Read more: As oil prices plummet, is a global recession imminent?
On Friday last week, global equity markets perked up, bringing some relief to what has been a dire start to the year. About $7 billion has been wiped off share values since the high point of 2015, over half of which happened since the start of January, as measured by the Morgan Stanley index of global stock market capitalisation. Since most major markets are about 20 per cent or more lower—the Shanghai Composite is down about 40 per cent—this is a bear market. Could this financial turbulence spill over into the real economy and trigger a global recession, as excitable analysts are already predicting?
Unstable markets might be presaging economic woe because stock prices tell us something about expected company earnings, which constitute one lens through which to see the economic future. In December, before the current sell-off began, equity markets shrugged off some important signals of impending trouble. These included the narrow breadth of advance in markets, that is the number of stocks and sectors going up in price; the rise in credit spreads, or the extra premium that lesser rated companies have to pay to borrow; and the Federal Reserve’s first step to raise interest rates in a decade.
Stock markets, then, could simply be playing catch-up, and are now confirming that the more sober economic outlook did not warrant prior expectations about future earnings or stock price valuations. They haven't really shouted "global recession," but then again, markets and forecasters have a bad track record when it comes to predicting a recession. With three major macroeconomic shocks colliding over the last few weeks, some analysts and commentators have opined that a global recession is just what the markets are telling us. I happen to think otherwise, but how might this happen, if at all?
The first place to look is China and emerging markets. The repeated fall in Chinese stock prices and confusion over China’s foreign exchange policy have drained confidence about the competence of Chinese authorities in managing financial markets and the wider economy. There is a now common belief that official growth numbers are over-stated and, importantly, there is a wider perception that the government’s commitment to the kind of economic liberalisation deemed necessary to propel keep growth going, and to lowering debt accumulation, has weakened, stalled, or is being rolled back.
These things matter because a significant Yuan devaluation could trigger far-reaching currency and interest rate shock-waves through Asia and the global economy. Competitive currency depreciations, and the risk of higher interest rates in emerging countries would exacerbate financial instability and what is already a growth hiatus. An even stronger US dollar would further drive down oil and commodity prices and hurt US corporate earnings and economic activity.
Fortunately, China’s economy doesn’t look as though it is going into the deep-freeze yet, and remember the government has the capacity, and the will to respond to domestic weakness at home by cutting taxes, boosting infrastructure, and speeding up social security programmes. It has pledged to try and maintain a broadly stable Yuan, and if it can, by hook or by crook, it will probably cut interest rates and banks reserve requirements too.
Unfortunately, though, the government is getting cold feet on needed reforms, and relying on continued rapid growth in credit. If not soon, then within a year or two, I would expect this to generate alarm over a looming banking crisis and then an extended period of very low growth. This denouement may well be accompanied by fresh worries about financial stability. In short, China’s negative impact on the world may be exaggerated now, but it may be bigger at a later stage.
Second, the consequences of the collapse in oil prices to below $30 per barrel before last Friday are equivocal but potentially dangerous up front. On the one hand, it is a big boost to the real incomes of oil consumers and lowers business costs to support non-energy capital spending. On the other, though, the scale and speed of the oil price collapse are dishing out a massive negative shock to energy companies and oil producing countries. The effects include sharp cutbacks to investment spending and dividend payment cuts by energy companies; significantly tighter fiscal policies as sovereign oil exporters, such as Saudi Arabia, Nigeria and Indonesia, try to cope with huge revenue losses; and liquidity pressures on energy companies, commodity trading organisations, and oil-based sovereign wealth funds (SWFs) resulting in forced sales of assets, including equities. Oil SWFs, such as those owned by Russia, Norway and Abu Dhabi, may have had about $4.5 trillion of financial assets last summer, and have undoubtedly begun to execute asset sales to make up for oil revenue losses that could run to several hundred billion dollars.
This poses risks to banks exposed to the energy sector. US banks, for example, have recently been reporting exposure, and advising how much they are setting aside to cover non-performing loans or losses. For large US banks such as JP Morgan, Wells Fargo, Citigroup, and Morgan Stanley, energy exposure seems to lie between 1.5 and six per cent of total assets—significant, but materially lower than exposure to the housing sector in 2006-07. British, European and Canadian banks also have significant, maybe even bigger, energy exposure, as do local banks in oil producing countries. There is certainly a significant but probably not systemic exposure of global banks to energy.
Third, the US economy seems to have stalled at the end of 2015 according to production and manufacturing indicators, weak retail sales, the impact of the strong US dollar, an elevated reading of business inventories, and a drop in corporate profits. This is going to continue to worry investors because we won’t know for a while whether the end of 2015 and beginning of 2016 constituted just a soft patch or something more serious. Neither will the Federal Reserve, whose next moves on interest rates hinge precisely on this point.
But weak as the US looked at the end of last year, recessions are normally led by a steady and marked drop in job creation, and quite the opposite is happening. In any event, the US expansion is now 79 months old, which makes it average in terms of the eight expansions that have occurred since 1945, but no worse than middle-aged compared with the most recent three expansions before 2008. The UK expansion is 75 months old, a little over double the average for up-cycles from 1952-92, but a mere infant compared with the 16 year expansion from 1992-2008.
If, as I expect, the US skirts around a recession, the EU continues to plod on, and the positive consequences of low oil prices come through eventually, the markets can probably discount a global recession for this year at least, and the repricing of markets won’t go far enough to create circumstances that might lead to one.
But we should watch out anyway. With emerging countries unable to pick up the baton of global growth, China will continue to shake the global outlook. It is on a tricky economic and political path that makes the policy outlook highly uncertain. The old narrative we have been peddled can no longer be taken for granted. Its impact depends on how we cope with other shocks we are currently experiencing.
