In our previous post we posed five questions for the US economy, more or less focused on whether the the economy can grow at its recent rate even as the Federal Reserve rethinks their projected policy path amid market turmoil. Here we shift our gaze abroad. Though as we will see, the US matters a lot.
First a quick recap of global equities last year.
As bad as US equity markets were, especially in the final quarter of 2018, international equity markets fared even worse across the entire year. The MSCI EAFE index (net, USD) fell -13.8% while the MSCI Emerging Markets index (net, USD) lost -14.6%, more than three times the S&P 500 index’s -4.4% return. As the chart below illustrates, there weren’t too many places to hide amongst major equity markets.
Note that the chart shows returns in US dollar (USD) terms. Returns were slightly better in local currency terms, reflecting the dollar’s gain across most other currencies. The broad trade-weighted US dollar index rose almost 7.5 percent in 2018. The US dollar’s gain against Emerging Market currencies – particularly those of Russia, Brazil and India – was significant enough to completely wipe out all their local equity market gains.
A big reason for USD gains was the fact that the US economy powered ahead as the year progressed (on the back of fiscal stimulus) even as everyone else slowed. The big macro question is whether this continues in 2019 and that is where we begin.
Will global growth continue to slump in 2019?
One year ago we wrote that the global economy, especially in developed countries, was in the midst of a remarkable upswing. Things look vastly different today. The left panel in the next chart illustrates that growth in the fourth quarter of 2017 was as good as it got for most major countries. The US was a notable exception.
The right panel above shows that manufacturing PMIs in Germany, France, Japan and China peaked in late 2017/early 2018 and have steadily dropped since then. As of December, China’s official manufacturing PMI slipped below 50, indicating contraction in the sector. Even Chinese GDP growth, which typically can be hard to poke and prod away from 6.8 percent (a topic we have written about in the past), has fallen recently.
Japan, Germany and Italy actually saw their economies shrink in the third quarter of 2018. Recent industrial production numbers from Europe suggests that the Eurozone may well be flirting with a recession.
The US economy was an outlier in 2018 but the right side of the above PMI chart does not bode well. The ISM manufacturing PMI index for the US fell to 54.3 in December from 59.3 in November. As we discussed in our previous piece on the US economy, the economic data still looks good, especially in the labor market. However, a lot of other consumer and business numbers are softening. The fiscal stimulus from tax cuts and cancellation of sequester cuts (for 2018 and 2019) will also fade by the end of this year.
The question is whether the global slump will prolong and that gets to where demand is coming from, i.e. the US and China.
How long can the US remain the primary engine for global growth?
First a quick macro overview. Let’s look at current account balances as a percentage of world GDP for various regions as well as the US, Japan and China. The main component of the current account balance is net exports (exports minus imports) and so this gives us an idea of who is reliant on exports (if balance is positive) versus who is mainly importing (negative balance). And since the current account balances out the capital account, it also tells us who is saving more than it consumes, and vice versa.
As the next chart indicates, Europe (the orange line) has transformed itself into a net saver and a major source of exports since the 2010-2012 debt crisis.
China (the blue line) remains a net exporter but its surpluses have fallen quite significantly over the last few years. Though as Brad Setser astutely identifies, there is more here than meets the eye. The adjustment has not come about because China reduced its manufacturing exports and increased manufacturing imports – instead, it is importing more commodities and vacations (outbound tourism is counted as an import). Also, a quarter of Chinese imports are semiconductors and oil, both of whose prices rose over the last few years, and that helped reduced China’s surplus.
The obvious standout is the US (green line), which is the one country that continues to run large and persistent deficits, i.e. importing a lot more than it exports. Or in other words, consuming more than it is saving.
The rest of the world has happily taken advantage of this situation, more so after the recent fiscal stimulus in the US. In order to see this, let’s look at US trade, but excluding petroleum.
Why exclude petroleum? Setser points out that the improvement in the oil deficit can mask what’s happening with everything else. Since the shale revolution, the US has had to import a lot less oil and so the trade deficit in petroleum products (exports minus imports) has reduced sharply. Consider this: the overall trade deficit has climbed 35% since the end of 2013, but the non-petroleum trade deficit has jumped more than 75% over this period (using quarterly data).
The chart below shows the growth of US non-petroleum imports and exports from 2014 onwards, as well as the corresponding non-petroleum trade deficit numbers. The left panel essentially explains why you see the right panel’s trade deficit figure climb as high as it has, and there are a couple of reasons:
1. Between 2015 and early 2016, exports fell much faster than imports due to the rising dollar (making American goods more expensive abroad).
2. Since the second half of 2017, imports have accelerated faster due to fiscal stimulus (as opposed to a weaker dollar).
The irony is that fiscal policy under President Trump has brought about the opposite result of his stated wish to reduce the deficit. The stimulus measures were indeed a boon to the rest of the world, as accelerating US imports translated into an export boost for its trading partners. Which leads to the obvious concern: what happens when stimulus fades and US demand starts to soften.
Another question: If the US stimulus helped exporters around the world, why did they all slow down in 2018, particularly in the second half? Prime example being Germany.
Part of the answer is that US trade data is lagged and so we will see softer demand (especially for capital goods) when the fourth quarter data comes out. Germany in particular is also hurt by falling demand from countries like Italy and Turkey.
However, we also have to look at the other major source of demand in the world – China.
Will China crash land or continue muddling through?
China is clearly slowing. Authorities tried to close some of the credit spigots last year, but for a country that is heavily reliant on investment, that can be deadly. We discussed above that China’s manufacturing PMI is is now in the contraction zone but consumption is also slowing. We already got signs of this from companies like Apple and Ford.
Total car sales fell 3 percent in 2018, the first annual decline in more than two decades. On top of that, the latest December trade data showed the trade surplus rising. Why is this bad? While exports fell, imports fell even more (-7.6% from a year ago), indicating a huge fall in Chinese demand and a bad sign for the global economy. As economist Trinh Nguyen of Natixis noted on twitter, this is especially bad news for neighbors like South Korea, Singapore, Vietnam and Malaysia. Countries like India, Indonesia and Philippines are less exposed to the slowdown in China.
One thing with terrible economic data is that it can clarify the direction and strength of policy fairly quickly. Chinese authorities, who had already initiated some stimulus in late 2018 (including tax cuts and big rail projects), recently signaled even more measures. On January 15th, the central bank injected $83 billion into the China’s financial system – a single-day net record. This follows a large cut in banks’ reserve requirements as they look to free up more than $100 billion in new lending.
All of this is before potentially even larger US tariffs come bearing down – temporarily put off as China and the US work to find a deal. So we may yet see a trade pact that, temporarily, boosts investor confidence in both countries, not to mention across the world.
The impact of a Chinese slowdown on US corporate earnings may also give the Federal Reserve (further) reason to pause rate hikes in 2019 – giving a breather to China, and even export focused countries like South Korea. So one theme for 2019 may be that policy divergence will narrow.
In some ways it seems like we are back in 2015-2016 (when the Fed did pause as the global economy slumped), or even earlier in the decade when macro investors warned of a China hard landing. However, Chinese authorities managed to pull through with a mixture of stimulus measures that boosted investment and credit (mostly in infrastructure and real-estate), as well as capital controls. The consequent recovery of Chinese demand helped the rest of the world recover as well, driving growth in 2017 and early 2018. Then China turned off stimulus and here we are again.
The formula to fight the slowdown looks to be the same this time around – prioritizing short-term stability over long-term structural reforms, like reducing the savings rate (raising consumption), and relying less on investment spending.
What could possibly be done different?
As Setser recently discussed in a very good piece, China could build out its social insurance programs like pensions and increase spending on public health, thereby reducing consumers incentive to save more. Additionally, the world’s twin surplus counties i.e. those with a fiscal surplus and a trade surplus, should do more to boost domestic demand. In other words, countries like Germany, South Korea and Netherlands that rely on manufacturing exports should, and can, do a lot more on the fiscal side. Essentially contributing to global demand as opposed to only taking it.
Obviously all of this is easier said than done.
As we mentioned above, markets can sometimes react positively to really bad data if it means more supportive policy is coming down the pipeline. However there may be an element of complacency building as investors put a premium on monetary and fiscal policy support while discounting politics. Examples include the current US government shutdown and the trade-war (the politics of which were discounted throughout 2017). Perhaps this is due to the success of US authorities in staving off a second Great Depression in 2008-2009.
The most notable example may actually be Brexit, including the drama of this week. Without getting into all the details, what happened was that Prime Minister Theresa May’s bill to withdraw from the EU was defeated by a resounding margin in Parliament – the worst loss for a British government on a major vote. The defeat was expected but the margin was not, leading many to believe that odds are in favor of a delayed Brexit, a second referendum or even a cancellation of Brexit altogether. The British pound actually gained over the week.
Yet the reality is that not much has changed and Britain is a simply few days closer to exiting the EU without any deal. While many British politicians believe this will push the Europeans into giving the Prime Minister more concessions, the EU immediately clarified that none would be forthcoming. The EU has also said that they won’t extend the Brexit deadline until the UK has clarified its position on a future relationship with the EU. Something it has failed to do over the past 18 months.
So the path seems clear. Either Prime Minister May revokes Article 50 (canceling Brexit), or she asks for a delay. The Prime Minister has repeatedly said she has no intention of doing either, and if so, on March 29th, the UK automatically drops out of EU treaties and separates from the EU. And chaos may ensue for all sides. Though it could be a slow-burning one over time as opposed to a crash situation. A cliff-edge fall may be prevented by various governments temporarily pulling together all their resources.
In any case, the onus is certainly on the politicians to find a way out. Which may not be a great bet to make in todays world.
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