• Geopolitical risks on the rise
• Credit impulse points to slowdown
• 'Very defensive approach for Q4'
By Steen Jakobsen
The market has increasingly resigned itself to accepting
that things will never change – ever – exactly at a time when both risk and the underlying changes are already turning south. Our human bias to extend the recent past into the future is one of the brain’s fundamental flaws, which brings us to the conclusion that it is not only wrong but works against both science and empirical studies.
Geopolitical risk has not played a major role in the world
of markets and economics since the Great Financial Crisis in 2007-09 mostly because the world’s central banks have been meeting even the slightest bump in the road with a “wall of money” available to print.
The modus operandi of pretend-and-extend is now
coming to an abrupt end. The Federal Reserve is determined to implement Quantitative Tightening, letting its massive balance sheet shrink by allowing outstanding bonds to mature without being renewed. But in so doing they are making the huge policy mistake
of increasing steering rates based on their “hope” that inflation will play according to the academically disproved argument of the Phillips curve.
Yes, disproved. A recent paper from the Philadelphia
Fed by Dotsey, Fujita, and Stark concludes: “We find that forecasts from our Phillips curve models tend to be unconditionally inferior to those from our univariate forecasting models”. Inferior! Still, the Fed (and the European Central Bank, the Bank of England, and the
Bank of Japan) insist on using it and “hoping” it will work.
The Fed believes, or rather hopes that QT will happen
without a major upset to the markets, which is kind of ironic considering that most of world growth (if not all of it) since the crisis is predicated on the opposite: The $3,000 billion worth of expansion of the same balance sheet.
Now we are led to believe that taking away the punchbowl is not going to end the party because they “have communicated” this to the market – they have written it on their Facebook wall! Clearly we (or at least I) are not impressed.
The net drop in the impulse is the second-largest in the
history of the chart, and only matched by the 2007-2009 slowdown in magnitude (red arrows). The credit impulse generally leads the world economy by nine to 12 months – hence the present slowdown should bottom out in March-July 2018 in real economic data.
We believe this is a bad omen for Q4-2017 into Q2-2018
where we see a real chance of an economic slowdown which will feel like a recession, exactly at the time when the world’s economists and politicians are calling the all clear. This is again a classic case of not respecting the laws of nature and the path of least resistance.
The present improvement in data was born in 2015/16 through a big expansion of credit in China, the US, and Europe, as clearly seen on the chart above (green arrow). Again, our recent past makes us extend the “trend”
despite the evidence saying something else.
The Chinese leadership meet in October to dictate
the next five if not 15 years’ economic growth. My expectation is that president Xi not only will go for an extra term, as the first Chinese leader since Chairman Mao, but also will focus on quality over growth. China is fast emerging as not only the biggest mergers-and-acquisitions player (buying environment, utility, resources, water, alternative energy assets and more) but also increasingly as a technology leader.
We are witnessing the emergence of the new, greener,
China which is focused on reducing pollution through a big push for electrification but also through accepting less growth to gain that traction. This is bad news for the credit impulse, but more so for world growth.
China is roughly one-third of direct global growth, but more like 50% indirectly.
China carried the world on its shoulders through the last crisis in 2007-09; now its orientation is the long-term gain of China, which starts at home not overseas.
This leads to a very defensive approach for Q4 as
we believe excessively high economic expectations, combined with dangerously low volatility, low inflation, and major policy mistakes by central banks will lead to significant risk to the economic model as we know it.
What makes Q4 even more concerning is the escalation
of geopolitical rhetoric between the US and North Korea and Iran. It has descended to kindergarten level with accusations, speeches and press conferences spinning out of control. I estimate there is almost a 50/50 chance that “something will happen in October” – rarely have the various structures in economics, politics and world events been more in need of change; the problem is this need for change is met by the highest complacency I have seen in my 30-year career.
The world seems to think like the former F1 Champion,
Mario Andretti : “If things seem under control, you are not going fast enough”. Well, allow me round up by making my own quote about Q4 and 2018:
"If you think things are under control, you haven't understood anything".
— Edited by Michael McKenna
Steen Jakobsen is chief economist and CIO at Saxo Bank