Retreating expectations

By Iain Stewart, Newton

With global growth in retreat, 2016 looks set to present the world’s central banks with a dilemma: should they continue with QE or will they be looking at new ways of inflating their way out of debt?

Our view – and it is one we have stated many times – is that the issues facing the global economy are largely structural, not cyclical. Persistent and prolonged use of loose monetary policy to counter the deflationary consequences of demography, globalisation and the technology revolution has only served to distort important price and market signals being sent to the financial system and broader economy. Cheap money, we would argue, has led to an explosion of capacity, not just directly, but also by saving inefficient (zombie) businesses from default.

Using models that encompass only a relatively narrow view of the economy (as if it was a simple machine), the world’s central bank policy wizards overstate their influence on the real economy (by divining often spurious cause and effect between the variables they are focused on), while at the same time underestimating their effect on financial markets. This is important because, although the effectiveness of stimulus on the real economy might be open to debate, it is abundantly clear from history that taking risks with financial stability - creating financial asset booms that end in crashes – is very bad for growth and is hugely costly.

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Growth on the brink

Looking forward, despite continued bullishness about US economic prospects, expectations for global GDP growth continue to fall, with the OECD the latest to cut its expectations for 2015/16.1 Our view is that the biggest downward revisions are clearly in the developing world and among commodity and energy exporters. Some economies, such as Canada’s, are already in recession, and interest-rate policy globally remains biased towards cutting rates rather than any kind of normalisation.

With growth decelerating, much of the world is seeing its currency units fall sharply versus the US dollar, as giant ‘carry trades’, which have been popular in recent years, unwind. Global growth in US dollar terms appears already to be turning down, with obvious implications for sovereigns and corporations that have borrowed heavily in hard currency.

Not surprisingly, growth in cash flows and profits is also decelerating and  credit investors are demanding a wider spread over government bonds (i.e. risk spreads are widening). Given the scale of the credit expansion in this cycle, we should expect to see a sharp rise in the number of defaults up from the extremely low levels seen in recent years.

A backdrop of falling commodity prices is, however, a positive for western consumers, and it should help bolster disposable incomes at the lower end of the scale. The problem is that sharp and broadly based falls in commodity prices have in the past been associated with economic and financial market stress, and it is hard to see why this time should be different.

The weakening global growth cycle and imbalances between supply and demand have been flagged for some time in sovereign bond and credit markets. More recently, commodities such as oil and industrial metals and emerging-market currencies have confirmed the trend in a dramatic fashion. Equity markets seem to have got the message at last, with equities peaking last spring and subsequently experiencing elevated volatility.

What happens next?

The reason for our focus on the US is the sharp contrast between the expectations for that economy and the trends in the rest of the world. If the US is indeed on a path to ‘normalisation’, we need to believe it is able to decouple from other economies. Given that the emerging world, and particularly China, have been the engines of global growth in this cycle, such a decoupling is highly unlikely (just as decoupling of emerging markets from the US proved impossible in 2008). If current trends prevail, it seems increasingly unlikely the Fed will meaningfully raise rates in the near term.

This cycle is already extended versus the average, the window available for a rate cycle is closing fast.

If current trends do indeed prevail, it is likely the focus will turn to more stimulus rather than a ‘lift-off’ in interest rates. The question would then be what form further programmes would take and how markets would react. Can bad economic news continue in perpetuity to be considered good news for investors in growth assets if it involves more stimulus? This has been what market participants have been conditioned to expect in recent years.

Despite the bravado surrounding the success of QE, the hurdle for further rounds of bond buying is probably quite high, particularly in the US, where the unemployment rate is around 5%. Although we cannot rule out ‘more of the same’, even staunch advocates of QE might be prepared to admit that such programmes lose their impact when bond yields are already very low and more official buying could simply distort the fabric of capital markets further.

Despite the Bank of England’s Andy Haldane discussing the idea of banks charging customers for deposits,2 widespread adoption of negative interest rates also seems a less probable option - despite use in Sweden and Switzerland - not least because of the potential for mass withdrawals of funds from the banking system.

It seems more likely to us that money printing would step up a gear and move to full monetisation of deficit spending (as is already the case in Japan). In our view, this route would have popular appeal, as it would be seen as injecting money directly into the real economy rather than into the pockets of asset owners via the financial markets.

1.How low can you go? - speech by Andy Haldane, Bank of England, given at the Portadown Chamber of Commerce, Northern Ireland, 18 September 2012.
2.Ibid