November 5th has come and gone- so too the bonfire-bashing stories of Guy Fawkes that go along with that date. But one date remains before us, where playing with fire is about to burn the hand that reached out. That date is March 29, 2019. The Brexit negotiations where a sham: Britain was never going to get a fair deal, as politicians were involved; the EU was never motivated to help anyone other than themselves. In the US we call that, America First and get pilloried for it. Frances Macron let the cat out of the bag when he said that the backstop would be leveraged to get advantages over Britain.
The terms of the deal are a travesty. Britain is neither in or out of the EU and there is no clear plan how it ever will be. A clean break with fair trade rules was never possible. Many politicians avoid rational arguments; they seek advantage for their own position, not fairness. Fair trade and zero tariffs without freedom of movement, though logical and reasonable, was never possible: The French want to protect their farmers; Italy their factory workers, and Spain its fisheries. Competition and openness has been corrupted for years. Why is the EU anything different? See The Crisis of Good Intentions in this week’s US print edition of the Wall Street Journal.
Elsewhere in that newspaper is another article that highlights how the politicians in Brussels are close to ignoring a fire for which they have little awareness. ‘Finance Area Must Make Key Brexit Choices Now’ explains how certain financial transaction take three months to complete. The March 29 date when Britain leaves the EU is nearly 3 months away, yet the methods to assure safe passage for such derivative transactions remain in limbo.
Most of will never use or know what these $66 trillion of swaps and futures transactions actually do. Financiers do and will soon be in the front page of finance rags when they have to explain to their masters why costs are ballooning and finances settlements grinds to a halt. London is still an important central hub for a range of these transactions that are specialized; and aspects of global trade market operations. The EU, in their political stubbornness, are about to uncork a bottle of pandora; or they will light a fuse that will burn and brightly, very soon.
For the love of Pete, can Britain just get out from under the manifolds of madness and can we work an honest days effort without political oversight?
I had little choice but to hot-foot over to the IMF webpage once I spied the alert in my inbox today: UK’s Economic Outlook in Six Charts. Really, in just six charts? Awesome. Show me the money. Well it turns out a bit of a fiddle. Yes there are six charts and some of them are really interesting. Some however are pushing a political agenda.
Chart 1: UK GDP 2011-2018 compared to G7.
Yes, in the last couple of years the recorded GDP growth of the UK has fallen from being in the top set of G7 counties to the bottom. How much of that is due to Brexit or natural economic cycles or other causes?
Chart 2; Brexit will be costly to the UK.
Ok so now my spider-senses are tuned in. Have you read The Economics of Brexit – a cost-benefit Analysis of the UKs economic relationship with the EU, by Philip Wyman and Alina Petrescu? I would recommend it. Page by page, chapter by chapter, these two researchers explore the small print of the analysis completed by the IMF, OECD, the Bank of England and others, that all point to (or pointed to) the economic decline of the UK assuming Brexit takes place. The small print of every analysis that concluded and concludes depression, resection, decline, all point to assumptions about how the UK policies will change (or not) and how other countries responses will change (or not). Quite frankly the conclusion is embossing.
Virtually every analysis that falls back on WTO or other frameworks assumes something that is just not practical or likely. Won’t the UK adjust interest rates if prices increase? Won’t the UK devalue sterling if wages exceed global competitive rates? Won’t the UK’s innovation seek higher rents and drive new innovation? Won’t tax policy favor growth? These are all ignored in one or other analysis. Thus every analysis is misleading. The IMF is just as bad as everyone else. In fact I conclude that there is no fair or practical economic analysis of what will happen with Brexit. Few economists can prove what net change in GDP came ab-out from joining the EU; how can they estimate the losses when you leave?
I will let you look at the other charts. They are interesting and somewhat informative, if you take the time to understand the assumptions and try to think of the argument the author wants to message. Either way, I recommend the book.
James Mackintosh of the Wall Street Journal posts in today’s US print edition on “The 3 Things That Can Go Awry in 2018“. The article details three dynamics that, if played out as he suggests, could cause the global economy to trip in 2018. His summaries are good and compelling and, given our amazingly positive outlook today as 2017 comes to a close with all major nations growing at roughly the same time (an odd occurrence in its own right), they come at a good time to consider conservative actions against possible shifts next year.
The three are:
Monetary Tightening. The story here looks at Fed and central bank interest rate hikes. We all know that interest rate raises have started, at least in the UK and US, even though the EU remains firmly stuck taking that drug. Japan is taking it slow, even as its economy shows much signs of improved life – Japan will have to continue pushing rates up in 2018, just as the EU will have to follow the US’s lead. The problem with this item is that there are us a lot of debt out there – corporate debt, public debt and yes, some consumer debt. It is not the same kind of debt that was part of the run-up to the crash that put us where we are today, but for some firms and some governments its big risky debt. As an example, and tangentially related, another article in the WSJ reports on a few firms that are high in debt that will be financial impacted by Trump’s tax reform – see Tax Plan Downside for Dell, Others in Debt. A lot firms have issues debt in the last few years in response to QE and near zero interest rates. As rates increase, debt load and repayments will increase. If inflation were to join the party, it could be a messy time for a number of firms and governments.
China. This story has been used before since China has been the source of two recent periods where the US stock market (in fact the global stock market) fell by about 10%. As such, China’s management of its economy – shifting from a producer-based to consumer-based economy – is a major challenge. Debt remains a problem, and capital controls and currency exchange rates just add more menu items for Chinese leadership to wrestle with. Should China sneeze, so the saying goes, we would all fall could of a cold or something worse. Worse, there is no coordination between east and west – so we are somewhat at the behest of the Fed and People’s Bank of China – and we all hope they do the right thing. Of course, they will both do the right thing for their own constituents – or try to. Hence the lack of cooperation.
A Correlation Correction. This for me is the more interesting and most likely issue to blow up in 2018, and it is the least talked about in the press since it is not as well understood. Mr. Mackintosh states, “one reason investors hold bonds is to cushion losses in a stock-market downturn.” This approach has worked for quite a while, as prices have diverged short-term all the while converging over the long-term. The risk is that should inflation appear in 2018 the relationship between stocks and bonds may revert to how it was in the 1980s and early 1990s, with rising bond yields being bad for share prices. The problem for me is that I think inflation will rise in 2018 to just levels that this will be the catalyst for change in the markers. If you read the tea leaves, there is ample evidence of a change underway. Many commodity prices are doing very well. Copper prices are, as an example, reportedly at recent high’s due to increased production. If you look at producer prices in the US, they are inching up now over 3%. Even though wage pressures remain subdued, the pressure is building. Though participating rates for males in the US aged 25-54 are at near all-time lows, yes the employment rates seems low and may go lower, but there remains some slack to take up the growth we will see. But that pressure is there. I think that by the second half of the year, certainly by Q3, US inflation forecasts will show that 3.5-4% are on the horizon. This won’t cause a panic, but it will lead the change and correction that will come. On top of this the author suggests that the Fed may just “give in” to the needs to cap the bloated asset prices we see all around us, to nip the bubble before it becomes unsustainable. Trump’s tax deal will push this peak out a year or two, but the dynamics are in play.
Reading between the lines you can see that all three of the authors ideas overlap and intersect. Inflation is mentioned directly in 2 of the 3; growth is everywhere; public policy too. As such he has hedged his bets and tried to call out the category of challenge. I will try to break the triggers into more simplistic sections.
As such, I give the following percentage probability for each driving a correction by the end of 2018:
Monetary Tightening, most likely US led, due to over heating: 15%
China growth, debt to currency issues: 28%
EU or euro-zone debt or banking crisis: 15%
Inflation-driven policy changes: 22%
Japan public debt or growth challenges: 10%
Emerging Market currency or debt issues: 5% (this one won’t trigger in isolation but might follow from one of the others, namely 1, causing a currency drain)
William Gibson of the WSJ wrote on Sept 26th in the WSJ (see The Populist Wave Reaches Germany) an Opinion piece that neatly calls out the major issues now liberated in the recent general election that apparently awarded Chancellor Angela Merkel another four years in office. Mr. Gibson goes beneath the headlines to highlight what are actually disturbing issues.
The news that masks the issues suggest that the share of the popular vote won by the ruling coalition dropped from two thirds in 2013 to just over half. So far, ok. But as a result of declining popularity of the classic parties, the center-left Social Democrats have announced they will not participate in the next government. This is where issues emerge.
To creat a coalition this means Angela Markel has to work with either the Greens and the Free Democrats, or she and her party lead a minority government that limps along one parliamentary vote at a time, aligning with any party that works with her decision at the time. The bad news is the Greens are demanding the phase out of the internal combustion engine; the Free Democrats are skeptical of an ‘ever deeper’ EU. Their leader wants to phase out the European Stability Mechanism. All told its a deal with the devil or devils.
If that was not enough, there was a 7.9-point gain by the Alternative for Germany, or AfD, a far-right populist party. The AfD is incredibly the third largest party in Germany, and second largest in the old East Germany. This is more than incredible; this is significant and could be a sign of great and growing dissatisfaction. We all need to keep on guard. This situation can easily and quickly, and quietly, shift further.
News today suggests that the central European economies are beginning to surge ahead with growth while at the same time the periphery continues to struggle terribly.
In today’s US print edition of the Wall Street Journal there is news that German GDP in December continues to grow. We only just read that house prices are surging too. As Germany starts to surge ahead, it will need to push interest rates up to help control growth and prevent overheating.
In order or scale, priority and impact, here are my picks for the five most critical trigger-points that may impact, negatively, a return to ‘old normal’. Currently we stand at the edifice of a new normal, the great stagflation, but the anti-establishment and populist changes taking place seem to suggest a knew-jerk reaction by nations fed up with socialist dressed-up-as-market politics that have led the West for 20 years.
China’s economy stagnates or crashes. Debt levels are above EM levels and are now among the largest, approaching the incredulous Japanese levels. This dynamic is not sustainable for a nation whose currency is not a reserve currency. However the economy is the world second largest even without the development and emergence of whole swathes of other sectors such as healthcare and leisure, which may offset contracting first world growth over the next year or two. So the risk is there and there is no clear leaning one way or the other, yet. But debt is growing faster than these new sectors; exchange reserves at $3bn are limited (though huge), and currency value management is not market-bases. So greater risk is with the downside. China’s growth flags, currency sinks, counterbalancing US growth and confidence, creating a massive imbalance in the global economy. Europe watches on as global GDP sinks under its own debt weight. KPI’s to avoid/watch out for: China GDP falls to or below 4.5%; China’s debt load surpasses 300% of GDP.
Trump quits after 18 months due to intractable political limitations that prevent policy changes he seeks related to healthcare, regulatory complexity, tax reform and trade. Trump’s political rhetoric is being replaced with solid business-based policy. However not all such policies have ever been tested at a national level and scale. Some efforts will fall foul to physical, social and political limitations. This may prove frustrating for Trump. As growth will return short term, such medium term frustration will lead Trump to claim, “My policies worked, see? But now the system has reached its limit and there is nothing I can do until the country agrees with me to shut down the whole government system! Since they are not ready, yet, I am ‘outa here’ until they are!” Markets crash, interest rates balloon, inflation rages all within a year. World economy sinks into the abyss. KPI’s to avoid/watch out for: US GDP 1H 2017 reaches 4.5% but Congressional conflict leads to policy deadlock ; vacancy in position at Whitehouse.
Emerging Marker currency crisis as massed capital investment is siphoned away towards a resurgent US economy and dominant dollar, as well as a stable and even growing China economy. This situation is already underway. The risk is that what is currently a reasonably ordered trend becomes a financial route. This is possible since the financial markets are starved of yield due to the collective policies of central banks to keep interest rates very low for too long and for the build up in their massive balance sheets. If the trend becomes a torrent, EM’s will have to yank up interest rates far beyond what their local economics can support and economic disaster will follow. This will ferment more political instability and drive increased destabilizing ebonies to ruin. Though the US may be growing well, compared to its peers, it’s the imbalance they tips the ship over. KPI’s to avoid/watch out for: dollar index, the weighted value against basket of currencies, surpasses 115. It is currently at 103.33, which is a 14 year high; EM interest rate differential balloons.
Hard Brexit forced through by intransigent Europeans who think the EU experiment is more about political union than economic liberalism. A new trade deal, legal framework and social contract can be negotiated within a two year window. But only if politicians and civil servants want it too. Continental politicians however, under the strain from populist pressures, will equate intransigence over Brexit negotiations with an improved politicos standing with their electorates. Fool for them as this will actually create the opposite response for such behavior will simply worsen the economic climate. The lack of any sign of return to old normal will lead to political paralysis and the clock will time-out. Hard Brexit will be forced upon a supplicant Britian. Europe and UK economies will tank; currency wars will wage; global trade will collapse further. This will not sunk the global economy short term but will act as a dead weight slowing its resurgence down. KPI’s to avoid/watch out for: no agreement at end of two year period lost triggering of Article 50.
Latin or Indian debt or economic crisis. Much like with other EM’s, growing sectors of significant size around the world may blow up- India being the best example. India’s growth is different to China. It is more integrated socially and politically with the west, but it’s corruption levels are far greater than what one can see or observe in China. It is possible that local economic difficulties, hard to observe today, may trigger a collapse in confidence that leads to a destabilizing debt or currency crisis. Brazil’s economy is certainly in the dock currently; Argentina is struggling. India’s economy looks like paradise right now but the growth across the country is extremely uneven- you only have to look at public sector infrastructure investment. So should two such countries suffer local difficulties, the combination may result in significant risk to the global financial system. KPI’s to avoid/watch out for: two simultaneous financial/debt crisis afflicting EM or India.
These are my top 5 risks the global economy faces in 2017. I hope I am wide of the mark, in a positive way. I left Japan off the top 5 list yet their economy remains anathema to growth. The Japanese market invented the whole new normal cycle with a anaemic growth, massive debt, low inflation, and demographic contraction. And Japan has an amazing debt load that refuses to spook investors. Things may yet have a Japanese tinge before the year end. Does Japan, along with the US, lead the global economy back to the old normal!
What potential risks do you see?
Yet the articles covering both stories appear in different parts of every newspaper. The EU is blatantly two-faced. Better yet the US won’t be insular; Trump has more business skill than all the politicians of the EU. He is using the hint of tariffs as a negotiation tactic. Trump will likely do more for global trade than any political group, period. It will take time for the world to catch up, I am sure. I suspect the US and UK will fast-track a western union trade deal within the next 12 months.
Hopefully the EU will follow Britain and the US with some more rational, economicall liberal, free-trade leaders in the upcoming elections. Left leaning, socially progressive types are too focused on short term personal gain and not focused on the bigger issues.