Global economy

The recent buoyancy in global equities has raised fears that the markets have entered a major bubble, driven by the unprecedented expansion in central bank balance sheets.

To the extent central bank asset purchases have reduced government bond yields, they have certainly brought forward returns from the future into the present, thus reducing expected returns on both equities and bonds. But this is normal in a period of monetary easing, and it does not automatically mean that markets are in a bubble. Read more

The US official statisticians have today issued revised statistics for GDP dating all the way back to 1929. It may be alarming for investors and policy makers to hear that our understanding of economic “truth” needs to be amended for the last 84 years, but the changes have not in fact made much fundamental difference to the debates which matter for the economy today.

In particular, there has been very little change in the Fed’s likely view of the amount of slack which remains in the economy, though the latest version of growth in the last few quarters, including the publication of data for 2013 Q2 for the first time, may persuade them that economic momentum is a little firmer than previously believed.

The most dramatic-sounding news in today’s release is that the level of nominal GDP has been revised up by 3.4 per cent in 2013 Q4. This follows a number of methodological changes, the most important of which is to treat R&D spending as a positive contributor to investment and GDP, rather than as an input to the production process. But since this change impacts GDP levels for decades in the past, it does not make much difference to our understanding of the economy’s capacity to grow in the immediate future. It simply involves viewing the same objective truth through a different coloured lens. For most practical purposes, this change can be ignored.

There are, however, three areas where the revisions could be significant: Read more

In the past decade, the world’s central banks – first in the emerging and then in the developed world – have embarked on a Great Expansion in their balance sheets which is unprecedented in modern times. This blog sketches the anatomy of the Great Expansion and attempts to project what will happen as the US Federal Reserve tapers its asset purchases in the next 18 months.

The latest episode in the saga has, of course, involved the Fed’s attempt to distinguish between “tapering” and “tightening”, a distinction which the markets have been reluctant to recognise [1]. The US forward interest rate curve shows the first rate increase occurring very close to the time when the Fed is planning to stop buying assets in mid-2014. Whether it intended to do so or not, the Fed has de facto tightened US monetary policy conditions and will have to work hard to reverse this. Read more

Global equities have, so far, survived the bout of global deleveraging which followed Ben Bernanke’s remarks about slowing the pace of QE last month, though there have been nasty signs of volatility in Japanese and some emerging markets. Investors have, unsurprisingly, become temporarily obsessed by whether the Fed will taper its asset purchases in September or December. However, in the great scheme of asset valuation, this is nothing more than a passing detail. In the longer term, what matters is real factors, like the forward path for corporate earnings, and the interest rate at which they should be discounted.

The appropriate discount rate is the risk-free (real) bond yield plus the equity risk premium (ERP). The Fed acts on the former, while the market determines the latter. In recent years, the Fed has reduced the bond yield but the market has, simultaneously, required a higher ERP, so the overall discount rate on equities has remained broadly unchanged. As I have argued before, any rise in the bond yield as QE ends may be offset by a fall in the ERP, leaving the valuation of equities protected as bond returns become negative. We have seen a minuscule version of this playing out in recent weeks, for what it is worth.

This, however, does not necessarily mean that equities are fairly valued. A common concern among investors is that the profit share in the US economy is currently abnormally high, which is one reason why US equities have performed so well since 2009. It is frequently argued that the profit share must eventually “mean revert”, and when that happens the market will have to revise downwards its estimates of the sustainable path for corporate earnings. Equities will tumble, not because of a hostile Fed, but because the fundamental earning capacity of corporate America will be found wanting.

This, however, seems to underplay the persistence and global breadth of the rise in the profit share, and the accompanying decline in the wage share, in the last three decades. It is far from clear why this trend should “mean revert” in the foreseeable future. Read more

Since 2007, the world economy has lain in the shadow of huge financial crises. Crisis engulfed the US, the UK and other western high-income economies in 2007 and 2008. From 2010, it engulfed the eurozone. Japan never fully recovered from its crisis of the 1990s. Meanwhile, emerging countries have continued to grow robustly, though concerns have grown about these countries too, not least over the ability of China to manage a transition to slower and more consumption-led growth.

So how do Gavyn Davies of Fulcrum Asset Management and Huw Pill, chief European economist of Goldman Sachs see the economic future? What might it mean for the luxury industry?

 Read more

Fiscal austerity, a concept which German Chancellor Merkel says meant nothing to her before the crisis, may have passed its heyday in the eurozone. This week, the European Commission has published its country-specific recommendations, containing fiscal plans for member states that are subject to excessive deficit procedures. These plans, which will form the basis for political discussion at the next Summit on 27-28 June, allow for greater flexibility in reaching budget targets for several countries, including France, Spain, the Netherlands and Portugal.

Furthermore, there have been rumblings in the German press suggesting that Berlin is beginning to recognise that fiscal consolidation without economic growth could prove to be a Pyrrhic victory. If true, this could mark the beginning of a new approach in the eurozone, helping the weakest region in the global economy to recover from a recession that has already dragged on far too long. So how real is the prospect of change? Read more

Martin Wolf’s column on Wednesday and his subsequent blogpost have once again focused attention on the importance of trade flows in the eurozone. Martin’s argument is that the German strategy of fiscal austerity and internal reform to fix the imbalances needs to change. I would like to ask a different question, which is what happens in the likely event that it does not change?

Investors, ever more optimistic that the worst of the euro crisis is over, are asking whether the German strategy might actually work. Largely unnoticed by some, eurozone trade imbalances have in fact improved dramatically in recent years. But this has happened mainly for the wrong reasons, ie recession in the south rather than any large narrowing in the competitiveness gap. The eurozone is engaged in a race between the gradual pace of internal devaluation and the mercurial nature of democratic politics. It is still not obvious how this race will end.

When the euro was launched in 1999, its supporters believed that the balance of payments crises which had plagued its weaker members for decades would become a relic of the past. The crisis revealed this view to be entirely complacent. The current account imbalances which were generated by the peripheral economies during the boom of the 2000s soon became impossible to finance after the crash. It was only the growth of so-called “Target2″ imbalances on the ECB’s balance sheet which provided the official financing which held the system together. No Target2, no euro.

However, some of the contingent credits which the Bundesbank has acquired against the rest of the ECB in the course of this process might become worthless under certain break-up scenarios, and this has become a political hot potato inside Germany. The solution, many in Germany believe, is to foster an improvement in the balance of payments positions of the troubled economies so that no further rise in the Target2 imbalances will be needed. Read more

It is often claimed by economists that the central banks have run out ammunition to boost economic activity, but they certainly have not lost the ability to have an impact asset prices. Since the latest round of quantitative easing was signalled back in June (see this blog), global equity prices have risen by 14.5 per cent, and commodity prices are up by 15.4 per cent, despite the fact that economic activity data have shown no improvement whatever over this period.

Clearly, these impressive moves in asset prices have been triggered by a sharp decline in the disaster premia that were priced into markets only three months ago. Mario Draghi and Ben Bernanke have, in a sense, purchased global put options on risk assets, and have offered them without charge to the investing community.

By doing the market’s hedging for it, the central bankers have certainly had an impact. Confidence, while not fully restored, is much improved, which is exactly what was intended. But there is no sign yet from hard data that the downward slide in global GDP growth has been reversed. Until that happens, the market rally will remain on insecure foundations. Read more

As the eurozone crisis enters a critical phase, market attention is once more focused on the central banks to contain the crisis. They have promised in advance to provide unlimited liquidity to solvent financial institutions if necessary in coming weeks, which is now their standard response to financial shocks. However, the slowdown in global activity caused by the euro crisis may mean that they are thinking of acting more aggressively than that. A further large bout of unconventional easing is now on the agenda. Read more

With the Chinese economy seemingly in the midst of a fairly soft landing, global investors have not been paying much attention to China in recent months. However, all that will change as a result of the extremely weak Chinese activity data for April which were published last week. Asian equities and commodity prices have already fallen this quarter, and that will turn into a global problem if the April activity data are a harbinger of things to come.

The April data have not only shaken investors out of their earlier complacency, they have clearly affected policy makers too. The cut of 50 basis points in the banks’ reserve requirement ratio announced on Saturday suggests that the urgent need for a policy injection is at last being recognised. The question now is whether Chinese policy makers, in sharp contrast to their normally sure-footed behaviour,  have left it too late to stem the downward momentum in the economy, and especially in the property sector.  Read more

“You cannot solve a debt crisis by creating more debt.” As Martin Wolf reminds us, this disarmingly simple statement has been of profound importance in shaping public attitudes to the economic crisis. The failure to make a compelling political argument against this proposition has been crucial in limiting the feasible scale of the fiscal response to the crisis.

Whether one looks at the US, the UK or the eurozone, an aversion to “more debt” has become a dominant political theme, as it did in the 1930s. Richard Koo, a leading student of the debt crisis in Japan, has even argued recently that it is impossible to respond adequately to a balance sheet recession in a democracy because the public dislike of “more debt” becomes so profound. Read more

A large and important change is underway in global economic policy. This change will determine whether the developed economies can grow their way out of recession. Although the new strategy has been tried before by individual economies, this is the first time it has been adopted on such a global scale. If it fails, it is far from clear that policy-makers have a ready-made alternative plan waiting in the wings. Read more

Mount Fuji, Japan. AFP/Getty Images

Mount Fuji, Japan. AFP/Getty Images

Until recently, Keynes’ notion of a liquidity trap was of great interest to macro-economists, but was viewed by investors as a rare aberration which, outside Japan, could be safely ignored. In the aftermath of the 2008 credit crunch, all that has changed. Many developed economies seem to be falling into a liquidity trap, and may stay there for several years. What does this imply about asset returns? (This blog is a slightly longer version of an article which first appeared in the FT’s Market Insight column on 24 January, 2012.) Read more

In the second half of 2011, the US economy appeared to buck the impact of the eurozone crisis, with American economic data surprising on the strong side in the final quarter of the year. But, as the new year begins, it seems improbable that economic activity in the US and the eurozone can remain so divergent for much longer.

Will the weakness in the eurozone eventually bring the US economy to its knees? Or will the greater resilience of the US win the day? The answer to these questions will determine whether the global economy will experience a double-dip recession in 2012.

The data released over the holiday period seem to be pointing in a more optimistic direction than markets have recognised. A year of above-trend growth certainly looks like a stretch in the present environment of fiscal tightening and global deleveraging. But the risks of a global double-dip recession appear to be receding, at least for now. Read more

Risk assets fell sharply in the month of September, with equities generally down by between 5 and 10 per cent, and commodities falling by even more than that. The best performing asset in the month was the US dollar effective rate, a clear symptom of the widespread flight to safety. The worst performers were equities in the BRICs, and cyclical commodities like copper. (See charts on asset performance here.)

What had appeared to be mainly a problem for European markets in August has therefore broadened considerably in the past few weeks. The financial markets have started to price in a global recession. They will be very sensitive to the next move in the economic data. So far, it is hard to tell whether a renewed recession has  been triggered, or whether the developed world has “only” become stuck in a period of prolonged stagnation. Either outcome would be bad enough for labour markets, and risk assets – but there would still be a large difference between them, which is why the question matters a lot.  Read more

The Fed decision was fairly close to what was anticipated in this earlier blog – all “twist” and no “shout”. However, on balance, the statement was slightly more dovish than I expected. Concerns about downside risks to economic activity were at least as great as in last month’s FOMC statement, with new downside risks from financial strains being specifically mentioned, and this has swayed the majority of the committee to introduce a slightly more aggressive operation “twist” than expected. Inflation concerns, while marginally greater than in the August FOMC statement, are clearly insufficient to impress the committee, which remains biased towards further easing even after today’s announcement.

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Mervyn King

Mervyn King. Image by Getty.

A few weeks ago, the big central banks were calmly embarking on their “exit” strategies from unconventional monetary accommodation. Then the global economy slowed but for a while inflation remained too high for the Fed or the ECB to consider further easing. Their hands were tied until inflation peaked. Recognising this, markets collapsed. But now that there are some tentative signs of inflation subsiding, the central banks are rediscovering their ammunition stores.

There are basically three types of action that they are considering. In order of orthodoxy, and stealing some of Mervyn King’s terminology, here is a taxonomy of possible measures:

1. Conventional liquidity injections

This is safe territory for the central banks, and they are willing to act swiftly and decisively if necessary. Yesterday’s injections of dollar liquidity into the European financial system are a case in point. Some European banks, especially those in France, were finding it very difficult to raise dollar financing, which they needed in order to pay down earlier dollar borrowings, and to make loans to customers in dollars. The resulting strains in the money markets were undermining confidence in the ability of these banks to remain liquid, and markets were increasingly unwilling to accept their credit. This presented a classic case for the ECB to inject liquidity, using conventional currency swap arrangements to raise dollars from the Fed. Although the ECB will incur a minimal amount of currency risk in the process, and will also incur some credit risk (which will be collateralised), this is very much business as usual for any central bank, as it was in 2008. Read more

A couple of months ago, financial markets realised that the developed economies were slowing sharply, while the policy response from central banks and finance ministries was slow, or confused, or in some cases, like the debt ceiling debacle in Washington, directly damaging. Since then, some policy makers have woken up and smelled the coffee. There have been significant policy shifts in the US, and at the ECB. But there has been no progress whatsoever in the eurozone sovereign debt crisis. Last week, that became by far the most urgent problem facing the global economy. Read more

The global economy, at least in the developed markets, seems poised on the brink of a renewed recession. The growth in real GDP, at an annualised rate, has dropped to around 1 per cent or less in both the US and Europe, and it seems unlikely that growth can continue to hover at this low level indefinitely. Either unemployment will start to rise, in which case recessionary dynamics will take hold, or growth will rebound towards its 2-2.5 per cent long-term trend, and the world will have experienced a narrow squeak.

Which is it to be? I do not claim to know the answer, but I can suggest a few key indicators to watch. In August, these indicators suggest that growth has stabilised at a very low level, rather than nosediving towards imminent recession. Read more

The outbreak of pessimism about the global economic outlook, which seems easy to justify in the case of the developed economies, has now begun to spread to the emerging economies as well. For example, John Plender and Michael Pettis have recently warned that “miracle” rates of growth in the emerging world, notably in China and the rest of Asia, cannot be expected to compensate for failing growth in the US and Europe. These warnings require us to ask some deeper questions about the longevity of the Asian growth miracle. Read more