Some things you should know before investing. There are a number of real dangers lurking out there, most especially that the traditional levers of policy, monetary and fiscal policy, are close to hitting their natural limits. Here are eleven dangers for the world economy…
There are a number of significant risks to the world economy:
- Rising inflation
- Rising interest rates
- Dollar falling
- Rising commodity prices
- Rising unemployment
- Anaemic private expenditures in the US
- China’s faltering exports
- China’s credit binge
- Unsustainable fiscal positions in numerous countries
- Those green shoots could turn out to be just an inventory correction
- Bank’s bad loans
1) Rising inflation
- The level of fiscal and especially monetary stimulus is truly unprecedented, Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” is still striking real fear into people, like this greatest of investors.
- However, many economist think the economy is so depressed, and there are so many underutilized resources out there that inflation really is one of our last worries right now. In fact, deflation is a bigger threat, according to some
- They also believe the Fed can reign in the excess money once the economy recovers and capacity utilization goes up.
- In fact, some inflation would actually be welcome, as it eats away the real value of debt, restoring badly battered balance sheets (especially those in the public sector).
- However, whether the threat is real or perceived, it does real harm as it is inflationary expectations that are rising, which has real economic consequences (see 2).
- Some argue that because of the inflationary threat, the Fed should already tighten policy, and that could considerably smother any impending recovery.
- We don’t think inflation, at present, is a real risk, but perception of inflation is, and what’s more, the jury is out whether the Fed can indeed contain it once the economy recovers, especially if that recovery is, as we expect, weak. That would pose a rather awkward dilemma..
2) Rising interest rates
- At the long end of the yield curve (which unfortunately matters much more than the short end, and is also much less susceptible to policy interventions), rates have already risen quite a bit, despite (or, perhaps more accurately, because) the Fed’s unprecedented loose monetary policies.
- They are a consequence of rising inflationary expectations (see 1) and the unprecedented fiscal deficits, and hence financing needs, as the question becomes, who will absorb all these new bonds?
- There is considerable uneasiness about whether the Chinese are as committed to putting their excess savings into US assets as they were before.
- One side-effect of the recession is that the US savings rate has gone up substantially (basically from 0% to 5%), so there are more funds available domestically
- The upshot is, rising rates is a sign that lenders want larger compensation, and the resulting rise in rates is bad for the housing sector and private expenditures in general
- We rate this risk as pretty high.
3) Falling US dollar
- The monetary theory of exchange rate basically has this as a result of faster monetary growth in the US versus the rest of the world.
- So a falling dollar is another corollary of the monetary excesses, a sign of the resulting increase in inflationary expectations and waning investor confidence in US assets (especially bonds), so it’s a sign of 1 and 2 above.
- A central role is for foreign countries with large balance of payment surpluses, like China. Is their appetite for US denominated assets waning? There are signs that some countries are diversifying their reserve holdings, but we’re not sure this will be a major driver. Take China’s case. If it would stop buying dollar denominated assets, the dollar would fall further, depreciating it’s already large stock of dollar denominated assets, and worse, making it’s exports more expensive.
- An undervalued dollar brings some competitive benefits to the US though, but at the cost elsewhere in the world economy.
- However, many US imports, especially commodities, are priced in US dollars and there is a rather close correlation between some commodity prices (most notoriously the oil price) and the value of the dollar, so something of a vicious cycle lurks here, falling dollar, rising commodity prices, increase in US inflation triggering more dollar weakness
- However, the dollar is already some 20% undervalued against the euro on a purchasing price parity basis. As long as inflation is kept to moderate levels (and providing something similar happens elsewhere), we don’t see much reasons for a substantially bigger dollar depreciation.
- One could, in fact argue that the dollar might very well rise, as the US, because of it’s greater market and policy flexibility, will probably come out of the recession before Europe does, providing better investment prospects and higher interest rates, making the currency more attractive.
4) Rising commodity prices
- This is another manifestation of rising inflationary expectations and the threat to the dollar, as well as a return to economic growth.
- In some commodities, there are real worries about the longer-term supply, especially of oil (peak oil), and the insufficiency of investment (as a result of the recession, the availability of credit, and the fallen prices). According to the IEA, existing fields decrease 6.7% a year (rising to 8.6% in 2030) on average, requiring a new Saudi Arabia coming on-line every two years
- However, unlike the big rise in 2008, it’s likely that at a considerable amount of speculation is also taking prices higher, at least in oil. In oil, until recently, it was very profitable to buy spot, store, and sell forward, as the forward premiums more than made up for the cost of storage and interest expenses. As a consequence of this and other forces (China buying to increase it’s strategic petroleum reserves), inventories have grown considerably. Now that this trade is no longer profitable as a result of a narrowing of these premiums, these trades might very well unwind and the inventories released onto the market.
- Commodity prices will keep rising if there is indeed an economic recovery, or if the dollar falls further.
5) Rising unemployment
- We celebrate when job losses slow and unemployment is still in the single digits. However, the economy needs the creation of several hundred thousands of new jobs every month just to keep unemployment stable, at present we’re no way near that mark, so unemployment will keep on rising, even if the economy recovers.
- This will have consequences on private spending, the housing market, imports (and hence the world economy), and bad bank loans.
- A comforting thought is that the US labour market is rather flexible and recovered reasonably fast after previous recessions. But whether that’s going to happen this time remains to be seen. It’s hard to think which sectors can take up the labour shedding going on in the financial sector, for instance, and even if fully replaced in the end, it will be by jobs with significantly less pay.
6) Anaemic private expenditures
- Credit is still tight, business prospects impaired, unemployment high and still rising, balance sheets are being repaired hence savings are up substantially, asset prices (especially housing) can no longer function as the nation’s ATM machine. In fact, the mechanism is working in reverse, as a lot of wealth tied up in housing is destroyed, people with negative equity are forced out of their homes (or leave voluntary), leading to fire sales that further depress the housing market.
- The big question is, will private demand be able to sustain a recovery before monetary and fiscal policies have hit their limit? Nobody knows, but it’s a big ‘if.’
7) China’s faltering exports
- The Chinese economy is surprisingly open and private consumption comprises only 36% of GDP (versus 70% in the US). Exports have suffered at an unprecedented level so, the relevant question for China is whether exports will be able to substitute for public spending and credit induced (see 8) private investment when these have run their course. That is export to the US, Japan, Europe, and these economies must recover for that to happen.
8) China’s credit binge
- In the first four months of April, total bank lending already exceeded that for the whole of 2008.
- For sure, that must involve quite a few ‘marginal’ projects, and dare we say we already know how such a credit binge must end, despite the short-term gains..
9) Unsustainable fiscal positions
- Debts and deficits are already so large in a number of countries as to not allow them any stimulus spending. These countries are Ireland, Spain, Iceland, with the fiscal positions in Japan, The UK, and Italy, and a number of East-European countries hardly in better shape.
- The longer we have to wait for a recovery and the weaker that is, the more countries will hit the limits of their fiscal positions and will be forced to reign in spending and/or increase taxes, not a recipe for economic recovery (if you exclude the Irish miracle in the 1980s, but that started with much higher interest rates which the fiscal consolidation brought down).
- In fact, with a budget deficit surpassing 10% of GDP, the US might be close to an unsustainable fiscal position already, especially if one takes the dire fiscal position of many of the states into consideration as well. Bernanke has already warned that the deficits must be cut, despite others arguing that the stimulus spending is way too small.
10) Inventory correction
- It is something Paul Krugman has argued about the present recession, but also that of the early 1990s. Inventories have been depleted and have to be rebuilt, but if end-market demand is not recovering, this positive effect on production will soon peter out.
- However, we have argued that a modern view of supply-chain management could be a bit more optimistic here. Longer logistical chains (as a result of outsourcing and globalization) have increased, rather than reduced the needs for inventories, and inventory effects are magnified downstream. As the credit crisis made cash king, inventories were reduced, even without many end markets (except cars and housing) actually suffering much fall in demand. Now that this reduction has worked its way through supply chains and housing and car demand might actually turn, rebuilding of inventories might ensue in earnest, giving a substantial boost to production.
11) Bad loans
- Especially those of European banks, who have lent unprecedented amounts of money to countries on the fringe of Europe, which now suffer from their version of the Asian crisis, where falling currencies and sinking economies will make it ever more difficult to pay
- Although American banks have much less exposure to this European mess, but that doesn’t mean things are OK. For instance, the latest bank plan doesn’t seem to be working, banks want far higher prices for their dodgy assets, in fear of having to mark the rest of them down substantially.
- There is a large part of bad assets which do not have to be marked to market, and according to some, the crisis here is just starting.
- So the government plan is basically buying time for the banks, even changing accounting rules on April 2, providing banks more lattitude in how to establish fair value of assets. This is a dangerous strategy as unhealthy banks will not lend out much money which will be another significant drag on any possible recovery.
There are some positive developments though:
- Consumer confidence is rising in the US
- Policy reaction, although not perfect, has been rather dramatic, especially in the US
- A number of economies are still growing, like China and India. But electricity consumption seems to paints a less optimistic picture in China, and India is not a very open economy
- House and car sales are so far below replacement rates, these have to return to normality some time.
- The unprecedented policy response is stretching the possible. Rising inflationary expectations lead to higher interest rates and could force the end of easy money, unsustainable fiscal positions could seriously limit the stimulus program and even force reigning in public spending and/or increase taxes. This is already happening in a number of countries. We really think investors should be cautious.
- We think a weak recovery, which is about the best scenario we can envision from this, is close to being fully priced in.