imbalances (leverage, income distribution, competitiveness, dependence on capital flows, to name a few). Political uncertainty will also be an important input for the simple reason that this may alter the “rules of the game” that govern transactions in the real economy and the financial system (e.g., international trade). More uncertainty about these rules will generally lead to greater caution.
An important lesson of the past two years has been that these factors can act as substitutes for each other to some extent; that is, weakness in one element can be compensated by strength in another one within certain boundaries. Of course this idea makes sense when one thinks about how all the inputs interact to produce economic outcomes. In particular, the acceleration phase made the economy and markets relatively insensitive to bouts of political risks.
This certainly holds for the risks that in the end did not become a reality and that were never really the base case (such as the French and Dutch elections). Meanwhile, the risks that did become a reality have some special features. Brexit is very much a country-specific shock, which is primarily reflected in UK asset prices (mostly sterling). Of course there could be spill-overs to Europe, as a hard Brexit will certainly affect confidence in the main UK trading partners on the Continent. It could also affect financial conditions and credit supply to the extent that the role of the City in the EMU financial system changes drastically in a short period of time. In the case of President Trump the question for markets has always been to which type he will revert: the typical market-friendly Republican President who aims for low taxes, less regulation, etc. while staying within the existing institutional framework, or the populist who seeks revolutionary change to some of these institutions.
With the global economy entering a consolidation phase, this input is providing “less compensation” for political uncertainty, which is meanwhile on the rise. The big question going forward, then, is this one: How will these forces combine to affect the perceived probability distribution of economic outcomes and hence markets going forward? The biggest source of uncertainty is of course trade tensions, which come at a time when investors are also being confronted with a marked decline in macro surprise indices and some momentum indicators. There is even some fear that the latter point to a more pronounced slowdown.
Our view is that this is not the case because a significant number of indicators remain rather robust while the weakness seems limited to countries and sectors that were very strong late last year. Also, from a fundamental perspective there is little reason to fear a near-term growth slowdown. Financial conditions are still substantially easier than a year ago while the credit pulse remains positive in many parts of the world. What’s more, the US is benefitting from a substantial fiscal expansion and the G3 central banks’ moves towards the exit are very gradual. In the real economy, solid levels of employment growth, investment spending as well as business and consumer confidence suggest a continued strong feedback loop between income and spending.
All this having been said, one-off factors (weather effect, seasonal adjustment issues) may continue to affect the data flow negatively in the near future. If this coincides with a heating-up of the protectionist rhetoric this could well have a negative effect on markets. During the past year and a half when the real economy was clearly in acceleration mode it was easier for markets to digest various kinds of (political) risks. The reason is that markets mostly trade on the expected marginal change in the macro environment rather than the absolute level. Even though this is certainly not our base case, the consolidation phase thus entails an increased risk that the combination of a temporary soft patch in some data and increased protectionist risks produce a more persistent decline in sentiment.
The March round of PMIs in the emerging world painted a picture similar to that of the previous month: the level of confidence is falling while remaining in positive territory. Of the 14 emerging countries that publish PMIs, nine had declining levels, but only four had an aggregate reading below the neutral 50-mark.
As has been the case in the past few months, growth momentum is declining in the exporting economies in Asia while strengthening in the more domestic-demand-driven economies elsewhere in the emerging world. PMIs fell in all Asian countries except China, whose official PMI we should treat cautiously due to seasonal effects related to the Chinese New Year. Three of the most open economies – South Korea, Malaysia and Thailand – even had PMIs below 50.
Meanwhile, the Latin American and emerging European countries performed clearly better. Their PMIs increased (Brazil, Mexico, Russia) or stayed the same (Poland). Only South Africa continues to struggle: its PMI fell back by 4 points to 47.
All in all, the aggregate growth picture in EM remains reasonable, but growth momentum in the exporting economies is clearly declining. This confirms our view that global trade growth peaked in Q4 2017. The developing trade conflict between the US and China and the market worries about the secular trend in global trade come at a time when the cyclical trend is already negative. This is a key reason why financial markets have been so nervous in recent months.