Com­pla­cency will be tested in 2018

De­spite seem­ingly ro­bust in­di­ca­tors, the world econ­omy may not be nearly as re­silient to shocks and sys­temic chal­lenges as the con­sen­sus view seems to be­lieve. In par­tic­u­lar, the ab­sence of a clas­sic vig­or­ous re­bound from the Great Re­ces­sion means that th

Financial Nigeria Magazine - - Contents - Stephen S. Roach, for­mer Chair­man of Mor­gan Stan­ley Asia and the firm's chief econ­o­mist, is a se­nior fel­low at Yale Univer­sity's Jack­son In­sti­tute of Global Af­fairs and a se­nior lec­turer at Yale's School of Man­age­ment. He is the au­thor of Un­bal­anced: The

Af­ter years of post-cri­sis de­spair, the broad con­sen­sus of fore­cast­ers is now quite up­beat about prospects for the global econ­omy in 2018. World GDP growth is viewed as in­creas­ingly strong, syn­chro­nous, and in­fla­tion-free. Ex­u­ber­ant fi­nan­cial markets could hardly ask for more.

While I have great re­spect for the fore­cast­ing com­mu­nity and the col­lec­tive wis­dom of fi­nan­cial markets, I sus­pect that to­day’s con­sen­sus of com­pla­cency will be se­ri­ously tested in 2018. The test might come from a shock – es­pe­cially in view of the ris­ing risk of a hot war (with North Korea) or a trade war (be­tween the US and China) or a col­laps­ing as­set bub­ble (think Bit­coin). But I have a hunch it will turn out to be some­thing far more sys­temic.

The world is set up for the un­wind­ing of three mega-trends: un­con­ven­tional mon­e­tary pol­icy, the real econ­omy’s de­pen­dence on as­sets, and a po­ten­tially desta­bi­liz­ing global sav­ing ar­bi­trage. At risk are the very fun­da­men­tals that un­der­pin cur­rent op­ti­mism. One or more of these pil­lars of com­pla­cency will, I sus­pect, crum­ble in 2018.

Un­for­tu­nately, the die has long been cast for this mo­ment of reck­on­ing. Af­flicted by a pro­found sense of am­ne­sia, cen­tral banks have re­peated the same mis­take they made in the pre-cri­sis froth of 2003-2007 – over­stay­ing ex­ces­sively ac­com­moda­tive mon­e­tary poli­cies. Mis­guided by in­fla­tion tar­get­ing in an in­fla­tion-less world, mon­e­tary au­thor­i­ties have de­ferred pol­icy nor­mal­iza­tion for far too long.

That now ap­pears to be chang­ing, but only grudg­ingly. If any­thing, cen­tral bankers are sig­nalling that the com­ing nor­mal­iza­tion may even be more glacial than that of the mid-2000s. Af­ter all, with

in­fla­tion still un­der­shoot­ing, goes the ar­gu­ment, what’s the rush?

Alas, there is an im­por­tant twist to­day that wasn’t in play back then – cen­tral banks’ swollen balance sheets. From 2008 to 2017, the com­bined as­set hold­ings of cen­tral banks in the ma­jor ad­vanced economies (the United States, the eu­ro­zone, and Ja­pan) ex­panded by $8.3 tril­lion, ac­cord­ing to the Bank for In­ter­na­tional Set­tle­ments. With nom­i­nal GDP in these same economies in­creas­ing by just $2.1 tril­lion over the same pe­riod, the re­main­ing $6.2 tril­lion of ex­cess liq­uid­ity has dis­torted as­set prices around the world.

Therein lies the crux of the prob­lem. Real economies have been ar­ti­fi­cially propped up by these dis­torted as­set prices, and glacial nor­mal­iza­tion will only pro­long this de­pen­dency. Yet when cen­tral banks’ balance sheets fi­nally start to shrink, as­set­de­pen­dent economies will once again be in peril. And the risks are likely to be far more se­ri­ous to­day than a decade ago, ow­ing not only to the over­hang of swollen cen­tral bank balance sheets, but also to the over­val­u­a­tion of as­sets.

That is par­tic­u­larly true in the United States. Ac­cord­ing to No­bel lau­re­ate econ­o­mist Robert J. Shiller, the cycli­cally ad­justed price-earn­ings (CAPE) ra­tio of 31.3 is cur­rently about 15% higher than it was in mid-2007, on the brink of the sub­prime cri­sis. In fact, the CAPE ra­tio has been higher than it is to­day only twice in its 135plus year his­tory – in 1929 and in 2000. Those are not com­fort­ing prece­dents.

As was ev­i­dent in both 2000 and 2008, it doesn’t take much for over­val­ued as­set markets to fall sharply. That’s where the third mega-trend could come into play – a wrench­ing ad­just­ment in the global sav­ing mix. In this case, it’s all about China and the US – the po­lar ex­tremes of the world’s sav­ing distri­bu­tion.

China is now in a mode of sav­ing ab­sorp­tion; its do­mes­tic sav­ing rate has de­clined from a peak of 52% in 2010 to 46% in 2016, and ap­pears headed to 42%, or lower, over the next five years. Chi­nese sur­plus sav­ing is in­creas­ingly be­ing di­rected in­ward to sup­port emerg­ing mid­dle-class con­sumers – mak­ing less avail­able to fund needy deficit savers else­where in the world.

By con­trast, the US, the world’s need­i­est deficit coun­try, with a do­mes­tic sav­ing rate of just 17%, is opt­ing for a fis­cal stim­u­lus. That will push to­tal na­tional sav­ing even lower – notwith­stand­ing the vac­u­ous self­fund­ing as­sur­ances of sup­ply-siders. As shock ab­sorbers, over­val­ued fi­nan­cial markets are likely to be squeezed by the ar­bi­trage be­tween the world’s largest sur­plus and deficit savers. And as­set­de­pen­dent real economies won’t be too far be­hind.

In this con­text, it’s im­por­tant to stress that the world econ­omy may not be nearly as re­silient as the con­sen­sus seems to be­lieve – rais­ing ques­tions about whether it can with­stand the chal­lenges com­ing in 2018. IMF fore­casts are typ­i­cally a good proxy for the global con­sen­sus. The lat­est IMF pro­jec­tion looks en­cour­ag­ing on the sur­face – an­tic­i­pat­ing 3.7% global GDP growth over the 2017-18 pe­riod, an ac­cel­er­a­tion of 0.4 per­cent­age points from the anaemic 3.3% pace of the past two years.

How­ever, it is a stretch to call this a vig­or­ous global growth out­come. Not only is it lit­tle dif­fer­ent from the post-1965 trend of 3.8% growth, but the ex­pected gains over 2017-2018 fol­low an ex­cep­tion­ally weak re­cov­ery in the af­ter­math of the Great Re­ces­sion. This takes on added sig­nif­i­cance for a global econ­omy that slowed to just 1.4% av­er­age growth in 2008-2009 – an un­prece­dented short­fall from its longert­erm trend.

The ab­sence of a clas­sic vig­or­ous re­bound means the global econ­omy never re­couped the growth lost in the worst down­turn of mod­ern times. His­tor­i­cally, such V-shaped re­cov­er­ies have served the use­ful pur­pose of ab­sorb­ing ex­cess slack and pro­vid­ing a cush­ion to with­stand the in­evitable shocks that al­ways seem to buf­fet the global econ­omy. The ab­sence of such a cush­ion high­lights lin­ger­ing vul­ner­a­bil­ity, rather than sig­nalling new­found re­silience – not ex­actly the rosy sce­nario em­braced by to­day’s smug con­sen­sus.

A quote of­ten at­trib­uted to the No­bel lau­re­ate physi­cist Niels Bohr says it best: “Pre­dic­tion is very dif­fi­cult, es­pe­cially if it’s about the fu­ture.” The out­look for 2018 is far from cer­tain. But with tec­tonic shifts loom­ing in the global macroe­co­nomic land­scape, this is no time for com­pla­cency.

From 2008 to 2017, the com­bined as­set hold­ings of cen­tral banks in the ma­jor ad­vanced economies (the United States, the eu­ro­zone, and Ja­pan) ex­panded by $8.3 tril­lion.

Stephen S. Roach

US Fed­eral Re­serve Bank, Wash­ing­ton, D.C.

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