3rd January 2018
As a rookie economist working for Bank of America in San Francisco, I can still remember the then CEO, Sam Armacost, paying a surprise visit to the Econ Department, and quoting someone’s warning that ‘he who lives by the crystal ball, soon has to learn to eat ground glass’. This assertion seems to have gathered some weight in recent years. As punditry goes overboard this week on the 2018 outlook, what do we really know?
Last year, after all, no one was really enthusiastic enough about global growth and equity markets, and sombre enough about the ubiquitous rise of authoritarian politics. If you were worried about the latter, you probably understated the latter, and if you leaned towards economic optimism, you almost certainly thought the politics wouldn’t be so bad. Trump was either going to be toast by the end of the year, or destroy American democracy. Brexit was either going to be hard or be derailed. It was going to be a bad year for Jeremy Corbyn, and a great year for Marine Le Pen. The Chinese would keep the economy above water only until the 19th Congress was out of the way. North Korea lacked the technology to launch a long distance missile with a nuclear warhead, and, Iran, with a strengthened President Rouhani, would be stable and the clear winner in the struggle for influence in the Middle East.
Amid all these predictions and surprises, I think the biggest issue for economics and markets is continuity. Or rather discontinuity. If we could only figure out what events and outcomes will present as discontinuities, it would be a lot more straightforward to paint a picture of the year ahead. None of the things that happened in 2017 really presented in this way, and it was, accordingly, a solid year (relatively speaking) for the global economy, and a very good year for riskier assets such as equities, and emerging markets.
So, how should we think about 2018? Here are some of my hunches about possible sources of discontinuity.
America and Trump
Trump’s America remains one of the major sources of discontinuity. Some people say that this just goes to show how America’s institutions, mostly the legal system and the press, have kept Trump in check but just one year on, this strikes me still as wishful thinking. The man and his Administration could yet do some pretty serious damage to US democracy at home, and to America’s central role in the global economic and political order. The November Congressional elections take on special significance in this vein.
Most people thought there would be economic war between the US and China in 2017. It never happened, but it might yet. The White House has commissioned investigations under important sections of 1960s and 1970s trade legislation, and recommendations are going to come to Trump’s desk from late this month onwards. We could see action taken against individual products exported by China, such as steel, aluminium, or solar panels, as well as more general measures taken against China related to accusations that the latter plays unfairly with regard to technology transfer, intellectual property and so on. This is going to prove a major area of contentions, especially with the US and China battling for global leadership in AI, robotics, the harnessing of Big Data, and digital technologies.
China’s response will be equally important. It may not react in Pavlovian fashion to what it would regard as every provocation, and it might refer some measures to the WTO, which China seems to back more than Trump. But there is little doubt that China’s tolerance threshold with regard to US anti-China trade measures is quite low, and it would surely react assertively to any measures that it doesn’t regard as a humiliation.
A second important source of discontinuity could be the Fed to which Trump has already pointed his own Chair, Jay Powell – with another 3 Board appointees to go. The markets are expecting the Fed to raise policy rates 3 times, but I think there could be more, and more again in 2019. The economy left 2017 with an exit growth rate of over 3 per cent, and with the tax cuts coming into effect, it is not unreasonable to think that growth momentum will pick up to over 3.5 per cent, tightening the already tight labour market even further. I think this gives the Fed the wherewithal to sanction more rate increases than the market is discounting through 2018-19. Especially as we are already starting to see early signs of a pick in wages and salaries in industries and states where unemployment is lowest.
The US dollar which started off 2017 as favourite trade proved to be a big disappointment last year, mercifully for China, emerging markets and global growth. I don’t think this is going to happen gain. On the contrary. The US dollar should now get a second wind in this cycle, if Fed expectations change as I suspect.
The upshot of all these developments may be growth and rate-positive in 2018, but they don’t augur well for the medium term. The US expansion will become the second longest ever in April 2018, but I’m much lexss convinced it’ll have the staying power to outlive the 120 month record of 1991-2001 that would normally be equalled in June 2019. It could be a close run thing, but by the end of this year, my hunch is that people will be trying to call the next downturn. That’s serious discontinuity territory.
I am not convinced there are huge discontinuities looming over the Euro Area, itself. The regional economic expansion is not without structural drags, and no one thinks the banking sector is out of the woods yet, but the economy’s sea legs should be good enough to get through 2018. So, there’s no big story regarding the ECB, which will begin to unwind QE this year. The Germans will get a coalition government before long, Macron will continue to press domestic reforms and stake out EU reform, but who knows how the Italy vote will fall this spring? That could be the surprise of the year. I can’t imagine Berlusconi back in government, but that’s my politics speaking, not my judgement. He could be. And if Italy regressed again, having made ever so tentative progress in the last couple of years, it would certainly raise a red flag.
Brexit will continue to suck the oxygen out of the British government, and fuel the government with unfounded ideas about what the UK can achieve after April 2019. Unfortunate as these phenomena are, the country could rumble along, nevertheless, with Theresa May in situ towards an outline agreement with the EU by the autumn of this year. Yet, there is still many a slip etc before we get this far, and Brexit could yet torpedo best laid plans.
The Northern Irish border is not yet settled. Too hard a border, and it’ll be politically explosive. Too soft, and the rest of the UK will want the same treatment. The money isn’t settled. Some leading Brexiteers seem to think it isn’t the price of commitments on leaving the EU, but that it can be withheld if the EU doesn’t grant the UK special trade treatment. Both of these could cement splits in the Cabinet and Government, but the biggest issue is going to be the friction within the Cabinet over what sort of deal and transition the PM will bring back to Parliament.
If the deal is designed to support the UK’s economic interests, the Brexiteers could revolt. If it leans instead towards their 19th century views of 21st century sovereignty, Tory Remainers and the Labour Party could unite to rebel. Under both outcomes, Theresa May’s position could be in jeopardy, and the door to a new General Election could open. Parochially, it is hard to see how Sterling could avoid another dump, but the implications go much further of course.
Xi Jinping’s China
China is all about Xi Jinping, and the central and increasingly important role of the Party in everything from the economy to finance, AI and new industries, and the furthering of Chinese interests abroad by commercial and covert means. In the wake of recent revelations in Australia and New Zealand, for example, and the increasingly suspicious attitude by government trade and investment agencies in the US and the EU, we should expect to see a much more outspoken and tense relationship between China and the West over matters of not just trade and investment, but also other channels through which Beijing seeks to grow its influence overseas.
China’s economy came through 2017 with flying colours after the 2015-16 slowdown, as the Party intended, but it strikes me that this was merely to postpone a problem that’s going to re-emerge this year and after. In a nutshell, the investment cycle is decaying, and there’s next to nothing with which to compensate. The issue for the government is how to sustain demand in the economy without over-stimulating investment either via credit policy and or fiscal policy. Manufacturing and real estate investment growth rates have been in decline for nearly 4 years, and are virtually at a standstill. The only ‘active’ investment component has been infrastructure investment, fuelled by government agencies in the form of local governments, and new vehicles such as public-private partnerships (which are more public than public private), special construction funds and government guided funds. Many of these agencies have small or no revenues, and are incurring significant debt. According to the IMF, the ‘augmented’ public sector financial deficit is over 3 times the official estimate, that is around 12.4 per cent of GDP in 2016.
With the Chinese economy in mild deceleration again at this stage, the main question is whether last year’s financial tightening will endure allowing deleveraging to happen, economic circumstances notwithstanding. Property lending, purchases and transactions are now being regulated more closely, and the authorities are trying to cut capacity in key industries, clean up the environment, tackle inequality, and bring all businesses, public and private and civil society under the greater influence of the Party. These goals can almost certainly not be realised simultaneously without a more harmful economic slowdown, and the acid test is whether the government would then be prepared to allow it to happen, or revert to higher credit creation again.
The rest of world consequences could be significant either way. I don’t think China will have a banking crisis this year, but we there will probably be a growing focus on the fragilities of leverage and wholesale funding of liabilities. Capital outflows from China have never really stopped despite tighter controls, and the economy and currency could be hostage again to higher outflows and or slow lending in foreign currencies by foreigners to Chinese borrowers.
The dyed-in-the-wool discontinuity that’s brought all expansions to an end eventually is expensive energy. Brent oil has had a great year rising to current levels of around $67 a barrel, up form $55 a barrel this time last year. The International Energy Agency attributes the oil surge to a combination of better than expected economic growth and the success with which OPEC countries and Russia have curbed production, allowing bloated surplus inventories to fall by about two-thirds during 2017 (https://www.iea.org/topics/oil/)
So what happens next? If prices rose another 20-25 percent over the coming year, it would certainly get tongues wagging about another and bigger headwind to the global economy in 2019. As with the year just gone, the outcome will depend on the sustainability of the global expansion further production restraint by OPEC and Russia to dispose of the remaining third of excess global inventory, and both of these against a background of restrained upstream capital spending in the industry in the aftermath of the price peaks in 2014. This is aside from politics of course.
Consensus forecasts for crude are little change this year to a bit lower. But this is one to watch. The upside risk looks rather bigger to me than people think.