The Key Risks to Synchronous Global Growth
Category: Portfolio Management
History tends to repeat—or at least rhyme—in the investment world where Sir John Templeton’s oft-quoted cycle of pessimism, skepticism, optimism, and euphoria has stood the test of time. Today’s market environment is almost undoubtedly somewhere between the optimism and euphoria stages of Templeton’s bull market cycle. A cornerstone of this late cycle bullishness is the ongoing synchronous global economic expansion and the associated uptick in corporate profitability and business sentiment (see Exhibit below).
Alas, we can be certain that the expansion will end—eventually. Here are the five factors that we believe are most likely to derail the expansion (from least likely to most likely).
A geopolitical crisis and/or trade war. It is impossible to ignore the rising number of potential global hotspots (e.g., Iran, Syria, North Korea, Russia). Of course, that has generally been the trend for several years and the cumulative market and economic impact has been negligible. Historically, that’s been far more the norm than the exception. Still, markets have occasionally been lulled into a false sense of complacency, such as prior to the Arab oil embargo of 1973, the Iraq invasion of Kuwait in 1990, and the September 11, 2001, terrorist attacks.
While the US has its fair share of political uncertainty these days, it is unlikely to experience major near-term policy changes, even if there is a strong “blue wave” in the November mid-term elections. A geopolitical crisis appears more likely in Europe, where recent economic growth trends have decelerated. Fears of a European populist wave largely failed to materialize in 2017, but recent elections in Italy, continued uncertainty regarding Brexit, and uncertainty regarding Spain’s elections and tensions with Catalonia could reignite those fears. In addition, the same structural challenges that have weighed on the Eurozone since the founding of the common currency remain (e.g., monetary union without fiscal union and tensions between Germany and the wealthier north versus the less prosperous south). Furthermore, Europe remains highly export dependent amidst weak internal demand. Elsewhere, could there be a second “Arab Spring,” that would cause a further spike in oil prices? Surging oil prices are a very common precursor to a global economic downdraft.
On the trade front, President Trump clearly has a more protectionist orientation than his recent predecessors. The Wall Street consensus is that the Administration is increasing the pressure on China, Mexico, Canada, the EU, and others primarily to negotiate better deals and that no one has a desire to reprise the Smoot Hawley experience of the 1930s. However, the art of these particular deals is far more multi-faceted than any standard business negotiation. For example, the interplay between exacting trade concessions from China while also persuading the Chinese to pressure North Korea to end its nuclear program.
Emerging market contagion. Emerging markets have a long history of spreading contagion to the global economy (e.g., the Latin America sovereign debt crisis of 1982, the Mexican peso/“Tequila crisis” of 1994, the Asian Tiger crisis of 1997/98). More recently, even a relatively modest US dollar rally has intensified fears related to countries such as Turkey and Argentina, although neither is likely large enough in isolation to pose a systemic risk to the global economy.
China is a very different story though. The world got a glimpse of what a hard landing in China might look like in late 2015/early 2016 when yuan devaluation fears sparked global growth concerns and a sharp global equity correction. There is no shortage of bear arguments for a forthcoming hard landing in China—surging household and corporate debt as a percentage of GDP, a murky shadow banking system, a potential housing bubble, and many others. That said, the naysayers have been persistent for over a decade—and, on balance, persistently wrong.
A “known unknown.” Some risks are perpetual but unpredictable, such as terrorism and cyber-terrorism. Here’s just one other example: suppose that markets decide that central banks are behind the curve, or perhaps fears of an inverted yield curve trigger a run on bonds similar to the 2013 “Taper Tantrum.” Even in the last five years, there has been a dramatic increase in the use of passive fixed income vehicles, including ETFs. There is also a lot more leverage in the system. A technically-driven liquidity crunch exacerbated by passive vehicles that fail to meet liquidity needs could rile markets, create a negative feedback loop, and weigh upon global economic growth (somewhat akin to how the bursting of the tech bubble led to the 2001 recession more than the other way around).
An inflationary surprise… The widespread fear of deflation that gripped global markets during the height of the Great Recession appears to be gone. Even the post-financial crisis fears of “secular stagnation” and disinflation seem to have withered. Still, the consensus is that central banks will continue to telegraph every exceedingly gradual step toward interest rate normalization. A spike in inflation—the kind that has occurred in most previous economic cycles consistent with the Phillips Curve—may not be as far-fetched as it seems. That is why the market reacted so violently to the uptick in US wage inflation data this past January. While some inflation pressures have remain muted, largely due to the impact of technology, one simply has to take a look at current gasoline prices or, if you are more industrious, the most recent Richmond Fed Wage Component data that reached its highest level since 1997 to see that inflationary pressures may be building. Inflation is a true game changer for central banks and could further diminish the case for historically rich equity market multiples.
…At a time of rapidly rising debt. A bona fide global tightening of credit would come at a difficult time for both sovereigns and privates who have taken ample advantage of sustained low interest rates. Since 2000, US government debt has more than tripled to $20 trillion and corporate debt has more than doubled to nearly $15 trillion. Meanwhile, global non-financial public and private debt is now 245% of gross GDP, 20% higher than the pre-financial crisis level. Rising real rates could unleash a default cycle for weaker credit and the attempt to normalize interest rates in the face of rising inflation in the US and/or globally could crowd out growth and unleash a default cycle for weaker credits.
Business cycles often end when macro imbalances or a major economic shock cause policy makers to aggressively tighten monetary and/or fiscal policy. However, the recent rise in populism in the US, Europe, and elsewhere argues against a near-term fiscal tightening. The risks appear far higher on the monetary policy side given the extraordinary liquidity injected into the global economy since the financial crisis of 2007-2008. The two major pillars of support for synchronous global growth have been bond buying from global central banks and credit expansion from China. While the 2017 US tax cuts may well have extended the global growth cycle, neither pillar is sustainable in the long-term. As such, the risks highlighted above deserve ongoing scrutiny.