Macro economic commentary – December 2018

Author: Ntsekhe Moiloa.

Economics is a minefield. The neoclassical school of thought dominates current economic thinking, including researchers who have suggested that there might be unique and stable equilibria in prices. Interestingly, some of these research efforts have started from the balancing equations of the standard Keynesian macro model, which is unsurprising given that the Walrasian tâtonnement process that guides it has a whiff of central planning rather than decentralized market-led behavior. Yet one of the great critics of general equilibrium theory in economics was the great proponent of government interventionism, John Maynard Keynes himself. That students can graduate sane as economists is an enduring mystery; Lord Keynes is remembered for stating that “there is nothing more suicidal than a rational investment policy in an irrational world” back in 1931. The end of 2018 certainly had many investors puzzled about how to respond to an environment where negative returns were widespread with no obvious calamity other than perhaps elevated valuations. After all, the leading global economy was doing well with low unemployment and the bellwether American housing market was still a seller’s market. Those who agree with Herbert Spencer that unrestrained capitalism breeds for success could scarcely hope for a better poster child than the deregulating American economy; so all should have been well with the world. But the worst December in US equities since Keynes’ 1931 suggested something altogether different.

In an age of nationalism and slogans such as “America First” it has been possible to forget that we live in a global environment where different dynamics may be at play halfway across the world. While America steamed ahead, Asia dropped its pace somewhat. The slowdown in one of Asia’s most export-exposed economies, Singapore, is a window into how the end of 2018 suggests a difficult 2019, not only for Asia but for the global economy.

There is a lack of inflation in Asia. Demand at the consumer level is not strong, and producer level figures are also looking lackluster. Quarter-on-quarter seasonally adjusted figures showed Japan’s economy shrinking in the first quarter of 2018 after two years of quarter-on-quarter economic expansion. The pattern of quarter-on-quarter real private consumption mirrored the wider GDP trend by being negative in the first quarter, positive in the second quarter, and negative again in the third quarter. By the third quarter, the year-on-year non-seasonally adjusted real growth rate had slowed to zero. The Japanese economy will surely be looking forward to a tourist bump in 2019 when the Rugby World Cup arrives on its shores in September.

Across the Sea of Japan, China experienced an outbreak of African swine flu in the second half of the year. This covered an area accounting for about half of the country’s domestic pork production. This outbreak further dampened the final demand outlook in China, contributing to weak PMI expectations. Ignoring the swine flu for a moment and looking at the evolution of two important production-level variables in South Korea which is also across the Sea of Japan, we are met with a worrying picture: producer price inflation has slowed down and may even turn negative, while PMI figures are also weak.

A year of full-throated trade war threats is unlikely to have been helpful. In the case of China what might be capable of supporting inflation is a weaker currency, or capacity shutdowns which are not unusual in the Asian winter to deal with pollution. However, this kind of inflation, which does not come from the demand side of the economy, may have trouble being sustainable. It also carries with it the risk of policy error.

Fixed asset investment did start to come through in the Chinese data earlier in the year, largely from local government spending on infrastructure. Local governments had been borrowing to fund investment, but the most recent figures show debt issuance by local governments having fallen off a cliff. Looking further down the track, it is not clear that there will be money available to prop up further spending.

The Chinese government has tried to deploy a range of policies to increase final demand. Having tried with limited success to encourage consumer spending, the temptation for the central government is to revert to old approaches of simply pouring money into infrastructure. But nationally, China no longer had a current account surplus in the first half of the year. Without those capital inflows there is not much runway to increase infrastructure spending. In fact, with a weakening currency, the temptation rises for Chinese businesses and nationals to send money out of the country.

The reality is that China’s economy does not exist in a bubble. As the US Federal Reserve raises rates, it makes for a tense situation for the PBOC which would prefer lower rates to support the domestic economy. That lack of rate synchronicity means that in a world where investors are looking for relative yield, foreigners are less likely to bring money into China, decreasing the ability of the central government to turn on the spending taps.

For the global economy it is an unattractive situation. On the one hand China and the rest of Asia are looking less likely to be able to generate the kind of demand that fuels the global economy, while at the same time the Fed hikes are part of a picture leading to a slower US economy. All of this before we have even mentioned the name of the US president, Donald Trump.

This December the American president has been caught up in yet more questionable decisions that have contributed to declining financial markets. He has allowed the US government to slide into a partial shutdown over his demand for a border wall; made a surprise trip to Iraq which offended the political class there; let go of his Chief of Staff who was considered one of the few senior people keeping his wildest impulses in check; and ignored his national security staff resulting in the resignation of his widely respected Secretary of Defense. All this took place while the US was in the midst of sanctions conflicts with China and Iran. The US president is unfortunately said to lack any sort of investigative élan, and so the lagniappe that Donald Trump thought he was giving to Turkish president Recep Tayyip Erdoğan turned out to be far costlier than he had likely imagined. Israel’s Haaretz newspaper reported that the decision to withdraw American troops from Syria came about during a telephone call between the two leaders. Trump apparently ignored the talking points guidance provided by his diplomatic and national security team which emphasized that American participation in Syria has been one of its few beneficial military involvements in the Middle East. Instead Trump asked Erdoğan if the Turkish military could cope with regional threats like ISIS, and when Erdoğan said they could, Trump surprised the Turks by saying American troops would go home. Pulling out of Syria is likely to concede influence to Iran despite the sanctions, and Levantine countries like Iran, Syria and Afghanistan are more likely to turn to China for economic assistance as America’s presence and dollars in the region recede. Turkey, despite being a NATO member, will find it easier to do military business with Russia when American troops are no longer manning the watchtowers.

The willingness of the United States to stand back from certain theatres of engagement appears to be opening up spaces for China – and to a lesser degree, Russia – to become more assertive. Transitions like these invariably come with a greater level of uncertainty – something financial markets traditionally do not like. Our sense is that while we have expected a sudden crack to signal the end of this decade-long global expansion, it may be that we start to see a grinding decline into negative rolling returns in 2019. Equity investors hoping for a bounce might be underestimating the risks, and forgetting that despite the pull-back we have seen in global markets, they continue to trade at reasonably dear levels compared to history.