The dramatic turnaround in sentiment

The US economy is growing and its labour market, improving. GDP will rise from below 2% in 2016 to above 2% in 2017. With global capacity tightening, inflation and interest rates will rise.

But there remains much confusion about the possible impact of policy changes.

Indications point to a doubling of the federal budget deficit between now and 2020. The economy just can’t grow fast enough to bridge this gap. It is not unreasonable to expect the deficit to reach 5% of GDP (2.5% today). Still, markets rest on very low yields. Elsewhere in the developed world, negative yields prevail – it’s a fool’s errand. They do not spur growth. Indeed, they have proved rather toxic to banking systems.

This arose because of undue reliance on monetary policy as it is the only game in town. Indeed, we are approaching a period of global fiscal stimulus at a very odd time – in fact, the wrong time. US recession ended in the summer of 2009. A better time was 2009-10, when unemployment was very high, especially for construction workers. As a nation, the US has under invested in capital and labour: with little infrastructure spending and fixed capital build-up has been deficient. Labour force participation has fallen and investment in innovation hasn’t been enough. Basic RandD spending now accounts for 2.5% of GDP – used to be 4.5%.

US workforce rose just 1% and productivity is running at below 1%. Here’s the rub. If you substitute technology for labour, profit margins rise. If you substitute technology for capital, asset requirements fall, so sales per dollar of assets rise. The best friend of capitalism is technology – robotics and artificial intelligence. The trouble is that robots don’t spend – yes, you get productivity, but lose on consumption. Europe has more fundamental problems. Sure, its underlying growth momentum has since improved. Eurozone’s GDP rose 0.4% in Q4’16. The region has enjoyed a steady pace of expansion that looks set to be sustained in H1’17, as Germany, France, Spain and Belgium continue to expand, while Italy and Finland slacken.

EU’s problem rests on the euro – it’s strangling many economies and killed many jobs. EU’s centralised governance is inefficient, leading to the rise of populist movements throughout Europe. Germany remains its biggest beneficiary (has since doubled its exports to 50% of GDP) with Italy, its Achilles heel. Then, there is immigration. Latest Pew polls show that more than two thirds of the French and Italians are dissatisfied with the EU. Poor prospects for long-term growth and political risks remain of great concern.

Markets will do better is Japan, with the yen/US dollar already significantly weakened.

At its present size, China can’t grow the same way as before. Further, it’s trapped in a debt bubble. Although there has been substantial capital outflows, China’s external investments are far below the 25-40% ratio that typifies its level of development.

So expect more capital outflows and hence, a weaker yuan. External reserves (now at below US$3 trillion) is already down 25% from its peak - it’s lowest in six years.

This complicates the central bank’s balancing act in trying to contain asset bubbles, without triggering a liquidity crunch. China really has two options: stabilise the yuan by tightening monetary policy (and run the risk of recession) or shut-off capital outflows, which with bank credit rising at 40% of GDP, could lead to inflation.

Knowing the Chinese, they will try to do a little of both. But, with generating employment a key national priority, it’s likely the RMB will have to go. The US won’t like this, with new export orders in China rising fastest since September 2014.

India is going through a difficult period because of some anticorruption efforts, including the withdrawal of high value bank notes. I believe its secular GDP growth rate hovers between 7.5 and 8% for 2017.

Finally, there’s Russia – it did the right thing by letting the ruble fall 50%. That helped Russia rebalance the domestic economy after the collapse of oil prices. Although improving, structurally, it does not have a strong economy. Its long-term outlook is not so promising with a falling population (mortality rate is high and fertility, low) after two years of recession.

Big obstacles

Two forces are making it tough for Trump to boost US growth: an aging population and stagnant productivity. Tax cuts and infrastructure spending can give growth a boost in the short term; but doubt runs deep that Trump can get an additional 1%age point of GDP growth beyond the conventional 2% (up 2.1% on average since recovery started in H2’09).

Many reasons underlie this tepidness, ranging from the high household debt overhang to low net savings to excessive regulation. But over the long-term, the economy’s growth potential comes down to how much people are working and how productive they are.

Decelerating labour force growth as the baby-boomers generation starts to retire and the fall in labour force participation pose a real problem that’s not easy to unravel.

Boosting productivity since the IT-fuelled boom of the late ‘90s and early 2000s is a daunting task. Markets have also focussed on Trump’s proposals to cut taxes and spend US$1 trillion on infrastructure thro’ the deficit-neutral use of tax credits to incentivise business to undertake the tasks.

Even though Congress may agree to such huge credits (and it may not), there is no guarantee the response will be there to boost effective demand. Bear in mind that Reagan’s famous Tax Reform Act 1986 was a supply-side policy designed to improve incentives rather than a “demand-push” way of putting cash in people’s pockets. As it turned out, the incentives worked. However, a rise in aggregate demand isn’t needed at this time as the US economy is already near full employment and facing rising prices.

The innovation paradox: we do see new advances in artificial intelligence (AI), gene therapy, robotics and software apps; the share of US workforce in science and engineering more than doubled over the past 30 years; Research and development spending on healthcare is rising rapidly; intellectual property (patents) is piling up, yet these have not translated into meaningful advances in real standards of living.

Economies grow by equipping an expanding workforce with more capital, and then combining them more creatively – resulting in what economists call rising “total factor productivity” (TFP) to capture innovation’s contribution. TFP growth peaked at 3.4% a year in the ‘50s, but has since steadily fell to 0.5% in the current decade.

Outside personal technology, improvements in everyday life have been incremental, not revolutionary. Indeed, US living standards have stagnated since 2000.

Why? (i) Society is now more risk-adverse; (ii) hurdles on transforming ideas have grown; (iii) regulations have raised the bar; and (iv) industrial concentration has made start-ups more difficult; etc.

However, it takes years for breakthrough innovations to transform an economy. Some 40 years elapsed after the electric bulb was discovered in 1879 before its full impact was felt on growth. It took another 20 years before the personal computer in the ‘70s really lifted productivity.

So, we won’t see the full ramifications of the recent burst in innovation, especially in AI, for another 10-15 years. But, it is not difficult to imagine how these efforts can have a staggering impact. Regulators and venture capitalists will need to be more tolerant of risk taking.

For emerging markets (EM): the worst of the Trump impact is already priced in.

Investors should focus on the benefits of stronger global growth, near record low stock valuations and rising commodity prices.

IMF’s expectation is for EM’s GDP to rise 4.5% this year (4.1% in 2016), more than double the rate in advanced nations. Still, risks remain, notably the strong US dollar. EM are the ugly ducklings.

Already, EM currencies are in retreat. The “Fragile 3” Asean countries (Indonesia, Malaysia and the Philippines) continue to remain vulnerable – the wrinkle being politics.

This time, local politics. Investors hate uncertainty but they hate uncertain EM politics even more. Malaysia’s predicament shows few signs of easing.

The perception is not being helped by the ringgit’s fall ( minus 7.6% in Q4’16 and minus 33.5% since May 8, 2013) to levels not seen since the Asian financial crisis – after which draconian capital controls were imposed.

Malaysia deserves better, certainly not RM4.50 to US$1.

Compared with Trump, anxiety politics of the “Fragile 3” looks relatively predictable.

Investors looking past the recent sell-off need to remember that Trump is not the only political risk they need to consider.

Former banker, Harvard educated economist and British Chartered Scientist, Dr Lin is the author of “The Global Economy in Turbulent Times” (Wiley, 2015). Feedback is most welcome; email: starbizweek@thestar.com.my