US

The global economic recovery that started amid the gloom of the financial crash in March 2009 is about to celebrate its 8th birthday. In the advanced economies (AEs), the GDP growth rate during this recovery has averaged only 1.8 per cent, well below normal, but unemployment has dropped from 8.1 per cent to a still fairly high 6.1 per cent. According to JP Morgan, the volatility of GDP growth has fallen to the lowest levels for four decades since 2014.

This slow but extremely steady period of expansion has of course been accompanied by much lower interest rates, which have proven terrific for asset prices. The index of total equity returns in the AEs has tripled since the bear market ended.

Janet Yellen and other officials at the Federal Reserve have said on many occasions that “recoveries don’t just die of old age”. Unless something goes wrong, the upswing in the cycle will be prone to continue. At present, econometric models that attempt to assess recession risks suggest that these risks are exceptionally low over the next 12 months.

Furthermore, the growth rate in the US and other AEs seems, if anything, to be breaking upwards. This may be because the headwinds that have held growth down for so long – excessive debt, a malfunctioning banking system, extreme risk aversion, low capital investment etc. – may finally be fading away. Perhaps the world economy is at last attaining escape velocity.

However, good times cannot last forever. It is common for euphoria to set in just when the economic and financial cycle is nearing a peak. As in 2001 and 2008, the end could come much sooner than anyone predicts [1]Read more

US monetary policy has now clearly embarked on an important new phase. For a long while, the markets have been extremely reluctant to recognise that the Federal Reserve might actually mean what it says about increasing short term interest rates by 0.25 per cent on three separate occasions this year. Remembering repeated episodes in which the Fed has failed to deliver its threatened tightening in policy since 2013, investors have concluded that dovish surprises from the Fed are endemic.

Last week, however, they woke up to the fact that FOMC really is serious about raising rates in March, and that this may be the first of three or even four rate hikes this year. After a series of hawkish speeches by several FOMC heavyweights, the coup de grâce came on Friday, when Janet Yellen warned that a rate rise in March “would be appropriate” unless economic data surprised in the meantime. She added rather ominously that policy accommodation would be removed more rapidly this year than in 2015 and 2016.

The great unknown is whether this will come as a major shock to the financial markets. It will certainly mean that investors will need to build in a faster path for rate hikes in the near term than anything that has previously been contemplated in this cycle. But the good news is that the final destination for rates does not seem to be changing, at least in the view of the FOMC. The Committee is increasing the speed of travel towards its destination, but is not changing the destination itself.

So what has justified the shift toward more hawkish thinking on the FOMC? And will this upset the equity market, which is still ignoring the prospect of higher rates? Read more

President Trump has an almost unprecedented opportunity to reshape the key personnel and legal basis of the Federal Reserve in the next 12 months, essentially rebuilding the most important economic organisation in the world in his own image, if he so chooses.

The President may be able to appoint five or even six members to the seven-person Board of Governors within 12 months, including the Chair, Vice Chair for monetary policy, and a new Vice Chair for banking supervision. He may also be able to sign into law a bill that alters aspects of the Fed’s operating procedures and accountability to Congress, based on a bill passed in 2015 by the House of Representatives.

Not surprisingly, investors are beginning to eye these changes with some trepidation.

Some observers fear that the President will fill the Fed with his cronies, ready to monetise the budget deficit if that should prove politically convenient. Others fear the opposite, believing that the new appointments will result in monetary policy being handed over to a policy rule (like the Taylor Rule) that will lead to much higher interest rates in the relatively near future. Still others think that the most important outcome will be a deregulation of the banking system that results in much easier credit availability, with increased dangers of asset bubbles and economic overheating.

It is not difficult to see how this process could work out very badly indeed. But, at present, I am optimistic that a modicum of sense will prevail. Read more

Investors are an emotional crowd, especially when US equities, measured by either the Dow Jones Industrial Average or the more accurate S&P 500 index, have just hit all-time highs. I am not sure who first remarked that market behaviour is motivated by two competing emotions, fear and greed. But I do know that Albert Einstein claimed that “Three great forces rule the world: stupidity, fear and greed”.

Some of the macroeconomists that I have learned not to ignore, like Lawrence Summers and Martin Wolf believe that the outlook for the US economy under President Trump is at best uncertain, and that the recent equity market highs are a “sugar rush”. I recognise that some of these critics have major political differences with the new Administration. But many others, like the perceptive and apolitical John Authers, are also very concerned about equity over-valuation.

So, are investors being “stupid”?

One of the advantages of using economic models to analyse the equity market is that the models should be good at avoiding all three of Einstein’s great forces.

That does not make the models the only source of wisdom about future asset returns. Far from it. They are good at avoiding some of the behavioural mistakes that investors are known to commit, such as a tendency to dislike losses about twice as much as they like gains. But human beings may be better at recognising when the investment climate is about to change because of policy upheavals.

In this article, I will try to eliminate emotion by reporting some recent results from the suite of economic and financial models built by Juan Antolin Diaz and his team at Fulcrum. The results are somewhat encouraging: recession risks in the US are low and the over-valuation of equities is less clear cut (on some measures) than is sometimes supposed.

In the short term, however, there are signs that the most active short term traders in the market may be heavily exposed to equities at the present time. This could make the market vulnerable in the short term to policy shocks that cannot be incorporated into the models, such as a major outbreak of trade protectionism. Read more

The financial markets have begun to wake up to the fact that the Republican reforms to US corporate taxation will probably include important new “border adjustments” to the definitions of company revenues and costs. The basic idea is that US should shift to a “territorial” system, with corporations being taxed only on revenues and costs incurred within the US itself, and not on their worldwide aggregates, which is the principle behind the present system. [1]

A border tax was not explicitly part of the Trump platform before the Presidential Election. It was, however, included in the tax plan published last year by Paul Ryan in the House of Representatives, and Mr Trump has recently tweeted that companies that do not “make in USA” can expect to “pay big border tax”. That might be compatible with the Ryan plan, though it also might not be.

Although most other countries already operate “territorial” systems, the Republican plan includes other features that would make the new tax regime operate like a tariff on imports into the US, combined with a subsidy on many exports from the US, a combination that would have profound international economic consequences.

This is not just an obscure change to the details of America’s corporate tax code. It would be seen by trading partners as a protectionist measure that could disrupt world trade.

The direct effects of a border tax adjustment to the US corporate tax regime would be likely to raise American inflation, cut imports, boost exports and raise tax revenue, possibly by over $1.2 trillion over a decade. However, it would also raise the dollar’s exchange rate, which could offset or cancel out some of these other effects.

The impact on real GDP and employment would depend on how these effects panned out, and how the Federal Reserve reacted to the increase in inflation. It cannot be assumed that the effects would be beneficial. Recent estimates by Michael Gapen and Rob Martin at Barclays Capital suggest that the first year effects would be to raise US inflation by about 0.5-1 per cent, and to reduce real GDP by 1.0-1.5 per cent.

Given these economic effects, it is very doubtful whether this form of border tax, taken in isolation, would be good for the overall equity market, though other planned reforms to the corporate tax regime (including lower marginal tax rates, and full deduction of capital spending in the first year) certainly would be. Read more

Exactly a year ago this week, the mood in the financial markets started to darken markedly. As 2015 had drawn to a close, financial markets had seemed to have weathered the first increase in US interest rates since 2006 in reasonable shape. The Federal Open Market Committee had telegraphed its step to tighten policy in December 2015 with unparalleled clarity. Forewarned, it seemed, was forearmed for the markets.

Meanwhile, China had just issued some new guidance on its foreign exchange strategy, claiming that it would eschew devaluation and seek a period of stability in the RMB’s effective exchange rate index. This had calmed nerves, which had been elevated since the sudden RMB devaluation against the dollar in August 2015.

A few weeks later, however, this phoney period of calm had been completely shattered. By mid February, global equity markets were down 13 per cent year-to-date, and fears of a sudden devaluation of the RMB were rampant. It seemed that the Fed had tightened monetary policy in the face of a global oil shock that was sucking Europe and China into the same deflationary trap that had plagued Japan for decades. Secular stagnation was on everyone’s lips.

We now know that the state of the global economy was not as bad as it seemed in February, 2016. Nor was the Fed as determined as it seemed to tighten US monetary conditions in the face of global deflation. And China was not set upon a course of disruptive devaluation of the RMB. Following the combination of global monetary policy changes of February/March last year, recovery in the markets and the global economy was surprisingly swift.

A year later, the key question for global markets is whether the Fed and the Chinese currency will once again conspire to cause a collapse in investors’ confidence. There are certainly some similarities with the situation in January 2016. The Fed has, once again, tightened policy, and China is battling a depreciating currency. But there are also some major differences that should protect us this time. Read more

The global markets remained in reflationary mode for much of last week, a regime that has now persisted for many months. Led by the US, bond yields have been rising, mainly because inflation expectations are on the increase. Risk assets have been performing adequately, with the exception of the emerging markets.

This reflationary regime has been driven by much stronger global economic activity since mid-2016, and latterly by a belief that Donald Trump’s election victory will lead to US fiscal easing, along with the possibility of the “politicisation” of the Federal Reserve, implying overly accommodative monetary policy.

There are various ways in which this regime could end. The world economy could suddenly go back to sleep, as it has on many occasions since 2009. The US fiscal easing could become bogged down in the Washington “swamp”. Or the Fed could become unexpectedly hawkish, stamping on the first signs of inflationary growth in the American economy. This last risk is probably under-estimated, and is worth considering in detail. Read more

Hillary Clinton and Donald Trump

Hillary Clinton and Donald Trump  © Getty Images

Presidential elections have often marked major changes in American attitudes towards fiscal policy.

The arrival of President Kennedy in 1960 represented the beginning of Keynesian fiscal activism. President Nixon’s election in 1968 marked the high point of inflationary budgetary policy designed to finance the Vietnam War.

President Clinton in 1992 ushered in a period in which the reduction of public debt was paramount. The elections of President Reagan in 1980, and George W. Bush in 2000, marked eras in which tax cuts took precedence over budget balance, and counter-inflation policy was ceded to the Federal Reserve.

As the 2016 election approaches, investors are wondering whether another major change in the approach to fiscal policy is in the works. Is a lurch towards fiscal stimulus the “next big thing” in Washington? Possibly, but I am not convinced. Read more

Maurice Obstfeld, the Research Director at the IMF, said last week at the IMF/World Bank Annual Meetings in Washington that global growth “remains weak”, but is “moving sideways”. That is an accurate description of the current situation compared to previous decades, according to the latest results from the Fulcrum nowcasts of global activity.

However, compared to the more recent past, a better assessment would be “solid at the trend growth rate”. Although that trend growth rate is disappointingly low, it is no longer falling (according to the models), and the actual growth rate is no longer below trend, so the global margin of spare resources in no longer increasing. Read more

This month’s regular update from the Fulcrum nowcast models shows that global economic activity is growing fractionally below its trend rate, and is little changed from last month’s report. Global recession risks have therefore fallen recently to more normal levels, compared to the elevated risks seen in February. However, neither the advanced economies nor the emerging markets appear to be sustaining a break-out to above trend growth.

The overall picture is therefore one of steady but disappointing growth, with little indication of a major cyclical acceleration at present. In particular, growth in the US remains subdued, and seems to be running at or below the 2 per cent threshold apparently required by the Federal Reserve to justify a June/July increase in interest rates. Although the jury is out on this point, Friday’s weak employment data have given extra weight to the subdued nature of our recent US nowcasts.

We also report for the first time forecasts for global GDP growth over the next 12 months derived from the dynamic factor models that are used to produce the nowcasts. These forecasts are a natural extension of the nowcast models. They should be used in conjunction with other forecasting methods to assess the statistical likelihood of activity “surprises” relative to consensus forecasts in the months ahead.

The latest results suggest that US GDP growth in the period ahead may well come in below the latest consensus forecasts.

The full set of the latest global nowcasts is available hereRead more

Since mid-February, the financial markets have become much less concerned about a hard landing in global economic activity, or at least about a potential clash between slowing economic activity and inappropriately tight macroeconomic policy from China and the US Federal Reserve. Financial conditions indicators have eased in the big economies, and this has been accompanied by a partial recovery in business surveys in many parts of the world.

In the last edition of our monthly report card on Fulcrum’s global nowcasts, we commented that economic activity had turned a corner in the US and China, but this was offset by continued weakness in several key economies, including Japan and the UK. A similar pattern is apparent in this month’s nowcasts. Global recession risks, which seemed elevated in January and February, have now receded, but the world economy is far from robust.

We therefore leave the overall verdict unchanged from last month: global activity growth is somewhat better, especially in the emerging economies, but it is still a long way from being satisfactory. (Full details of the latest nowcasts are shown here.)

 Read more

Foreign exchange traders are buzzing with talk of a new “Plaza Accord”, following the marked change in the behaviour of the major currencies after the Shanghai G20 meetings in late February.

Since then, the dollar has weakened, just as it did after the Plaza meetings on 22 September 1985. The Chinese renminbi has been falling against its basket, in direct contrast with the “stable basket” exchange rate policy that was publicly emphasised by PBOC Governor Zhou just before Shanghai. The euro and, especially, the yen have strengthened, in defiance of monetary policy easing by the ECB and the Bank of Japan.

Following Shanghai, the markets have become loathe to push the dollar higher, believing that the G20 may now have come to a co-ordinated agreement, as they did at the Plaza, to reverse the direction of the US currency. Does this comparison make any economic sense?

The Shanghai communique did place increased emphasis on an agreement among the major economies to avoid “competitive devaluations”. The main suspects here were Japan, the Eurozone and (sometimes) China, all of whom have good reasons to push their currencies down. The fact that the communique eschewed this course of action is therefore a reason to believe that the dollar might be subjected to less upward pressure. But that does not make it a new Plaza. Read more

Financial asset prices have been on a roller coaster in 2016. In mid-February, gloom was pervasive and global equities were down about 10 per cent year to date. Then came a sudden rally, wiping out all of the losses in the US equity market, but not in the eurozone market, and especially not in the Japanese market, which fell further.

What happened to generate this abrupt change of direction in February, and what does this tell us about the future? Read more

As Paul Krugman pointed out a year ago, a sharp difference of views about US monetary policy has developed between two camps of Keynesians who normally agree about almost everything.

What makes this interesting is that, in this division of opinion, the fault line often seems to be determined by the professional location of the economists concerned. Those outside the Federal Reserve (eg Lawrence Summers, Paul Krugman, Brad DeLong) tend to adopt a strongly dovish view, while those inside the central bank (eg Janet Yellen, Stanley Fischer, William Dudley, John Williams) have lately taken a more hawkish line about the need to “normalise” the level of interest rates [1].

My colleague David Blake suggested that this blog should carry a Galilean “Dialogue” between representatives of the two camps. Galileo is unavailable this week, but here goes. Read more

This is the latest report in our regular monthly series of “nowcasts” for global activity.

Global economic data published in November have shown a further uptick in worldwide activity growth after the significant dip that was reported after mid-year.

It now appears almost certain that the 2015 Q3 dip in world activity was not the precursor of a slide towards global recession. Instead, it seems to have been another of the minor mid-course corrections that have been a consistent feature of the moderate upswing in global activity that started in 2009.

Although the recent flow of data has therefore been somewhat reassuring about the global cycle, serious problems are still prevalent in the world economy. China has not suffered a hard landing; but severe deflation in the manufacturing sector remains unchecked, and the economy is clearly slowing as rebalancing between old and new sectors takes effect.

Most other emerging economies are now embarking on a major deleveraging cycle, and this may drag on EM growth rates for several more years. Growth in the advanced economies as a whole has been stable at about trend rates throughout 2015; but underlying productivity growth remains extremely weak by past standards. Therefore the advanced economies do not appear sufficiently robust to withstand an intensification of the EM shock, should that occur.

Overall, the global economy continues to grow below trend rates, so at some deep level the deflationary pressures in the system are not abating. However, the specific deflationary impetus from the commodity price collapse is now passing its maximum effect so recorded rates of headline and core inflation are likely to rise significantly in the next few months.

The latest data therefore confirm the conclusion reached in last month’s report: the global economy is suffering from a longstanding malaise but not from a cyclical recession. Full details of this month’s nowcasts and global industrial production data are attached hereRead more

Janet Yellen

Janet Yellen, Fed chair  © Getty Images

This week has seen speculation about a mutiny from two members of the Federal Reserve’s board of governors against the leadership of Janet Yellen and Stanley Fischer, both of whom continue to say that they “expect” US rates to rise before the end of the year. Although “mutiny” is a strong term to describe differences of opinion in the contemplative corridors of the Fed, there is little doubt that the institution is now seriously split on the direction of monetary policy.

Furthermore, these splits could extend well beyond the date of the first rate hike to the entire path for rates in the next few years. Ms Yellen faces an unenviable task in finding a compromise path that both sides of the Federal Open Market Committee can support. Read more

In the aftermath of the supposedly “weak” US employment data published last week, investors seem to have shifted their assessment of the likelihood of the US Federal Reserve tightening interest rates by December — and also of the extent of tightening in the next two years.

Since the data were published, several investment banks’ economics teams have ruled out a December rise. Furthermore, equities have been strong; and the bond market’s implied probability of a 25 basis points rise in the federal funds rate by December has fallen from 76 per cent in mid-September to only about 40 per cent.

Nor is this seen as a minor postponement in the first rate rise. The expected federal funds rate at the end of 2016 implies only two Fed rate hikes in total over that entire period. Clearly, investors increasingly believe that the US economy is now slowing enough to throw the Fed off course.

This big change in market opinion is, frankly, surprising. The rise of 142,000 in non-farm payrolls in September was not all that weak, given the normal random fluctuations in the monthly data. And as John Williams, president of the San Francisco Fed, has pointed out, a slowdown to a monthly rate of increase of under 200,000 was long overdue anyway. Rightly or wrongly, there is little indication so far that important Federal Open Market Committee members share the market’s increased post-jobs-data dovishness.

The crucial question is how much growth in the US has slowed since the middle of the year, and whether this will continue. This is the kind of question that economic “nowcasts” are best suited to answer, so let us examine the recent evidence. Read more

Summary

The turbulence in the global financial markets in the past few weeks has been widely attributed to a “China shock” that has increased the risks of a major downturn in global activity. Last month, this blog concluded that our regular “nowcasts” for global activity had not yet corroborated this narrative.

This month, we have identified the first clear evidence that the global economy has slowed down since mid year, with emerging markets and advanced economies both now growing more slowly. A new factor is a clear slowdown in the US economy, though much of this appears to be due to the temporary effects of an inventory shake-out.

The Chinese economy has not shown any further signs of slowdown in September. The dominant contractionary force in the global economy is a commodity shock, which of course is somewhat connected to events in China (as it rebalances its economy away from commodity-consuming sectors), but it is not exactly the same thing.

The commodity shock is redistributing activity away from commodity producers and towards commodity consumers, both within and between countries. Eventually, the commodity shock should be net beneficial to the global economy, but so far global activity growth has dropped to only 2.6 per cent, which is 0.4 per cent below the rate in mid year, and 0.8 percentage points below trend. This means that global spare capacity is currently rising at a worrying rate.

Because the emerging markets are much more exposed to commodity producers than developed markets, they have been hard hit by the commodity shock. They are now growing at 3.5 per cent, or 1.5 percentage points below trend. It is unclear whether this growth rate is still dropping.

In the advanced economies, the growth rate in activity is about 1.7 per cent, which is roughly at trend. The slowdown identified in the US in September has been offset to some extent by signs of firmer activity in the eurozone.

An important and worrying feature of global growth in 2015 has been the large drop in global industrial production relative to services in the second quarter. This was driven mainly by weakness in industrial production in the US energy sector – not in China – and it has since been reversed. Read more

When Janet Yellen announced last week that the Federal Open Market Committee had considered, but decided against, a rate rise in September, many commentators concluded that the Fed had taken a decisive shift towards dovishness. Yet the markets, so far, have not really shared this interpretation. Since Thursday’s press conference by the chair of the US Federal Reserve, the interest rate path expected by the bond markets has dropped very slightly; but the dollar has risen and equities have remained weak.

There is little sign that investors’ assessment of the Fed’s underlying policy stance has been altered by what is increasingly seen as nothing more than a “postponement” of the almost inevitable rate hike later this year. Whatever it intended to do, the Fed has not cleared the air. Read more

The extreme turbulence of the financial markets in August resulted in a temporary rise in the Vix measure of US equity market volatility to levels that have been exceeded on only a few occasions since 2008. Markets have now settled down somewhat, but it is far from clear whether the episode is over. In order to reach a judgment on this, we need to form a view on what caused the crisis in the first place.

The obvious answer is “China”. The response of the Chinese authorities to the stock market bubble, and the manner in which the devaluation of the renminbi was handled, raised questions about policy credibility that added to ongoing concerns about hard landing risk in the economy. The conclusion that a China demand shock was the main driving force behind the global financial turbulence was given added credence by the simultaneous collapse in commodity prices, and in exports from many emerging economies linked to China.

It would be absurd to deny that China had an important role in the crisis of August 2015. But was it the only factor involved? After all, China’s growth rate does not seem to have slowed very much. Furthermore, standard econometric simulations of the impact of a China demand shock on the major developed economies suggest that the effects should not be very large, and certainly not large enough to explain the scale of the decline in global equity prices, or in the “break-even” inflation rates built into US and European bond markets.

It is conceivable that bad news from China triggered a sudden rise in risk aversion among global investors that exacerbated the shock itself. It also possible that markets were responding to the fact that the Federal Reserve apparently remained determined to raise US interest rates before year end, regardless of the new deflationary forces that were being triggered by events in China.

New econometric work published today by my colleagues at Fulcrum suggest that the perception of an adverse monetary policy shock may have been important in explaining the financial turbulence, in which case the Fed needs to tread extremely carefully as it approaches lift-off for US rates. Read more