Saturday 04/04/2020

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More thoughts on the state of the world economy

Chief Economist

Financial markets are seeing lots of volatility and uncertainty has spread widely. Investors are fretting about several factors including China’s slowdown and its impact on emerging markets, US economic slowdown, the non-linear fall in oil prices, geopolitical risks and the European refugee crisis, uncertainty linked to future monetary policy as well as its effectiveness to boost demand, stretched equity market valuations, high private and public debt levels and so on.

Even leaving aside the massive problems with regards to social inequality and climate change, it’s extremely difficult to be relaxed about the problems facing today’s world. Looking beyond the short term, recent progress suggests there may be reasons to be optimistic of a robot-fueled rise in productivity. At the same time, however, it is still far from clear how fast the process of automation and disruptive technological progress will proceed, let alone what the effects will be on prices, employment and inequality. Indeed, the immense complexity of this world and the struggle itself towards the heights, as Albert Camus noted, is enough to fill a man’s heart… Still, we have to ask what exactly has changed recently that we didn’t know already, what the appropriate policy response would be and how likely it is that policymakers will act accordingly. Moreover, importantly, let’s not forget that macroeconomics and financial markets do not always move in sync. Remember Benjamin Graham’s quote in this respect: “in the short turn, the market is a voting machine but in the long run, it is a weighing machine.”

The USD will continue to play a decisive role for the world economy. In real trade weighted terms the USD has appreciated almost 20% since the summer of 2014. This is a reflection of relative better economic conditions in the US (or outright sluggish economic activity in the rest of the world if you like) leading to the first Fed rate hike since 2006. But the stronger USD has also come with serious challenges. What’s more, a further sharp appreciation of the USD (or expectations thereof) could spell more trouble for example in terms of capital flight out of China (in turn casting more doubts about the strength of its economy) and the whole emerging world. This, in turn, would cause even more problems for several emerging markets trying to pay back USD denominated debt. Moreover, this would likely put further downward pressure on prices of commodities including oil. In theory, the latter should be positive as cheaper energy prices increase consumer spending power. However, the sharp non-linear fall witnessed in recent quarters has had a huge negative effect on oil producers to the extent that it has outweighed the positive impact for net oil importing countries thus far.

Given all this, a further sharp USD appreciation would not be desirable. At the same time, this simple observation, of course, will not necessarily prevent it from happening. That said, we don’t think the USD will see a major appreciation over the coming months and quarters. The main reason is that the stronger USD is also weighing on economic activity back home. Indeed, as we mentioned before, several leading indicators for the US economy are showing signs of hesitation. The latter should make Fed policymakers more prudent with regards to hiking rates much further. The latest Fed communication confirms this. Yellen and co now describe the outlook for domestic consumption and investment as moderate rather than solid.

All in all, it seems that the USD is strong because the rest of the world is weak but also that the world and the US economy are suffering from a strengthening USD. It can be expected that the significant currency depreciation seen in many EM will eventually help those countries to get back on track but this obviously will take time against the back of China’s economic rebalancing and structural growth downtrend. The upshot is that the world economy remains stuck in ‘slow-growth gear’ and this despite historically low interest rates. In addition, demographic headwinds are intensifying and the private and public debt overhang implies that there is much less scope for debt releveraging going forward. Those who dismiss the theory of secular stagnation as complete nonsense better come up with convincing arguments. We would not agree that budgetary and monetary policymakers have lost all ammunition to fight this seemingly desperate situation. At the same time, it is not clear whether policymakers are ready to think more out of the box in this respect. As stated before, recent technological progress does offer hope but not more than that. ‘One must imagine Sisyphus happy’.