Global Economic Outlook Still Supporting Deflationary Forces

Published with the permission of Desaque Macro Research

The Global Economic Outlook Gets Messier

The reversal in sentiment towards emerging markets has been dramatic during 2013. These economies have witnessed major capital flight that has raised borrowing costs for local entities. The responses by governments to these unfolding events have been mixed: India, for example, took measures to limit capital flight, while Brazil has engaged in foreign exchange intervention. The economic fallout over the next few quarters to recent financial events in emerging markets will be critical if investors need to revise the outlook for risky assets in developed countries. If the anticipated slowdown in economic activity is worse-than-expected, then the subpar post-Great Recession recovery in developed markets could be under threat. The risks of such an outcome should not be taken lightly. According to the International Monetary Fund (IMF), emerging markets accounted for nearly 50% of world GDP in 2012. This figure has risen significantly since 1998 (Asian financial and Russian sovereign debt crises) when these economies accounted for 37% of global output. The Fed was credited with preventing the onset of global recession in 1998 by easing policy in response to these financial shocks. The capacity of the Fed to repeat the policy response is, however, much more limited in the current environment.

Who Should We Be Monitoring?

All eyes should justifiably be focussed on China. The country’s share of world GDP has risen from 7% in 1998 to 15% in 2012. In other words, China’s is responsible for over 50% of the growth in emerging market output over the aforementioned period. The financial crisis of 2008 prompted an aggressive policy response by the Chinese authorities, who are now confronted with legacy issues. In particular, working off the excesses of the credit bubble will be both tricky and prolonged. The impact on China’s real economy will depend on the banking system’s ability to withstand credit losses. If the banking system has sufficient capital to absorb losses, then a hard-landing may be avoided.

Other emerging economies will be affected by how events in China unfold due to their role in the supply-chain: Brazil and Russia are particularly exposed to negative economic shocks in China. The official rhetoric is that the emphasis of growth is now towards social equality vis-à-vis the “get rich quick” activity embraced by the disgraced Bo Xilai. The Chinese authorities could seemingly be content with 7% economic growth, although their official forecast for 2013 remains at 7.5%. What would constitute an economic shock for China? Real GDP growth below 6% would adversely impact the global economy. The magnitude of the impact will depend on whether there could be other economic shocks coming into play, some of which may offset the negative spillovers from China. What is currently on offer?

No More Fiscal Headwinds in the United States?

The US economy has essentially been in stuck in a 2% growth trap since the end of the Great Recession. Underlying GDP growth has been 80 basis points lower since the recovery commenced than during the 2003-7 period. The contribution of federal government to GDP growth during this recovery has been tepid, to say the least. Since 2010 Q4, there have been just 2 quarters where federal government spending has imparted a positive contribution to headline GDP growth. Much of the weakness stems from defence spending due to the nature of sequester cuts.

The US managed to avoid the so-called fiscal cliff, but the degree of policy tightening in 2013 is still significant. According to the Congressional Budget Office (CBO), fiscal policy was going to be tightened by 3% of GDP this year. Under current budget law, the magnitude of tightening was expected to fall significantly in 2014. Lower headwinds from fiscal policy would have been factored in by the Fed in its aspirations to taper asset purchases.  There is, however, a major complication that may prevent this scenario unfolding in the form of potential impasse in raising the debt ceiling.

Another Round of Political Brinkmanship

The debt ceiling currently stands at $16.7 trillion. According to the US Treasury, the ability of federal government to meet obligations will be exhausted by mid-October. It is all about ideology once again: Republicans wish to link any further increase in the debt ceiling to additional spending cuts. There are implications for financial markets: the US Treasury will honour coupon payments on its debt should funding conditions tighten, but the issue of the creditworthiness of the US Treasury will inevitably resurface. This will be an unwelcome development for financial markets.

Continued impasse in raising the debt ceiling could complicate the Fed’s attempts to taper asset purchases. A rise in bond yields related to stalemate in the debt ceiling issue will constitute a tightening of financial conditions. Under these circumstances, the Fed could potentially be compelled to dilute tapering plans until the debt ceiling has been raised by a sizeable amount. The US government reached its borrowing limit in May and has, in fact, been operating under a so-called continuing resolution ever since. New debt issuance has been cancelled. The continuing resolution will expire at the end of September. This coincides with the start of a new fiscal year, but a budget has yet to be passed. Political brinkmanship is likely to be elevated, with both sides willing to play a game of chicken with financial markets. The bottom line is simple: the current political backdrop for fiscal policy means that the timing of any onset of less tight conditions will be highly unpredictable. Easier US fiscal policy should not, therefore be taken for granted as a means of offsetting negative economic shocks in emerging markets.

US Bond Yields and Risky Assets

The relationship between interest rates and equity prices has been periodically unstable, but it is intuitive to expect a negative relationship. The post-1982 period of disinflation in the US until 2000 is a powerful testimony to the influence of falling bond yields on risky assets. The post-2000 relationship between bond yields and US equity prices is less robust: corporate earnings growth appears to be the dominant force driving risky assets. The negative correlation between US government bond yields and risky assets between 1982 and 2000 has, in fact, been turned on its head with the arrival of Gibson’s Paradox.

US and Emerging Market Equities: Characterised by Gibson’s Paradox

What is Gibson’s Paradox? It originally referred to a positive relationship between general price levels and interest rates under the Gold Standard. Movements in interest rates were not correlated with the rate of change in prices. Gibson’s Paradox is also said to prevail whenever there is a positive correlation between equity prices and bond yields. In the case of US equities, Gibson Paradox has been firmly in place since 2000, while the condition surfaced in emerging markets way back in 1994. Since May, however, the rise in US government bond yields, associated with talk of the Fed tapering asset purchases, has been against a backdrop of falling equity prices in emerging markets. Is this the end of Gibson’s Paradox?

Continued Deflationary Pressures: Critical to Gibson’s Paradox

The global inflation backdrop since 1998 has been broadly disinflationary. In fact, the prevalence of Gibson’s Paradox for both US and emerging market equities owes much to the oversupply in the world economy. Capitalism has always had an inherent bias to engage in overproduction, placing downward pressure on prices. The end of Gibson’s Paradox will, therefore, require an inflationary shock from somewhere in the global economy. Where could this come from?

Risks to Global Economy Concentrated in China and Emerging Markets

The overwhelming bulk of potential cyclical weakness to the global economy is concentrated in China and emerging markets as prior credit excesses are unwound. Any impending weakness in economic activity within these markets is likely to be concentrated in capital spending. It is doubtful, however, that this outcome will have any immediate impact on oversupply in the global economy. This is due to the fact that the US capital spending cycle is long overdue a period of respectable growth. It is, therefore, difficult to construct a scenario where inflationary pressures suddenly emerge due to a lack of supply potential. This enhances the likelihood of a continuation of Gibson’s Paradox.

Rising US bond yields, based on unhinged inflationary expectations, will probably require a massive economic shock that is sufficiently large enough to offset emerging market weakness. Under this scenario, Gibson’s Paradox could potentially come under pressure. The chances of this happening are, however, remote. In meantime, the structural backdrop for corporate pricing power remains weak, suggesting that deflationary pressures will continue dominate the global economy. Against this backdrop, therefore, Gibson’s Paradox could well have further to run.

Summary and Conclusions

The chances of weakness in emerging markets undermining the global economy have risen, given their increased share in world output. Risky assets in developed markets could be undermined if emerging markets were to weaken in excess of expectations. The Fed does not have the capacity to ease policy in the same manner as it did during the Asian crisis.

China is the main source of concern in emerging markets. Unwinding recent credit excesses will be a difficult and protracted task. Slower growth is now accepted, but there are risks the slowdown could overshoot.

The impact of a greater-than-expected slowdown in China on global growth will be partly determined by possible positive shocks in other regions. Easier US fiscal policy was cited as a potential offset to slower Chinese growth.

Another looming impasse on raising the US debt ceiling could undermine financial markets, possibly resulting in a tightening of financial conditions. The onset of financial market volatility could complicate the Fed’s tapering of asset purchases.

Both US and emerging market equities have enjoyed a positive correlation with US government bond yields, known as Gibson’s Paradox. This is attributable to the significant deflationary forces in the global economy that have prevailed since the late 1990’s.

Cyclical risks to the global economy are concentrated in emerging market capital spending, but it is unlikely to impact global oversupply. The continued lack of corporate pricing power suggests a continuation of strong deflationary forces in the global economy and a continuation of Gibson’s Paradox.