The James Bevan long read: Is the global economy out of the woods?

The performance of the global economy has recently raised concerns. James Bevan explores what will happen to commodity prices, how China is driving change and what we can expect from the Bank of England.

At present, China’s private sector is thought to be exporting around $200bn per month of net capital as its domestic credit system, and more importantly its broad money supply, continue to inflate at a hectic pace.

Some of this capital will be connected with debt repayments and may therefore tend to ‘disappear’ as international lenders continue to shrink their balance sheets.  Some of the remainder of the funds may also end up sitting idle as excess reserve deposits of the recipient commercial banks in Developed Markets. Some of the money will also be offset by China’s public sector sales of foreign bonds as it is obliged to run down in FX reserves.

However, even allowing for these offsetting sums, it is probable that China is adding $30-40bn to market liquidity at present on a net basis, and somewhat more to risk markets. We can therefore suggest that China has in effect started to take the place of the Fed’s QE3 in terms of its impact on global financial market liquidity. In fact, we could argue that since there is implicitly ‘less leakage’, China’s outflows are exerting an even more potent effect than did QE3.

Meanwhile, the European Central Bank (ECB) is expanding its balance sheet by around $45bn per month and the Bank of Japan (BoJ) is expanding at close to a $60bn average rate.

For sure, the bulk of these funds are ending up as excess reserves in the banking system, but it does seem that there is a sort of de facto QE process involving China, the ECB and the BoJ, that may be impacting sentiment and perhaps even fund flows within markets. In addition, we also have Japan’s Government Pension Investment Fund (GPIF) and others being encouraged to support their own equity markets.

Against this background, perhaps we should not be too surprised that in the absence of hard economic news from China, risk markets have made some upward progress.

However, we must assume that at some time markets will get to focus on the ongoing emerging market industrial recession and the increasing likelihood of a Chinese devaluation as pressure on its foreign exchange reserves reaches a level of unacceptable discomfort.

Something for the ECB to think about

If negative yields are now accepted as being toxic for the financial system, it makes little  sense for the ECB to reduce official rates further or even to buy more sovereign bonds.

It would make more sense for the ECB to buy corporate bonds, particularly given the commercial banking system’s ongoing disposal of its holdings of these instruments. Better still, the ECB should be looking to provide long-term ‘bond-like’ financing to the banks. This in order to offset the commercial banks’ ongoing loss of ‘monetary capital’ that the ECB’s own regime has caused, and which has had the effect of shortening (and therefore damaging) the commercial banks’ liability structure.

We can suspect that in reality, the ECB’s forthcoming policy statement will include rhetoric designed to talk down the euro, but we should doubt whether the ECB can actually deliver a weaker euro, given the ongoing banking system divestment from overseas assets.

Equally, we can but hope that the ECB does not invoke yet more negative rates or sovereign bond purchases. The ideal outcome would be for the ECB to finance infrastructure spending by the European Investment Bank (EIB), by buying in EIB paper, but if this is not permitted, then it should at least use its next policy actions to seek to attempt to repair at least some of the damage that it itself has done to the banks via its current policy mix.

Worries on the UK & Australia

The math of income and expenditure at an economy level is interesting, instructive – and frightening.

National income can be seen as essentially the number of people employed times their output and therefore adjusting for shifts in productivity.

In the UK at present, the number of employed people is rising at around 1.6% per annum and productivity per person employed is expanding at 0.6%.

There is on this basis 2.2% growth in notional value added. A more cautious assessment is provided by the ONS which calculates real disposable incomes as rising 1.8% per annum.

Yet the real volume of consumer spending is expanding at just over 3% per annum.

UK households borrowed £45bn last year, in effect bridging the gap between the growth in income, whether it be +1.8% or +2.2%, and the spending increase of 3%.

The sizeable financial deficit is a significant shift given that only a few years ago, the UK household sector had been running a financial surplus. It does seem that UK households have returned to the ‘borrow & spend’ behaviour of the late 1990s and the mid-2000s, despite the various global uncertainties and the remarkably patchy nature of jobs and income growth in the UK at present.

Thus, in reality, real incomes are only growing within the Southeast of the country, and this may be encouraging consumers in other parts of the country to resort to the greater use of credit.

Clearly, the historical precedents for this type of behaviour are not good and although it is only ten years after the run-up to the global financial crisis, UK households would seem to be back in the same position that they were in during that period. Indeed, the ‘capital account version of their financial position, shows that they in a worse position relative to incomes.

Meanwhile, Australia has reported a 3.1% year-on-year increase in real personal consumption expenditure (PCE).

In per capita terms, Australia’s rate of PCE growth is somewhat lower than that of the UK but it is still significantly faster than the country’s rate of household real disposable income growth. Australian households have financed the gap between income and expenditure with credit, and household borrowing growth in Australia is currently running at a rate of 7-8%.

This rapid growth in borrowing has occurred despite Australia’s weak terms of trade, uncertain trading outlook (i.e. with China), and signs of regional weakness.

In thinking about the UK and Australia, it’s interesting that the central banks of both countries have a clearly revealed preference for maximising economic growth whenever possible but it could be argued that both the BoE and the Reserve Bank of Australia are now “behind the curve” in that they should be tightening their domestic policy settings in order to rein in their seemingly reckless household sectors.

These medium sized economies risk exposing themselves to considerable risks of current account problems and even foreign indebtedness problems at some point in the future if they remain on their current tacks.

In so doing they become magnets for the world’s stock of unsold inventories that are currently looking for a home. Indeed, there have already been warnings over the current account positions of both countries and conservative central bankers probably would be tightening at present in these circumstances.

First principles

Taking a few steps back to consider what’s going on from first principles, and this is particularly relevant to Japan, it is only rational for households to embark on borrow-and-spend types of behaviour in the present, if they believe that their real incomes in the future will be sufficiently bright – i.e. that they believe that their future income trends will be sufficient to allow them to have an acceptable standard of living even after servicing their debts.

More formally, it really only makes sense to borrow if the individual thinks that the net present value of their income in the future, after any necessary debt repayments, will be sufficient enough to allow them to borrow some of this income to finance current consumption and still achieve a target future level of ‘well-being’.

It might be argued that the Anglo Saxon household sectors, as a rule, tend to be rather more optimistic, or trusting, about their futures than some others and their policymakers do seem to have a more overt growth bias.

However, given the UK’s ongoing weak productivity trends and Australia’s adverse terms of trade, in conjunction with the current uncertain global environment, it is not clear that the future is necessarily brighter for these countries, at least in the medium term.

It’s on this basis that we can argue that conservative policymakers should consider reining back the enthusiasm of their household sectors.

There is also the issue of the impact of strong capital flows on the domestic economies. Although in general, international credit flows have been deflating, it does look as if Australia may have gained a disproportionate share of China’s multi-trillion dollar capital outflows of late.

These inflows have not only inflated parts of the housing stock and some corporate valuations, but have also implicitly provided Australia’s banks with significant new funding, and Australia’s banks will therefore have been encouraged to make more loans and therefore to increase the supply of available credit.

It may well be with the UK, that flows from China, elsewhere in Europe, Africa and even Russia, have exerted a similar effect, at least until recently.

Over here there have also been government initiatives aimed at increasing the potential supply of credit and this increase in the notional supply of credit may well have implicitly encouraged the demand for credit to rise sub-optimally, offering yet another reason why central bankers should be attempting to lean against the household sectors’ increased desire to spend relative to their incomes at  present.

However, there are other ‘new’ factors at work in any rate decision. First, the ratio of house prices to average earnings in many UK and also Australian cities is now so high that many people may have given up any hope of owning a property.

The lingering effects of previous credit booms on house price levels, the high rates of population growth, the impact of the relatively large capital inflows, and the latest credit cycles have conspired to lead many people to consign themselves to renting and this in turn may be leading them to ‘live for the moment’ in a wider sense by buying goods and services today now that they are free of the need to save for deposits or suffer the burden mortgage payments.

Such behavior can be seen to represent a rational response to the irrational level of house prices in these economies, although the real world importance of this possible shift in behaviour is hard to gauge. What this implies for central bank policymaking is also not entirely clear but it may have altered people’s ‘life cycle’ spending habits.

There’s also the possibility that the current weakness in world trade prices and, by extension, in the prices of many consumer goods is being viewed by consumers as representing an unusually good opportunity to shop.

The text books have it that falling goods prices lead people to defer purchases, and that’s why deflation is considered dangerous, but in the Anglo Saxon world, in which there is little or no modern history of deflation, it may be that expectations of future inflation remain positive for many people, and therefore the current bout of deflation can be viewed less as a crisis, and more as an opportunity to spend more while goods are temporarily cheaper.

This logic can be extended to a national level. Since import prices are falling/low, it can be argued that for any given current account deficit or level of nominal imports, a country can import more volume, and that it is therefore rational for the country to attempt to import more.

For example, (in the pre-Brexit worry world) an £80bn current account deficit in 2015 allowed for 7% more imports by volume than did the same sized nominal deficit in 2014, despite modest export trends in the interim.

Given that we may expect that most UK and Australian consumers still have positive expectations of inflation, the current bout of deflation will have potentially provided a reason to spend more, and if policymakers also view world trade price deflation to be transitory, then letting households exploit low prices may be rational.

With Australia, where the authorities seem to fear weakness in China in the near term, but still expect long-term success, thereby implying that Australian incomes will likely be materially better in the future, again the authorities may stand by assuming no signs of expectations of sustained price deflation and continued capital inflows, financing the current account deficit and providing funding to the credit system.

So, until the situation in China becomes clearer over the next few months, the RBA can probably afford to sit and watch from a domestic economy & currency perspective – as it did last week.

It would be better if Australia’s falling savings – investment balance was the result of rising productive investment rather than falling household saving, and we certainly have some reservations over the state of the (Sydney) housing market, but 1.5% per capita household spending growth at a time in which there are potentially bargains around would not seem reason enough for the RBA to start raising rates (or cutting rates).

There are certainly problems implicit in Australia’s current economic situation, but none that at present cry out for central bank action.

In the UK, the BoE would probably have been in the same situation had it not been for the impact of the Brexit debate, which is likely at least a short-term negative for the economy and a reason for foreign investors to hold off investing in sterling/UK assets.

Put simply, the UK cannot be sure that it will be able to attract the necessary financing to fund the current account deficit and therefore can’t really afford to try to take advantage of weak world trade prices.

This means that it can be argued that the BoE should be raising interest rates at present – and that this, in a sense, would be a ‘cost’ of the Brexit debate. But it’s highly unlikely that the BoE will raise rates, thereby allowing the UK consumer to continue deficit spending, despite the uncertain outlook for the funding of the (resulting) current account deficit. Given this state of affairs, it looks risky to buy sterling against the USD, the EUR and even the JPY.

With the AUD, the outlook will likely remain broadly neutral until China finally reveals its medium term destiny, which may not be as bright as some optimists assume. We can therefore have concerns over the outlook for the AUD over the medium term but in the near term it does at least not have Brexit to worry about.

Global inventories

It’s hard to determine but important to decide just how long the deflation in finished goods prices in particular can be expected to continue.

If the deflation lasts longer than households, and indeed their policymakers, appear to believe, then future income trends may not in fact be sufficiently bright to justify any decision to go bargain-hunting now, as seems to be taking place in the UK and Australia.

If this is the case, then future consumption trends will in turn be somewhat weaker than markets, including currency markets), currently anticipate, and it will be a moot point whether central banks should have made people save now rather than spend.

Unfortunately, the data trends suggest that we still have a considerable period of deflation ahead of us. Asian inventory levels remain high across both the consumer and investment goods sectors.

This can be assumed to imply that the manufacturing recession in these economies will continue, in line with the latest crop of PMIs, as the region’s producers continue to reduce current output.

Indeed, the inventory data would seem to suggest that world trade prices will remain depressed as the unsold goods are offered at discounts by their producers, or the countries adopt weaker FX regimes, while suffering weaker production levels.

If we adopt an optimistic frame of mind, the data for Asian inventories did show some improvement in January, largely as a result of apparently favourable developments within Japan.

Thus Japanese shipments of cars, general machinery and some precision instruments revived significantly in January, allowing inventory ratios to improve in these sectors despite an uptick in production levels.

Indeed, without being curmudgeonly, Japanese companies enjoyed a good January. The snag is that this may have been Lunar New Year related. Korea also witnessed some decline in its inventory ratio in January, but the pricing of the shipments seems to have been weak, while Taiwan apparently had a poor  month.

Unfortunately, it is not only Asia that is now struggling with high levels of unsold goods. As had been indicated by some retailers late last year, domestic retail sales levels have been disappointing of late (relative to expectations if not their near-term history) and this has resulted in a sizeable pick up in inventories in the auto, clothing, foot ware, electrical goods and even building material sectors.

Indeed, the latest US inventory data appear to offer a very troubling message at this time and, in the 1970s & 1980s, this sort of inventory build would have been viewed as representing a (very loud) recession warning.

Taken as a piece, both world trade and global inventory data and developments are much more suggestive of continued weak global industrial trends rather than recovery, which in turn suggests that the recent rally in commodity plays may turn out to have been unwarranted.

With this in mind, we suspect that Australian households may well need to revise their income expectations and accept a lower currency as a result. In the near term, Brexit clearly represents a ‘problem’ for the GBP but ultimately China may represent a bigger problem for the AUD.

So the summary messages are:

1. The recovery in commodity prices may be temporary
2. The global economy is not out of the woods
3. China’s credit flows will or at least may support markets for now
4. In the period ahead, cyclicals may then be marked down again, and genuine sustainable quality growth will outperform once more.
5. This is absolutely not a good time to follow the herd into expecting and pricing cyclical recovery and strong growth.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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