Article / 28 November 2017 at 13:00 GMT

Macro Outlook: Are we too optimistic on global growth?

Head of Macro Analysis / Saxo Bank
  • We expect softer-than-consensus 2018 growth
  • Lowflation structural, not transitory
  • Housing bubbles remain a concern (Bitcoin not so much)

By Christopher Dembik

The year 2018 starts with four main questions:

  • Is economic growth on a solid footing?
  • Will inflation ever come back?
  • Should we fear higher bond yields?
  • What could go wrong?
Is economic growth on a solid footing?

We have a contrarian view on global growth in 2018 and consider that the consensus is a bit too rosy. We expect lower GDP growth in the second and third quarters due to the contraction in the credit impulse in China. 

As mentioned by the International Monetary Fund, China still represents one-third of the global growth impulse. In Q2'17, China’s credit impulse declined by 25% year-on-year, therefore reaching a new post-crisis low. Since this index leads the real economy by nine to 12 months, we expect worse data next year for China, but also for the global economy.

Credit impulse
The global economic situation has been improving over the past years. Global trade but also non-construction investment in Western countries has been catching up with the pre-crisis long-term trend. 

World Trade Index
However, growth is not as solid as most believe and could derail anytime soon due to the following headwinds:

   • What we call growth is a recovery driven by debt and property bubbles. There exist serious concerns about increasing global corporate debt, which represents 93.5% of global GDP versus 84.5% in 2008. As a result of cheap money, many companies have increased their indebtedness, sometimes unwisely. In the US, corporate debt is at its highest level relative to GDP since the financial crisis (45.2%) but, at the same time, the spread on US corporate bonds is at the lowest historical level, around 1%. This is clearly a market anomaly that could be one of the triggers of the next crisis. 

In addition, the credit impulse leads to a lower growth impulse than before 2008. Based on Bank for International Settlements data, before the crisis, the euro area needed on average 0.9 units of credit to create one unit of GDP. After the crisis, 1.06 unit of credit is required to create one unit of GDP. 

The evolution is even more worrying in China: before the crisis, one unit of credit was necessary to create one unit of GDP versus 2.5 units of credit since the crisis. The world is sitting on a mountain of debt but it does not  generate enough growth to handle it.  

   • China’s post-Congress tightening means lower global growth. The shift towards credit restriction started in the second part of 2016 but it should be accentuated by the authorities now that the Party Congress is over. For example, China’s seven-year bond yield is above 4%, versus 3% at the beginning of the year. We also expect that the seven-day repo rate, which is a pertinent liquidity indicator for the country, will keep moving higher in 2018 in an effort to reduce shadow banking and liquidity excess. 

For the rest of the world, China’s tighter credit conditions and lower growth are not good news. Like in the past, it is likely China’s slowdown will impact global growth through trade and the currency.

   • The US economy is also facing a tougher year than in 2017, but recession is not on the radar yet. The market has been worried recently about the flattening yield curve but as we can see on the chart below, the last five US recessions were all preceded by a negative yield curve. 

This means that we need to closely monitor this leading indicator but it is too early to call the next recession. So far, what the market has been telling us is that there is no reason to expect much reflation or a boost to growth in 2018-19 in the US. Based on our models, 2017's growth mostly resulted from a positive credit impulse, confirming our assessment we are in a situation of debt-driven recovery. 

Expectations concerning Trump’s fiscal reform remain high but it is unlikely that an agreement will be reached by end-of-year. If the bill goes to Q1'18, the Democrats and the Republicans will certainly be motivated by the mid-term elections to make cuts favourable to voters... and less favourable for businesses. 

If this occurs, the positive momentum created by the reform could vanish and the hopes of extending the business cycle could also fade away. 
Yield curve and recessions
   • There are many reasons to be optimistic for the euro area, meanwhile, but it does not mean we should overlook the problems. Economic growth in the euro area may be synchronised but the destruction of wealth in the aftermath of the great recession explains why PIIGS are still lagging behind and remain very fragile to any external shock (such as a global slowdown). 

With the exception of Ireland, GDP at constant prices is still lower than in 2008 in Italy, Spain, Greece, and Portugal. Therefore, it would be more correct to talk about a partial economic recovery in the euro area. 

Will inflation ever come back? 

Lowflation has been one of the main macroeconomic issues in recent years and it is expected to remain a thorn in the foot of central bankers for longer yet. Since September 2016, China – the main exporter of deflation – has started to export inflation along with higher global commodity prices (up 3% in October 2017 year-on-year, based on data from the World Bank), but global inflation still remains subdued.  

Central bankers, and particularly European Central Bank president Mario Draghi, consider that low inflation is only a transitory phenomenon linked to hysteresis and underemployment and that job gains will eventually push inflation to target. Those elements certainly play a role in the short and medium terms but as pointed out by Benoit Coeuré, the problem is that the Phillips curve is “flatter, non-linear, mid-specified”. 

We don’t expect that inflation will significantly pick up next year since, in our view, lowflation is primarily a structural phenomenon. More and more economists are agreeing with that take, including outgoing Federal Reserve chair Janet Yellen who recently confirmed that we don’t properly understand inflation dynamics. 

Monetarists explain low inflation by the slow rate of growth in broad money since the great recession. This might be part of the problem, but it is not completely convincing since the money stock has not been constant and has started to decrease since 1997 in the United States.

Figure four
 It is certainly a combination of factors, including demographics, the technological revolution, and debt that best explain the current trend. Everything, even cryptocurrencies like Bitcoin, is deflationary and, if the factors above are correct, monetary policy has little capacity to influence it.  

Should we fear higher bond yields?

Since the Fed has mentioned a switch towards a more restrictive monetary policy, the market fears higher bond yields. As a matter of fact, global market conditions remain very accommodative. Yield on global government bonds (all maturities included) have stabilised in a range between 1.1% and 1.4% in 2017 after dropping to a bottom at 0.65% in July 2016. 

Figure five

Contrary to common belief, an exit from lax monetary policy does not mean an end to the bond market madness. The most striking financial event of end-year, though one of the less commented-upon, is that the French BBB Veolia is getting paid to borrow. 

This is not a normal market condition at all. We are in "la la land". Tighter monetary conditions are not expected to change this situation to any significant degree since central banks are actually not the main drivers of low yields.

Three factors are highly significant in explaining this phenomenon: the drop in inflation expectations, ageing, and Basel III. 

From our viewpoint, ageing is a key long-term structural trend that pushes yields quite low for a prolonged period of time. In most developed countries, the largest population cohort is associated with baby boomers (net savers) while the cohorts behind are relatively smaller than in the past (predominantly net borrowers). The consequence is that there are fewer opportunities for savers to deploy their abundant savings. 

The borrowers hold the cards in today’s lending market, so the cost of capital can only remain low to encourage more borrowing. This trend is particularly noticeable in countries that are in an advanced phase of demographic decline such as Japan as well as some CEE countries. 

If the explanation of ageing is correct, as we believe, the fear of a global bond market crisis is over-exaggerated. Low yields are here to stay.

What could go wrong?

   • Geopolitical risk is still on the radar in 2018 due to the upcoming elections in Italy and in the US, the complicated Brexit process, and persistent tensions in the Middle East and in the Korean peninsula. 

However, geopolitical risk has faded since the French presidential election and we expect this trend to continue next year. It usually creates a lot of market noise but it has moderate impact in the medium-term, as proved again this year by the limited negative effect of the Catalonian referendum on the IBEX which recovered its losses in just 10 days. 

In fact, geopolitical risk should be considered by investors as an opportunity to buy the dips in order to take advantage of the inevitable price rebound. Our geopolitical risk index based on Caldara and Iacoviello’s working paper of 2017 does not indicate any significant near-term tension and is still well below its highest level reached in March 2003 at 450 points on the occasion of the Iraqi war. 

What may cause market consolidation, though, are the factors that have not been yet well-priced in, such as the uncertainty around the regional strategy of Saudi Arabia’s Mohammed bin Salman, increasing political tensions between Western and Eastern Europe (and Austria’s adhesion to Visegrad Four), and finally a midterm meltdown for Trump and the GOP. 

On this last point, there is a strong historical relation between the president’s popularity and the mid-term elections. Considering that Trump’s popularity is not exactly stellar (his approval rating felt from 45% in January to 37% recently), the risk is high that he will need to deal for the rest of his mandate with a reinvigorated Democratic Party and a Republican Party that holds him responsible for its electoral failure. 

In this tricky political context, it is almost certain that Trump won’t be able to deliver on his promises.

   • We are in a world of excess liquidity leading to the creation of bubbles. This is the most dangerous financial and macroeconomic risk for the debt-driven recovery. A market is in a bubble situation when prices become super-exponential, which is currently happening in many markets all over the world: property, virtual currency, FANG, and the negative-yielding part of the bond market that accounts for around $8 trillion. 

The technology behind Bitcoin is undeniably promising but the interest in Bitcoin is mostly driven by liquidity excess. It is economic nonsense that Bitcoin’s market cap is just above that of General Electric, one of the largest companies in the world with more than $123 billion US in revenue. 

In a tighter monetary policy environment, investors would have been much more reluctant to invest in this asset which has all the characteristics of a speculative bubble. However, the Bitcoin bubble burst, which could be triggered by the exit from accommodative monetary policy, is not expected to have any significant financial consequences. 

The most dangerous bubbles are actually the ones we have experienced in the past, especially in the property market. Bubbles in financial assets are worrying but they affect a smaller part of the population than bubbles in the property market. The most risky markets we see are Australia, London, and Hong Kong but the trends in Sweden and Norway are also extremely concerning. 

Since 2007, the housing price index has increased by 90% in Sweden and by 70% in Norway. We are slowly entering into a very risky period where bubbles keep growing while the credit impulse is negative and central banks are returning to a more orthodox monetary policy. 

We know quite well how bubbles work... what looks at first glance like a non-event can often cause the burst. Therefore, it is impossible to correctly predict the timing. 

What we are saying is that 2018 is certainly the most favourable occasion for a bubble burst since 2007. The end of the year is especially risky since the Fed will have significantly hiked rates and the ECB will stop injecting liquidity through QE, leading to a higher cost of capital and more realistic market valuations. 

Economic bubble
Ready? Photo: Shutterstock

— Edited by Michael McKenna

Christopher Dembik is head of macro analysis at Saxo Bank
m7010306 m7010306
One must like this environment.
m7010306 m7010306
Anytime a mention of bubbles, +1pct follows.
Bluesboy2 Bluesboy2
Well thought out and articulated writing, Christopher. It is important to put things in perspective when everyone is overly bullish on all asset classes, citing a 'goldilocks' scenario where the most important factor appears to be inflation not gaining traction, so the party must continue. Thank you for your voice of skepticism, and a balanced view.


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