MySay: Clouds darken over world economy

This article first appeared in Forum, The Edge Malaysia Weekly, on August 20, 2018 - August 26, 2018.

Turkey is being buffeted by its worst financial challenges in almost 20 years

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There are clear signs of an economic slowdown across the world and things could get worse. Several forward-looking indicators are foreshadowing a moderation in growth in production and trade for the rest of the year. Adding to the woes are ill-tempered negotiations over trade spats, which are likely to get worse. As a result, business confidence has already been hurt and actual exports and production could follow. A number of large emerging economies such as Turkey and Argentina are under severe stress — more countries could join them in the coming months. Finally, we could be getting to the point where geopolitical frictions escalate and damage the world economy.

 

Global economy is poised to slow down

The composite lead indicator devised by the Organisation for Economic Cooperation and Development has been edging down in the past few months and is now below its long-term average. Since the track record of this indicator in predicting growth is good, that means growth in the OECD club of rich nations is likely to slow in the next 6 to 12 months. This is particularly the case for Europe and Japan while the outlook for the US remains strong.

In addition, the World Trade Organization’s lead indicator for world trade volumes has also fallen significantly this year. In other words, not only is there likely to be slower growth in production, but whatever demand growth there is will not spill over as much as before into the demand for imports, which powers Asian exports.

 

How worried should we be — underlying drivers of growth show mixed prospects

The one truly bright spot in the global economy is the US. The economy has been growing above its trend rate this year. All signs point to the blockbuster growth in the second quarter being replicated this quarter. Virtually all the important engines of the economy are operating robustly:

• The labour market is vibrant, adding an average of 224,000 workers each month, more than double the number needed to employ new entrants into the labour force. That will bring the unemployment rate down and allow wages to rise. The combination of expanding payrolls and higher wages will provide firepower for stronger consumer demand.

• Moreover, the impact of tax cuts and higher fiscal spending is only just beginning to flow through to demand. As that unfolds, economic growth should strengthen further.

• Then there is capital spending, which is set to fuel even stronger economic growth. Core capital goods orders are rising, a portent of an accelerated pace of investment. Moreover, the recovery in oil prices is boosting spending on equipment in the shale oil sector.

• And, if all that was not enough, credit conditions are easing despite the central bank’s rate hikes. The US Federal Reserve survey of loan officers showed that banks are relaxing conditions for commercial and industrial borrowers including small and medium-sized enterprises. That is important because SMEs are the most credit-constrained segment of the corporate sector; any loosening will tend to encourage more borrowing and then more hiring and capital spending.

Clearly, the US economy will continue to grow strongly. That will be good for global growth, but it will also mean that the Fed will keep raising rates.

Unfortunately, the US represents only about 23% of the global economy. Things are not so rosy in the remaining roughly three-quarters of the world:

• Europe and Japan are likely to see slower growth. New export orders in both these economies have softened to their weakest levels since the third quarter of 2016. Purchasing manager surveys in these two giants of the world economy are also reflecting a general loss of momentum. Germany, Europe’s powerhouse, has seen a sharp tail-off in factory orders, which could mean that the fall in its industrial production in June might not be a one-off. The one silver lining in Japan, however, is that real wage growth has accelerated to its fastest pace in more than 21 years as a result of very tight labour markets, and that should support consumer spending. Yet, household spending has been falling for five months, as consumers have been rattled by the trade wars as well as bad weather.

• China is also showing signs of decelerating, going by the latest indicators for industrial production and fixed asset investment. The main reason for this is the government’s policy of reducing debt in the economy. As a result of tighter regulations, the shadow banking sector, which provides the bulk of funding to the dynamic private sector, shrank in July. Policymakers are now worried enough about the economy to have started easing up. For instance, spending on infrastructure is being stepped up. However, while regulators are not pursuing deleveraging with the same zeal as before, they are not relaxing their grip on the shadow banking sector either, worried that any easing would unleash another torrent of credit that could destabilise the economy in the longer term. Total social financing, a broad measure of credit availability in the economy, grew at its slowest pace since records began. The net effect of all this is likely to be a modest further slowing of the economy.

• Taken as a whole, the other large emerging economies are not likely to add momentum to the world economy. While India, Indonesia and the Philippines are doing well, the outlook for the others is not promising. Turkey is being buffeted by its worst financial challenges in almost 20 years. Its currency has lost more than half its value, inflation is soaring and confidence has been hurt by what financial markets see as the erratic policies of the government. Another example is Argentina, whose government has been courageously reforming its economy. Yet, its currency is under severe pressure and the central bank has been forced to raise rates to punishingly high levels. Brazil faces a general election in two months’ time — there is huge uncertainty over the outcome, which will hold back business spending. Mexico is in the middle of a transition to a controversial new president who takes office in December, and so businesses are holding back hiring and spending. Russia has benefited greatly from the recovery in oil prices, but additional US sanctions have caused its currency to tumble, which could hurt business confidence there.

 

More things could go wrong than right

Looking forward, the global economy is likely to face several challenges:

First, financial conditions are likely to tighten. As argued earlier, the US’ central bank has little choice but to keep raising rates. The European Central Bank will begin to cut back on its quantitative easing at the end of this year. In emerging economies, central banks are being forced to raise rates as well because of the recent currency market ructions.

So, after a long period of ultra-low interest rates and massive quantitative easing, rates will be rising and central banks are reining in their monetary expansions. As capital becomes scarcer, there will be more competition for it and investors will become more rigorous in how they price it as well as in how they allocate capital. Investor risk aversion will grow, which means that investors will be very sensitive to anything that seems risky — and that implies more money being pulled out of emerging economies at the slightest hint of trouble.

Second, trade tensions are also heading into an awkward patch. The US and China are engaging in an escalating tit-for-tat series of tariffs against each other. Efforts to resume talks between the two giants have stalled. Trade frictions between the US on one side and Europe and Japan on the other appear to have cooled recently. However, we believe the US is likely to go ahead with tariffs on automobiles, which will hurt both Europe and Japan, ending that ceasefire. It looks like things will get worse before there is enough incentive for these trading behemoths to begin serious negotiations to resolve their differences. In the end, they will do so — but it could take months and in the interim, business confidence and therefore investment spending may be hurt. Export growth is also likely to slow.

Third, geopolitical risks are also rising and could reach a point where they materially damage economic prospects. Take the Middle East as an example. The US has imposed new sanctions on Iran after US President Donald Trump pulled out of the

multilateral agreement on Iran’s nuclear programme. Iranian security officials have warned that, if Iran is pushed into a corner, it could decide to restrict the flow of oil through the Straits of Hormuz. Since about a third of the world’s traded oil passes through those straits, just the fear of such disruption could cause oil prices to soar. Given that excess oil production capacity is now limited, the spike in oil prices could be quite severe.

 

What does this mean for our region?

The global environment is now more difficult for Southeast Asia.

First, as growth in global demand moderates, the region’s exports of manufactured goods will see slower growth. Should trade tensions worsen, as we believe they will in the short term, then the slowdown in exports would be much more ­serious. Major exporting countries such as Singapore, Vietnam, Malaysia and Thailand would take a hit.

Second, prices of commodities that are sensitive to global growth — such as coal, base metals and rubber — could ease as well. This would hurt Indonesia, for whom commodity exports are still an important source of revenue.

Third, global financial conditions are likely to tighten further despite this slower growth. That means nervous global investors will need few excuses to keep taking money out of emerging markets that are deemed to be risky. Pressures on regional currencies and asset markets will remain.

Fourth, this region, however, is likely to do better than other emerging markets as a result of pro-active monetary tightening. Note how Indonesia’s central bank has just raised rates by another 25 basis points after having raised them by a cumulative 100bps in the past two months. The Philippines central bank is also raising rates. This has boosted the credibility of the region’s central banks among global investors, which should help provide a buffer.


Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy

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