US economy

Politics puts the skids under bull market


Bull markets, it is said, climb a wall of worry. When the last worrier turns into a fully invested optimist, the market has nowhere to go but down. That might be what has just happened: so much optimism was already in the prices of financial assets — in the US, above all — that once worry returned they had nowhere to go but down. How far might unfolding events exacerbate the worries? A long way, is the answer.

As the annual meetings of the IMF and World Bank last week made clear, reasons for concern abound. Above all, a struggle between old and new superpowers has arrived. This may change everything.

The good news is that the IMF’s World Economic Outlook continues to forecast strong economic growth, with global output growing 3.7 per cent this year and next (at purchasing power parity), as in 2017. The bad news is that this is a reduction of 0.2 percentage points in 2018 and 2019 from its April forecast. Above all, “the balance of risks . . . has shifted to the downside in a context of elevated policy uncertainty”.

On the downgrade, the report emphasises negative surprises to growth in some high-income countries in early 2018, US-initiated trade wars and problems in emerging market economies, which are due to country-specific weaknesses, tighter financial conditions, geopolitical tensions and higher oil prices. The Fund stresses that the surge in oil prices, partly related to the re-imposition of sanctions on Iran, might worsen. This would damage vulnerable oil importers. Moreover, with above-potential rates of growth and low unemployment in many high-income economies, notably the US, inflation could surprise on the upside. Even without this, monetary “normalisation” in high-income countries has a way to go.

As Warren Buffett says, “you only find out who is swimming naked when the tide goes out”. The most naked are those with vulnerable balance sheets — high leverage and big maturity, liquidity and currency mismatches. When the tide of easy financial conditions goes out, financial and economic distress is then inevitable. Already, a number of emerging economies have succumbed, Argentina and Turkey being obvious examples. A big decline in risk appetite, possibly triggered by trade wars or accelerated monetary tightening in high-income countries, could well trigger a more generalised capital flight.

A jump in risk aversion would affect financial — and thus economic — stability more broadly. Valuations of risky assets are, in many cases, stretched and balance sheet vulnerability is pandemic, as the Global Financial Stability Report makes plain. Just a small shift in global financial conditions managed to damage some emerging economies. But, as the GFSR points out, the aggregate debt of households, non-financial companies and governments in countries “with systemically important financial sectors now stands at $167tn, or over 250 per cent of aggregate gross domestic product”, compared with 210 per cent in 2008. Many debtors must be vulnerable to rising interest rates. (See charts.)

The US government has not helped by embarking on a highly irresponsible, pro-cyclical fiscal expansion on top of what the IMF labels “already unsustainable debt dynamics”. Yet private sector excess is not hard to find there either. In the eurozone, leverage in the corporate and government sectors remains high. The Chinese economy, too, is highly indebted.

Meanwhile, important asset prices remain elevated. In the US, the cyclically adjusted price/earnings ratio, developed by the Nobel laureate Robert Shiller, remains higher than it has been at any time in 137 years — except in 1929 and in the late 1990s and early 2000s. That is true even if one looks at an eight-year moving average of real earnings, instead of the normal 10-year one, thereby excluding the years of the crisis. An accident has been waiting to happen. Last week, a small one duly happened.

Chart showing how US equity prices remain high

The world’s economy and financial systems are fragile — nobody can know how fragile until they are really tested. Yet the most important source of fragility is political; a lagged legacy of the financial crisis. In country after country, populists and nationalists are in, or close to, power. Salient characteristics of such politicians are myopia and entrenched ignorance. Inevitably, they spread uncertainty. The Italian government, for example, has undermined confidence that Italy will stay in the eurozone, with perilous results.

Chart showing how global financial vulnerability has increased

The biggest shift of all is in the US. Last week, President Donald Trump broke a longstanding taboo by condemning recent tightening by the Federal Reserve. Under him, the US has also embarked on an assault on the World Trade Organization’s dispute settlement system and an open-ended trade war with China.

Above all, the US administration seems set on a new cold war with China. Mr Trump even talks of stopping the Chinese economy from becoming bigger than that of the US. Even if this stayed a cold war, not a hot one, it would be far more significant for the US than was its rivalry with the Soviet Union: China is more populous and its economy is far better run, more dynamic and more integrated with the world’s.

This folly might not matter so much in good times. But what will occur in the next crisis? Will policymakers co-operate as they did in 2008 and 2009? This question holds force within countries, within groupings such as the eurozone, and across the world as a whole. The open world economy might collapse.

These are dangerous times — far more so than many now recognise. The IMF’s warnings are timely, but predictably understated. Our world is being turned upside down. The idea that the economy will motor on regardless while this happens is a fantasy.

martin.wolf@ft.com



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