One of the few economists warning of impending doom before the financial crisis is doing so again. His views are easily discounted because the false prophets of doom, including an IMF former chief economist, have too often rolled out predictions of imminent doom.
There is an impressive array of global threats. But one thing holds them off: low interest rates. For most of the time since 2008 I have advised clients that things would muddle along globally because central banks had the incentive and tools to ensure this would be the case. Low interest rates and QE held things together.
But as Glenn Stevens, former Reserve Bank of Australia governor warned not too long after the financial crisis, there is the risk central banks will ultimately overdo it. This point has been reached in the US, NZ and probably the UK while Australia is slowly heading down the same path.
This Raving focuses most on the US where Trump's browbeating of Fed chairman Powell to back off plans for more hikes delays what I suspect will be the trigger of the next global crisis or minicrisis. On the other hand, it increases the odds of painful interest rate increases later; increases that will shock markets and more.
Most people warning about an imminent global crisis have been wrong, but …
Nouriel Roubini was one of a handful of economists who forewarned of the financial crisis. He was at it again in September 2018 by listing 10 reasons why there will be another crisis by 2020.
Professor Kenneth Rogoff, ex-chief economist at the IMF got lots of media coverage in January after warning about imminent global threats emanating from China. He also issued warnings in 2017, 2016 …. It is unlikely Rogoff issued warnings every year since 2008; I didn't bother checking. But he reminds me of a NZ commentator who has warned about a China crisis regularly for what seems like forever.
High debt in many areas not just government debt increases the likelihood of problems (chart below for government debt and this link for insights into how global debt has been evolving).
Lower interest rates now compared to prior to the financial crisis reduces scope for central banks to respond to another crisis (chart below). And fiscal deficits reduce the scope for governments to deliver fiscal stimulus when the next crisis arise while in some countries, like Japan, the fiscal deficit is high enough to mean government debt is still increasing as a % of GDP (second chart).
China is a concern and one day it could spark a crisis. Some focus on the Eurozone as a potential spark to a crisis.
If the BOJ ever succeeds in underwriting higher GDP growth and hitting the 2% inflation target it could expose the mega debt problem; it wouldn't take much resulting upside in interest rates to be a real threat. Too many people have lost credibility predicting imminent problems in Japan; making me wary of doing the same despite Japan clearly being a "wacko" economy.
The one that binds all the global threats and could trigger the next global crisis
I believe one of the risks Roubini highlights links the most important US/global threats and is likely to be the trigger of the next crisis: Fed hikes (and hikes by central banks in general).
Low interest rates have made super-high debt levels "manageable" even in the extreme case of Japan. They have helped fuel share, housing and junk bond market booms and played an important part in fuelling the increase in debt.
Fed hikes and the US-China trade war spoked markets in late-2018; they have partly recovered this year (charts below). This is just a taste.
Since the financial crisis I've been advising clients that the global scene would muddle along, largely because central banks had one job: make sure they did. But consistent with past cycles, the Fed will go from saviour to villain. As covered in our pay-toview reports, the same will happen in NZ. The RB is in the process of making a better job of mucking up than the Fed; although it won't have the same global consequences as the Fed's misjudgement that is being sponsored by Trump.
Talk of "normalising" US interest rates is wrong; they will have to go above neutral
Before Trump threatened the Fed Chairman with sacking if he continued to hike, Powell's plan was to increase the Fed Funds Rate towards "normal" or "neutral". In short, the level that is consistent with keeping inflation low over the medium-term. No one knows what that level is with certainty. It is lower now than before the financial crisis. But it is probably above the current rate (2.375% mid-point of the 2.25-2.6% range - see the black line in the top right chart of the previous page).
The Fed's aim is too low. The unemployment rate has already fallen to a level that has boosted wage inflation above the level consistent with the Fed's inflation target (chart below). The unemployment rate is advanced or shifted into the future by 11 months reflecting it taking almost one year for it to impact on wage inflation. Trump twisting Powell's arm is part of a pro-growth policy that will result in a tighter labour market and, allowing for the roughly normal lag, even higher inflation.
It isn't a case of one hike in time saves nine but there are parallels. The more the Fed allows the unemployment rate to fall below the level consistent with low price inflation the more interest rates will ultimately have to be increased to cool the labour market. Interest rates will have to be increased above the neutral level to slow GDP growth below average; with this being needed to restore balanced bargaining power in the labour market.
The experience over the last year highlights that interest rates are a threat to global share markets. They are also a threat to junk bond markets. The chart below shows the late-2018 increase and subsequent fall in yields on junk bonds, the more significant increase and fall as a result of the escalation of the Eurozone crisis in 2015 and the huge increase following the financial crisis.
The real threat is when interest rates increase enough to be painful. Higher interest rates and lower GDP growth that will hurt corporate earnings are what will cause share and junk bond market pain. Trump's intervention has stalled fallout from rising US interest rates, but at the cost of even larger future increases; large enough to mean more than just a bit of a slowdown in GDP growth.
There are some parallels in Australia where the RBA Governor has decried low wage inflation as a bigger threat to economic growth than falling house prices. His comments seem to overlook that wage inflation is responding to the fall in the unemployment rate (chart below). The RBA has much more leeway than the Fed but is heading down the same path to an inflation problem.
In the case of NZ, as covered in our pay-to-view reports, the RB is a bit further down the path of allowing an imbalance of bargaining power in the labour market than the Fed. The problem in NZ will be made worse by the government policies aimed at directly and indirectly boosting wage inflation.
At face value NZ's labour market imbalance implies interest rates will end up increasing much more than any of the economic forecasters including the RB predict. It looks like largely being a repeat of the RB's misguided pro-growth experiment last decade that culminated in 13 OCR hikes and a recession that arrived before the start of the financial crisis in 2008. But the mistake the RB is making needs to be viewed alongside the global threat as we do in the pay-to-view reports and plan to do in seminars that will be announced next month.
In the UK Brexit fallout has overtaken "normality" for the Bank of England; but the UK unemployment rate has probably already fallen below the level consistent with keeping inflation low (chart below). The BOE was moving to "normalise" interest rates before fallout from Brexit temporarily changed the focus. But the Brexit diversion could mean the BOE allows the unemployment rate to fall further into inflationary territory, etc., etc.
