Our summary on a complex world

Monday, August 3rd 2015, 4:47PM

by Andrew Hunt

Without a doubt, we find the current state of the global economy more complex than perhaps at any other time in our 25 years of experience. Even a year or two ago, one could reasonably attempt to put together a presentation or a report of reasonable length in which one could attempt to “join all of the dots” into one hopefully coherent global view but we must admit that we are finding the current situation with its multiple themes hard to summarise in what we might describe as prose.

Therefore, in this monthly review, we have decided simply to list what we believe to be the most important features and themes within the global economy in a hope that we can at least give a flavour of the type of world that we have observed as we have lapped the world (more than once!) over the last month or so.

Our biggest theme and one that we suspect will come to dominate the investment universe as 2015 draws to a close is the abrupt and crucial sea-change that has occurred within the international capital flows balance of many of the world’s more important emerging markets. Many of the world’s emerging markets are currently suffering chronic levels of capital outflows.

It would seem that as developed world central banks have become less predictable with regard to their future policy actions, the “unprecedented levels of capital inflows” that plagued emerging markets between 2005 and 2012 have begun to reverse, in some cases quite violently. Hence, the chronic balance of payments surpluses that once characterised these regions have been replaced by deficits.

These deficits are placing downward pressure on both the currencies and the domestic credit systems of the emerging markets. In addition, the resulting “dash for cash” amongst Asian companies that has been required so that they can repay their debts (either directly to foreign lenders or indirectly as the foreign-financed bank domestic credit booms unwind) has itself resulted in a probable CAPEX recession in Asia and a concerted effort to liquidate inventories. This is an inherently deflationary process for global traded goods prices and non-traded goods prices in the EM. We suspect that there is much more of this story to come; it is our “biggest” global theme at present.

Clearly, China’s economy has not been immune to this process and as a result of this, together with last year’s monetary tightening/political purge, economic growth in the PRC is now notably weak. Although the June industrial production data was perhaps a little better than its immediate predecessors as a result of a surge in ship production (an erratic item), China’s industrial sector is essentially flat-lining and overall GDP growth is probably down below 4%.

To combat the slowdown, the Chinese government has already begun to run a fiscal deficit of circa 8-10% of GDP, while interest rates seem set to fall towards zero. The PBoC has already begun to use extraordinary measures such as reductions in the banks’ reserve requirement ratios, an increase in direct lending by the central bank to the commercial banks and asset purchases to try to support the economy, but thus far these efforts are failing to gain traction. Given the legacies of the previous boom and the impact of the political clampdown, we suspect that China’s economy will take a number of years to recover, as it did following a similar chain of events in the mid-1990s.

China’s slowdown has exerted a severe negative impact on commodity prices. The fall in commodity prices has gifted terms of trade and hence income gains to Japan and much of Europe at the expense of incomes and growth within the commodity producers. Given our view of China, the latter will need to adjust their permanent income expectations and revise their spending plans accordingly. We therefore suspect that economic growth will continue to ebb away in the commodity producers and that their currencies will remain under pressure as a result – particularly as their central banks reduce their own interest rates.
Although Europe has spent some of the “real income proceeds” that resulted from its terms of trade improvement, both it and Japan have chosen for a mixture of demographic and policy reasons to save much of their income windfall. The same is true to some extent in the US.

The fall in commodity prices has therefore involved an implicit transfer of income and spending power from those that would spend the extra money (Australia and Latin America) to those that have a higher propensity to save it. This, too, is deflationary for global traded goods prices.
China’s capital outflows are not only connected with the need to repay external debts. We also find evidence that Chinese savers are diversifying away from the RMB into Hong Kong, Sydney, Auckland, West Coast US and even London property. China’s capital outflows have become significant inflationary influences in the markets in which they have arrived. Ultimately, the Chinese authorities may begin to (re-)enforce their existing capital controls to stem these flows but, for now, China’s diversification efforts represent an inflationary externality in the markets in which they are arriving.

In the US, the growth rate of aggregate supply has slowed by even more than the growth of aggregate demand has slowed. Therefore, we would that the US economy is technically overheating. This situation should place upward pressure on the US current account deficit and non-traded goods price deflation in the US. In this environment, the headline inflation rate in the US will simply be determined by the maths implied by deflating traded goods prices (approximately one-third of the CPI) and inflating non-traded goods prices. We suspect that the result will be inflation of circa 1% towards the end of this year.

This situation is problematic for the FRB. Given the boom in corporate zaitech financial engineering and the potential for non-traded goods price inflation, the FOMC should raise interest rates but the weakness in traded goods prices and the high level of global fragility suggest that the FRB should not raise rates. In 1998, the FOMC faced a similar dilemma and did not raise rates with the result that the NASDAQ bubble ensued. In (very) similar circumstances in 1929, though, the Fed did raise rates and a global depression occurred. Unsurprisingly, the FOMC is currently split on what to do but we sense that the odds for a rate hike in the near term are shortening.

The US – like much of the world – needs to take steps to raise real income growth via increasing productivity growth. This is not something that central banks can achieve; governments must become more supportive of reform and CAPEX. Those companies and countries in the world that can afford to invest – and need to invest – the recent 10-20% fall in capital goods prices represents an amazing opportunity. For example, this is the moment that Modi should launch an Indian CAPEX boom and thereby catch up with China for a fraction of the cost. Parts of Africa have also been gifted an opportunity by the deflation in global capital goods prices.

In Japan, Abenomics is losing traction and may soon be reversed as the BoJ seeks to exit or at least taper its QE in the early part of next year. Japanese households have responded to an increase in inflation/inflation expectations by saving more at a time in which investment ratios are still weak. This situation and the weak Yen have been a significant source of global deflation but if Japan shifts back to less QE and less fiscal tightening in 2016, the Yen may appreciate once again. The latter would be good news for the global economy, if not Japanese equities. We are (finally) turning bearish on JGBs.

In Spain, a relatively unique combination of last year’s tax cuts and the terms of trade improvement have boosted growth but much of the resulting spending has leaked abroad via the deterioration in the current account balance. Spain’s growth will subside as 2015 continues unless the domestic capital expenditure cycle revives meaningfully. Italy shows similar characteristics but the terms of trade impact on France has already been more modest.

In Germany, much of the benefit from falling commodity prices and the weaker Euro has been saved. Some of the extra income was spent and this boosted reported growth in 2015H1 but it is difficult to see what will carry the recovery through into 2016 and we are already finding signs that economic growth is subsiding once again.

Greece is the Euro’s problem child that needs both indulging and some tougher discipline at the same time but Europe’s political system is ill-suited to this task. If the Euro was a true monetary union, the level of fiscal transfers from the core to the periphery would be 20-50 times the level that occur currently but the voters of the core have shown that they are not prepared to allow such a transfer of wealth. This was always going to be the Euro’s Achilles’ Heel. Because it is now clear that Europe is not a true monetary union, though, we suspect that the Euro will continue to face an ongoing existential crisis and the trigger for the next phase will likely be either further problems in Greece or, more damagingly, a botched reform of the ECB’s operating systems and most importantly the system known as TARGET2. In the near term, we expect the ECB to remain in favour of a softer Euro but not of negative yields in the debt markets. This may make the ECB appear rather “inconsistent” at times.

Finally, the UK economy shares many similarities with the US, although higher wage inflation appears somewhat more established. The latter should boost consumer spending but we are also mindful that the probable weaker flow of compensation payments from the banks to households (“PPI”) and the deteriorating current account balance may yet act as a headwind for the economy. In practice, we suspect that it will be capital spending trends that determine whether 2015H2 is quite as strong as perhaps the markets are anticipating.

In summary, if there is a key theme that emerges, then it is that the threat of global traded goods price deflation remains well and truly in place but that the central banks seem to be becoming much less able to provide even short-term support to the global economy; it does seem that after ten years in which global capital flows were an overwhelming and pervasive inflationary force within the global economy, their reversal threatens to change the outlook for not only the EM but the world economy in its entirety.

Traditionally, financial markets have shown an amazing ability to ignore “inconvenient truths” but with value in the markets now hard to find, and at least some of the problems that we have described above becoming more visible, we do fear that financial markets may have some rather pressing problems to contend with as 2015 draws to a close.

Andrew Hunt International Economist London

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