Global threats are mounting: Fidelity

The hazards confronting the world economy are mounting. The US economy is recovering at an unspectacular pace of about 2%[1] and a sub-par labour market, sluggish wages growth, renewed doubts about the housing market and weak demand for the country‘s exports only portend more modest growth ahead.

On top of this, inflation is accelerating, the Federal Reserve is only months away from ending its asset buying and rate increases appear inevitable before too long. The defeat of House majority leader Eric Cantor in a Republican primary election in Virginia in June by a Tea Party candidate is expected to cement gridlock in Washington and could lead to more showdowns on raising the government’s debt ceiling. The eurozone is still in recession,[2] disinflation could fester into deflation, government debt loads are at default levels and banks are so crammed with dud loans they are restricting lending, while some are wobbling in Austria and have failed in Portugal. Even if European Central Bank Governor Mario Draghi’s bluff to protect the euro is soothing investors, the financial crunch in the eurozone has morphed into a political crisis revolving around a jobless emergency that is fanning support for nationalistic and fringe parties, the opposite environment needed to create the political jelling the euro needs to assure its survival. Housing is bubbling in countries from the UK to New Zealand.

The emerging world isn’t in much better shape, especially as it is riddled with conflicts. A civil war has broken out in Ukraine, only months after Moscow seized Crimea from its neighbour, and Russia could yet invade. Western sanctions against Moscow in response will damage more than Russia’s economy. In the Middle East, Syria’s civil war rages on. Islamists control much of northern Iraq and a third of Syria and the fighting pitting Shias and Sunnis could spread into other countries such as Jordan. Israel has been to war against Gaza for the third time in six years. Iran could still gain nuclear weapons. In Africa, Libya has become ungovernable. In Asia, China is creating tension, especially with Japan, as it seeks to broaden its ownership of the China Seas. Due to China’s flexing, military spending in Asia has inklings of an arms race. Nuclear-primed North Korea is as loony as ever while nuclear-armed Pakistan grows more unstable.

Financial and economic challenges are no-less menacing in the developing world. Argentina has defaulted for the second time in 13 years after a legal feud with “vulture funds”, an outcome that will damage South America’s second-largest economy. China’s property market is deflating, while Beijing is only making half-hearted attempts to police out-of-control lending because it worries that proper regulation might make the country miss its 7.5% growth target. So challenged are many emerging countries by current-account deficits, inflation, sluggish economic growth and plunging currencies that labels of the past such as BRICs that flagged the potential of developing nations have given way to “fragile” plus a number; i.e., the “fragile five” are Brazil, India, Indonesia, Turkey and South Africa.

Could any of these challenges morph into a shock as damaging as the collapse of Lehman Brothers in 2008? Or could some other threat not yet evident emerge? Maybe it will be a jump in interest rates. Some analysts say it’s only a matter of time before Saudi Arabia is engulfed in the political turmoil of its neighbours. Just think what that would do to oil prices. Whatever form any shock could take, if one should occur, it’s not so much the shock that should worry investors. It’s the powerlessness of authorities to respond. There is, however, one hope that shines out from the events of recent years.

It must be said that there are always dangers to the global outlook and most of them are overhyped and fizzle out. So most likely will today’s perils. Since World War II, global politics has been far more volatile than today, even when the nuclear armed superpowers confronted each other as during the Cuban missile crisis in 1962 or the Yom Kippur War of 1973 that led to the first oil price shock of the 1970s. Even amid all the current hazards, the World Bank still expects the global economy to expand this year, even if that expected pace of growth for 2014 was reduced to 2.8% in June from the 3.2% forecast the bank made in January.[3] Other good news is that inflation is only a menace in a few countries. Japan’s radical economic experiment is going well so far. In India, the dominant election victory of BJP has sparked hopes the government can enact reforms that will rejuvenate the world’s second-most-populous country. Indonesia, the world’s biggest Muslim country that only 15 years ago was an economic and political basket case, is expected to advance further under new president Joko Widodo. US banks are better capitalised and are under tougher regulation. Across the globe, current accounts are better balanced, thus removing the savings mismatch that was a key cause of the global financial crisis of 2007-08. Any shock these days would have to be huge to outdo the jolt to consumer and business confidence that was inflicted by the collapse of Lehman Brothers, most likely a once-in-a-generation event, for people are hardened to alarms nowadays. Even allowing for all this, though, the world appears more precariously placed to cope in the unlikely event of a shock than it was six years ago.

All together now

When the US sub-prime crisis morphed into a global financial crisis in September 2008 policymakers in affected countries responded almost in unison. Central bankers slashed interest rates. They provided emergency funding to banks. Those in the US and the UK embarked on unprecedented asset buying or quantitative easing, a cure invented by the Bank of Japan in 2001. Political rulers provided massive fiscal stimulus. They nationalised banks. They guaranteed bank deposits even, mistakenly in Ireland’s case, backed bank debt.

These steps succeeded in avoiding another Great Depression, a feat in itself, but some harm was unavoidable and unintended consequences arose. The resulting Great Recession ushered in double-digit jobless rates while low interest rates fanned housing and other asset bubbles around the world. Policymakers made mistakes too. Austerity policies implemented in Europe and elsewhere have hobbled economies, boosted the ranks of the jobless and worsened government debt levels. The ECB could well turn to asset buying too late to stave off deflation.

These side effects and errors could add to the severity of the next downturn in the unlikely event of a shock. The greater problem, though, is that if another jolt comes authorities are much more handicapped than they were six years ago. Most of the steps that supported economies and banking systems in 2008-09 have lost their muscle. Major central banks already have reduced cash rates to record lows, so on this score they are immobilised. Quantitative easing has been unmasked as no miracle cure, even if it can help avoid a catastrophe or deflation. Research in 2012 out of John Hopkins University found that any reduction in interest rates from asset-buying programs was fleeting and “quite modest”.[4] While other studies might be kinder to central-bank asset purchases, it’s hard to believe that the Fed would do much for the economy if , say, it restored its monthly asset buying to US$85 billion again to limit shockwaves. Such a policy retreat might even deal another blow to confidence for the Fed and other key central banks have swelled their balance sheets to levels that approach the limits of investor tolerance, or at least to levels that provide fodder for scaremongers. The new (old) world of macroprudential controls, or financial regulation, to fight asset bubbles is fraught because it injects central bankers into the centre of political decisions.

Politicians and the executives they control appear just as toothless. Many governments are so debt laden they would be challenged to pursue the fiscal stimulus matching that of 2008 to 2010. Net debt sits at 74% of GDP for advanced economies, about where the average stands for the 18-member eurozone.[5] The US government net debt has reached 82% of output, while Japan’s ratio has soared to 137%. The straightjacket that such ratios put on governments is shown by events in Japan. Fiscal pressures forced Tokyo to raise the sales tax by three percentage points in April this year, a move that acts against the consumer spending that propels the economy, thus jeopardising the gains won so from the radical monetary experiment to engender inflation and economic growth. The US debt pile is the defining restriction on Washington’s ability to stimulate the US economy, which post-2008 was helped by annual fiscal deficits averaging 9.2% of GDP from 2009 to 2011.[6] The fight over US government finances has already produced the brinkmanship over the so-called fiscal cliff and two debt-ceiling showdowns that took the country to the brink of default. Perhaps more worrying, austerity advocates are winning the political battle in countries where government debt is low. There would be few better examples than Australia, which promoters of smaller government claim is facing a budget emergency (rather than just a persistent gap between outlays and revenue) when net government debt is all of 16% of GDP. Consumers won’t be able to rescue economies either. Households are still burdened with near record debts as a percentage of GDP and, come a shock, will own plunging housing assets.

What hope then for the world if a thunderbolt materialises? Most likely this. Policymakers the developed world over know they are at the limits of their power. They must have thought of possible remedies if something bad happens. If not, they have proved they can whip up palliatives if economies and banking systems shudder. The years after the global financial crisis struck ushered in unprecedented amounts of quantitative easing and emergency lending to banks under central-bank lender-of-last-resort facilities and massive fiscal stimulus. The era produced soothers such as zero interest rates and the invention of negative interest rates, which Sweden introduced in 2009 followed by Denmark in 2012 and the ECB this year. Central banks entered into bilateral currency swaps with the Fed to ensure enough US dollars to support banks in their spheres. Other central-bank tonics were so-called forward guidance to soothe any concerns about rate increases, ECB repurchase agreements designed to shove massive amounts of money at banks, Fed purchases of mortgage-backed securities to help revive housing, Fed lending facilities for borrowers and investors in crucial credit markets and cunning bluffs such as timely pledges by policymakers to do “whatever it takes” to save this and that, as the ECB did for the euro. These cures may not be enough if strife hits again but they give hope that policymakers have the inventiveness to limit the damage in the unlikely event that a threat materialises.

Financial information comes from Bloomberg unless stated otherwise.

 by Michael Collins, Investment Commentator at Fidelity

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