September 29, 2017

News in Charts: Global outlook – it’s a mad, mad, mad, MAD world

by Fathom Consulting

The global economy is gathering steam. With one or two notable exceptions (the UK and, to a lesser extent, Japan), both the developed world and the developing world are enjoying above-trend growth — in some cases, a long way above trend. And the upswing has legs: in the US and the EA it is likely to run for another year or two at least, and in China perhaps for a bit longer. Other emerging economies will follow suit. Fathom’s Q3 global short-term forecast underlines this message.

In our central forecast, global growth is up in the mid-3% range, with the US peaking at around 3% (US economy in decent shape despite drop in durable goods orders), the EA running between 1.5% and 2%, China accelerating back up to around 8% (CMI July 2017), and other emerging economies benefiting from continued growth in global trade, for now (Globalisation  – it’s not over yet). By the standards of the ‘new normal’, this is boom time for the global economy. Japan (Japan’s GDP – nothing more than a sugar high) and the UK are laggards, with the UK in particular being negatively affected by the impact of uncertainty and higher import prices induced by Brexit (Odds of a UK recession are now greater than evens). But countries who have not recently shot themselves in the foot are generally doing relatively well.

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And yet…

Alarm bells are ringing for economic fundamentalists such as Fathom Consulting. Asset prices look increasingly out of step with fundamentals, and in some cases they look downright bubbly. And other geopolitical developments are similarly alarming. One might even describe them as…

Mad:

Equity prices in developed economies, and specifically in the US, are more than one standard deviation higher than their long-run average in relation to nominal GDP.

Mad:

The Nasdaq has again played its part, posting an even greater degree of fundamental overvaluation than the S&P 500. Its degree of overvaluation in relation to nominal GDP is now close to its dotcom bubble high.

Mad:

Government bond prices across the developed world are at all-time highs. Bond prices have been increasing consistently since the 1980s, with a series of global shocks driving that move.

Total central bank assets across the developed world now stand at over $14 trillion, having increased by about $10 trillion since the recession. Over the same period, the new issuance of government debt has increased dramatically right across the G5. All else the same, you would expect such an increase in government debt to result in higher government bond yields (lower prices). However, short rates have fallen to the lower bound and QE has been introduced, mopping up almost all of the value of new issuance of government debt across the major developed economies. It is no surprise, therefore, that the price of government bonds has increased over the same period, by around 18%.


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Is it possible for there to be a bubble in government bond prices in the world’s leading developed economies? Unlike other asset markets, there is no realistic question about the long-term risk attached to the underlying asset. Economies do not go out of business. However, they do default and, while a hard default is unlikely for these economies, a soft default via inflation and/or financial repression is not.

Bubbles in asset prices can arise, and can burst, without necessitating a complete collapse in the value of the underlying – in this case a hard default. Put another way: is there any threshold for bond prices beyond which we would call a bubble? If such a threshold exists, we have surely passed it. The bubble emerges as follows: the major central banks entered the market for government bonds in 2009 and have bought $1 trillion a year since then. They were committed to buying no matter the price. In addition, there are other parties who are obliged by regulation to hold large quantities of government debt from the major developed economies. For the remaining free agents in bond markets, the rational step is to buy, safe in the knowledge that, for the time being, there is always another buyer out there who will pay more. That implies we should be concerned about the impact of a reversal in QE – if we’re in a bubble, that could burst it.

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MAD:

Mutual Assured Destruction (MAD) was something we all hoped we had left behind in the 1980s. But now it is back. The only way we can sleep soundly in the current geopolitical environment is in the knowledge that possession of nuclear weapons will not result in Armageddon as long as the logic of MAD holds. No sane person would ever press the button. But, for MAD to work, all parties have to believe that every other party might press the button.

MAD fails if everyone is rational and is perceived as such. But it also fails if anyone is actually mad. At present, markets appear sanguine about the risks around North Korea (Equity investors are not worried about a US/China trade war): let us hope they are right.

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Despite all these uncertainties and fundamental disequilibria in asset markets, risk metrics are generally at, or close to, all-time lows.

Markets are not worried. Why?

Here are two, mutually exclusive candidate explanations.

First, markets believe that there is stronger growth to come in the global economy in the long term, and that makes them comfortable with high valuations for asset prices and low risk metrics: yields are set to rise across all asset markets in the long term, with fixed-income assets falling in price and equity assets holding or even rising from here.

Second, markets believe that yields will stay low, driven by high debt, permanent ZIRP, QE and other unconventional measures from the central banks and — increasingly — finance ministries. Bond prices will stay high, as will equity prices and other asset prices, but growth will remain mired in the post-recession new normal in the long term.

Immediately after the election of President Trump, Fathom took the first view. The US, fuelled by a fiscal splurge, would accelerate to old-fashioned, Reagan-era growth rates and, by doing so, would move decisively away from the zero lower bound for the policy rate. Other countries would either follow suit after an interval, or would be pulled along on the coat-tails of the US.

However, the evidence of the first eight months of the new administration suggests that the President will struggle to achieve this ‘escape velocity’ (in the words of Mark Carney, Governor of the Bank of England), because he will struggle to get any meaningful policy measures passed by congress. The US will not escape the new normal unless it can pull away from zero rates in the long term, and it cannot do that without unlocking significant, domestically-generated inflation: wage inflation. The prevailing headwinds for wage inflation are substantial. To overcome these headwinds, the tailwind provided by growth needs to be very strong — escape velocity for the US economy is growth rates persistently and substantially north of 3%.

That is no longer Fathom’s central case. We now take the second view.

The US will not escape, and neither will anyone else. Even China, posting growth rates back up in the 8% range now according to our China Momentum Indicator (CMI 2.0), is on a temporary, credit-fuelled binge. The common factor everywhere is a colossal build-up of debt and its corollary, a fall in real yields. Ultra-low yields, held in place for this long, gradually and progressively undermine the growth rate of productivity. The impact of debt on rates and thence on productivity growth is evident right across the developed world and as far afield now as South Korea, the world’s star performer for the last 40 years (Falling star?).

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In Fathom’s upside scenario, the Trump administration does successfully pass the planned fiscal measures and introduces significant tariffs on Chinese imports, too. In addition, the leading politicians in the euro area, Mr Macron and Ms Merkel, start decisively down a path towards full debt-mutualisation, and deliver the euro area into a much stronger long-term outlook. Other countries benefit from coat-tails effects, and the global economy looks rosy for the long term. Unfortunately, we only place a 10% weight on this outcome at present.

And there is an equal weight on the downside case, where a banking crisis in China pushes that economy into recession in the short term and into much lower growth further out. Without the support of China, other emerging economies also suffer. And a recession in China is strongly deflationary for the global economy as a whole. The downside scenario is global stagnation. Japan stands out in this scenario: the impact on Japan is so negative that they are forced into a radically different policy: shock and awe levels of helicopter money. Japan generates chronic but not hyper-inflation and, reduces the debt burden as a share of GDP substantially. It probably encounters a recession along the way but, after that, growth returns to old-normal rates. There is a chance of such a rosy outcome for Japan, but it should be acknowledged that the risks around such a policy are enormous. This is genuinely uncharted territory: here be dragons!

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