With the global synchronised recovery and central banks unwinding the quantitative easing measures, the global economy is now in the best form since the global financial crisis. Looking beyond the immediate horizon, the next financial crisis could arise from: (1) Rising inflation. Central banks have less ammunition to deal with the next crisis as inflation, whilst under control for now, could rise in the coming years. Inflation is a lagging indicator and there is an 18 month lag time of inflation vs. GDP. The low global inflation we are seeing now is a result of the soft patch in the US economy in late 2015 and early 2016. (2) Populism. More government spending and less money printing should result in inflation and higher bond yields. (3) Demographics. The opening of China since the late 1970s unleashed 1 billion of people into the global workforce and this has been deflationary for wage costs. However, with the effects of the one-child policy now coming through the system, labour is not cheap anymore. (4) China’s growing debt. With the ratio of financial debt to GDP at 200%, a crisis ensured in four countries that hit this level over the last 30 years – Japan, Thailand, the US and Spain. Whilst none of this factors may give rise to a crisis in the immediate future, we need to monitor these indicators.
Worries over geopolitics and the slide in US inflation data are amply offset by the continued and synchronised pick-up in global growth. Despite the relative maturity of the US business cycle, recession risks remain muted and a combination of global earnings upgrades and loose financial conditions are supportive for shares and other risk assets. Globally, central banks remain in mostly dovish mood; and even with balance sheet normalisation in the US and tapering of quantitative easing in Europe set to start, policy around the world is still loose. Equity returns in late cycle are typically positive unless financial conditions tighten sharply. The slow pace of rate normalisation and lack of inflation pressure create a good environment for taking risk. Any deterioration in data, in particular employment, business confidence and consumer lending metrics, may trigger a review of holding risk assets.
For the first time in a decade, the world’s major economies are growing in sync. All 45 countries tracked by the Organisation for Economic Cooperation and Development are on track to grow this year, and 33 of them are poised to accelerate from a year ago, according to the OECD. All the major developed world central banks – the US Federal Reserve, the European Central Bank and the Bank of Japan – have been buying government bonds as part of their quantitative easing (QE) programs. However, these programs are probably past their use-by date, with central banks now acknowledging their shortcomings. For example, the ECB asset purchases may have become counterproductive. By raising consumer savings, reducing income growth, lifting asset prices and harming bank profitability, QE in Europe has led to less lending to businesses. The question is whether central banks can unwind their QE programs if inflation is falling or low and stable. The coming months and years will see the tussle between cyclical inflation, which is driven by oil prices and the ongoing structural deflation headwinds of technology and globalisation.
Continue Reading:Monthly Notes - September 2017