Daniel Lacalle is Chief Economist at Tressis, SV a PhD in Economics and author of Life In The Financial Markets, The Energy World Is Flat” (Wiley) and Escape from the Central Bank Trap (BEP). He has been ranked as one of the Top 20 Economists in the World by Richtopia and has over 24 years of experience in the energy and finance sectors.
Most analysts have branded 2017 as the year of “synchronised growth”. Indeed, the average increase in gross domestic product has been better than estimated in developed markets and emerging countries have shown a healthy improvement from 2016.
For 2018, we expect that the global GDP will grow at pre-crisis levels, at 3.1%. We factor in the continued improvement in global manufacturing indices, which will likely remain in expansion if conditions remain the same.
There are important positives to consider before pondering on the risks. The Eurozone ends 2017 with a record trade surplus, a significant reduction in deficits as well as the lowest unemployment in nine years. China’s slowdown is happening, but industrial and consumption data indicate a 6% growth is very likely. Emerging markets end 2017 in a stronger note, helped by the recovery in commodities. Even Japan is growing, even if the rate is poor given the massive stimulus. And the U.S. is posting stronger growth indicators, the tightest labour market in more than a decade and a ten-year-low trade deficit.
What can go wrong?
Last year was the biggest debt binge in fifteen years. The world added more than $16 trillion in debt to reach more than three times the size of annual GDP. Massive monetary stimuli and very low rates have created a monster incentive to take more debt. The biggest concern about this debt binge is that solvency and liquidity ratios are not improving. China leads the debt pack. In 2017, the Asian giant added more debt than the equivalent of the GDP of the UK.
This increase in debt is a concern because it is predicated on an abnormal flow of capital into fixed income assets based on the weak dollar and market expectations of low rates. But inflation is creeping up, and bondholders may find themselves with large nominal and real losses as rates remain consistently below headline inflation. Furthermore, investors are financing increasingly higher risk debt expecting more growth than consensus estimates and weak inflation. This is a dangerous combination.
The emerging markets “carry trade” has soared in 2017, and that is also a large risk. Emerging markets are using the abnormally large flow of US dollars into their economies to finance enormous projects in local currency. If the US dollar remains weak and rates are low, this might work, but it is also the recipe for a big crisis, as we saw in the years after QE ended. It is true that foreign currency reserves remain adequate in most emerging economies, but not large enough to cover the risk of a “sudden stop” in the extreme flow of US dollars, as I explain in Escape from the Central Bank Trap (BEP).
The rise in commodities in 2017 exemplifies this risk. If we look at the commodity index in Bloomberg, we can see that all its revaluation came from a weaker US dollar, while the same index in euros fell almost 11%. It is an enormous risk when countries “buy” the idea that the market is strengthening due to higher demand when more than 90% of the price is explained by the US dollar weakness. Because when it reverses, it creates a large and abrupt imbalance in current accounts and growth estimates. If we look at most commodities for 2018, reality is that supply exceeds even optimistic demand estimates and that inventories remain above the 5-year average.
We need to pay attention to the US dollar because its move can rapidly end the optimistic scenario for emerging economies. Let us also remember that the economic surprise index has been falling in recent months. With a strong U.S. economy and three rate hikes expected for 2018, it is dangerous to bet on a permanently weak US dollar.
China remains the biggest threat to the global economy. The debt binge is part of the problem, but the biggest one is that the government has abandoned its objectives of cleaning up the financial sector and allows money supply growth to rise without control. Considering that almost 50% of the companies of the Hang Seng Index are zombie companies that increase debt to pay interests, the Chinese risk cannot be ignored.
The main positive we can highlight for 2018 is that Europe has significantly reduced their imbalances, although it is worryingly dependent on unsustainably low rates and ECB support.
As usual, we will need to monitor monetary policy to see whether this debt binge remains. I call this environment the “no-normalization”, because the main central banks continue to be significantly behind the curve and credit conditions remain extremely loose.
Considering all the above, we will have to analyse if earnings estimates improve as expected, making corporate debt more sustainable, and if governments are able to reduce deficits to moderate the rise in debt to GDP.
We believe that a normalization of the exchange rate of the US dollar with its main basket of currencies—a 15% revaluation—lowers inflation expectations and global GDP growth by 12% and 10% respectively.
When growth is synchronised due to concerted debt increases, the risks are also that we create the foundations of a synchronised crisis. Countries can use this period of high liquidity and low rates to strengthen their economies, focusing on higher productivity and lower debt. The biggest opportunity that 2018 creates is to prepare the world economies for a change in the economic cycle to avoid a crisis. The biggest risk is to ignore the threat of debt.
5-year economic forecasts on 30+ economic indicators for 127 countries & 33 commodities.