The IMF is right to worry about problems aheadby George Magnus / October 22, 2018 / Leave a comment
Stock markets don’t always correlate well with what’s going on in the economy, but a largely lacklustre showing this year may well be sending out warning pulses. For the economic and financial community, which had already been speculating that the next recession might be due in 2020, the IMF meeting in Bali last week was a bit of a cold shower. A decade after the financial crisis, the abiding sense from the IMF is that there are plenty of reasons to worry.
In the week ending 11th October, the best of the world’s major markets, the US S&P index, fell by nearly 7 per cent. Most of this happened in two days, marking one of the most volatile periods in the index’s 90-year history. Other markets reacted in similar fashion, but consider that while the S&P is still up 3.5 per cent this year, the FTSE 100 is down over 8 per cent, the 600 firms in the broad Eurostoxx index are down 7 per cent, the Nikkei is off 1 per cent, and the Chinese Shanghai Composite index is already in a bear market, having fallen 24 per cent. Markets have been skittish indeed.
As this global expansion gets ever longer—and if America’s keeps going until June next year, it’ll be the longest since records began in 1854—the IMF is worried about the financial consequences, in combination with rising oil prices, a concentration of debt risks, especially in China, and, inevitably, the politics of trade conflict.
Brent oil at around $80 a barrel is at its highest level since 2014, and up 17.5 per cent since January. Global demand is firm, but supply constraints are tightening the market: OPEC discipline is keeping a lid on output, new sanctions on Iran are biting, and so are bottlenecks in US shale oil production. Some market watchers think prices could top $100 next year. One thing that has led every global downturn for the last 40 years has been a trend of rising oil prices.
In the US, a moderate economic expansion has been turbo-charged by totally unnecessary tax cuts that will boost the Federal fiscal deficit by 20 per cent in 2019 to just below $1 trillion, or roughly 5 per cent of GDP. Moreover, with inflation reaching the Federal Reserve’s target of 2 per cent, unemployment at a 52-year low of 3.7 per cent, and the ISM non-manufacturing index at a record high in September, the Federal Reserve is set to carry on raising interest rates, perhaps by 100 basis points to over 3 per cent next year. The US bond market, which tends to move in the opposite direction to the stock market, is taking this on board. Ten-year yields have risen significantly this year to over 3.2 per cent, and few people think that trend is about to stall. That doesn’t bode well for equities, now more highly valued, according Yale’s Nobel laureate, Robert Shiller, than at any time since 2001.
“One thing that has led every global downturn for the last 40 years has been rising oil prices”
The debt overhang remains a potent cap on economic optimism too. The IMF notes that debt levels have risen significantly. Total non-financial debt in countries with systemically important financial sectors now stands at $167 trillion, or over 250 per cent of aggregate GDP, up $54 trillion and 40 per cent of GDP since 2008. Specific debt-related vulnerabilities differ across countries. The IMF highlights particular vulnerabilities of non-banking institutions in the US to derivatives and leveraged loan exposures, of Euro Area non-financial companies to rising interest rates and of some governments—especially Italy’s—to policy paralysis. It warns of the vulnerabilities of emerging market banks, companies and governments to a combination of slowing growth, rising interest rates, a stronger US dollar and capital outflows. We have already seen significant tensions this year in Turkey, Argentina and Brazil.
China accounts for the bulk of the rise in emerging market indebtedness. In recent weeks, economic data releases have pointed to a steady slowdown in growth, and policies are being relaxed to address this shortfall. Top officials last week made a point of saying in coordinated fashion that everything is fine—which is usually code for the opposite.
China is worth watching, not least because of its significance for other Asian economies and indeed the rest of us. Political direction is taking on an increasingly important role in China, with a heavier emphasis on the primacy of state enterprises at the expense of private firms. The slump in stock prices is also exacerbating the plight of private firms, many of which—in fact most of the 3,500 firms listed on the two main exchanges in Shanghai and Shenzhen—pledged their equities as collateral for loans they couldn’t get from banks. A modest but rising number of them are having to sell stakes in the whole company back to the government and state sector.
Last but not least, the trade conflict between the US and China, which has dug in for the foreseeable future, is casting long shadows over the economic outlook. So far, the consequences on world trade and economic growth are barely noticeable or have been offset by other factors. In a narrow sense, the longer it goes on, the greater the likelihood is that there will be negative repercussions on demand and on inflation and later, even on supply chains and production situated in China.
In a broader sense, trade conflict is just one element in a new adversarial relationship that seems to be spilling into investment relations between China and the west, and might spill into geopolitical relations in the South China Sea and indeed, in parts of China’s Belt and Road universe. These are things no stock market can price for or discount. Caveat emptor.