Q3 Outlook: The global fiscal panic
Chief Investment Officer
Summary: Central banks’ response to the looming economic slowdown and trade war has been panic cutting of interest rates and signalling of new extremes of easing, while politicians are warming to the idea of Modern Monetary Theory.
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Central banks’ response to the looming economic slowdown and trade war has been panic cutting of interest rates and signalling of new extremes of easing, while politicians are warming to the idea of Modern Monetary Theory. Our model indicates that the low point in the economic cycles lies in the third quarter for China, and in the first to second quarter for the US, UK and Europe. Furthermore, we could be headed for a massive repeat of the 1970s global supply shock.
Looking ahead to the rest of 2019, central banks are concerned about inflation, the voters about the environment and inequality, and business about the global supply disruption caused by the trade war, which some might call a war for technological supremacy.
The central banks’ policy response has been the predictable panic cutting of interest rates and guiding policy to new extremes of easing, while politicians are warming to the idea of Modern Monetary Theory as an intellectual backdrop to the fiscal expansion they will initiate as global growth falters further. Meanwhile, companies globally are scrambling to make sense of the trade war, Brexit and the disintermediation of a multilateral system in a world where environmental costs are about to explode, driven by consumer concerns and a wave of Green politicians getting into the political driving seats.
What does that mean for us investors?
We, Saxo’s strategy team, have learned through trial and error that the best way to forecast involves anticipating policy responses and to combine them with an analysis of the credit impulse.
The credit impulse – the growth or contraction of credit supply into the economy – explains economic activity nine months forward with an “r2” of .60; or, in layman’s terms, 60% of the economic activity nine months in the future is given already now. The credit impulses globally continue to indicate that the economic low point is ahead of us, not behind us. Our model indicates that it lies in the third quarter for China, and in the first to second quarter for the US, UK and Europe.
The lower policy rates will not help, as we have pointed out several times using our Four Horsemen theme. The price of money is only a derivative of the quantity of money. And currently, the change in the quantity of money, explained via the credit impulse, remains sluggish, which means that the current central bank effort to change the price of money will only create a short-term sugar high. The analogy we use is that the size of the credit cake is unchanged to smaller, while a piece of cake will now get a bit cheaper. This, of course, leaves only a marginal transmission to the real economy.
And once the central banks burn through the last bits of available policy headroom, policymakers will look for further policy initiatives as the rate cutting and restarting of quantitative easing will not be enough. We believe the next logical step will be a massive increase in fiscal spending as national budget talks get under way in October-November. This fiscal expansion will be aimed at infrastructure, environment and inequality.
Some countries, especially Germany, the US and Latin America, are in desperate need of infrastructure improvement. The McKinsey Global Institute’s Bridging Global Infrastructure Gaps report says that the world needs to spend 3.8% of GDP annually, or an average of $3.3 trillion a year. Emerging markets (the high-growth countries) account for 60% of that need. Right now, they estimate we are 11% short of that, or $350 billion per year. This is not including additional investment required to meet the UN Sustainable Development Goals.
A global push to expand fiscal spending and run larger budget deficits, while global interest rates are set at zero or below, while the globalisation benefit on inflation is structurally disappearing due to trade tensions and general globalisation fatigue, sets up a scenario reminiscent of the 1970s: Big government, trade troubles (back then the US vs. Japan), supply constraints (the Opec crisis), changing market models (the shift away from the gold standard), inflation, the opening of the US-China relationship, and — who knows? — maybe even bad hair. This may seem an outrageous prediction, but the structural forces keeping inflation low have disappeared.Austere fiscal policy (excluding the US) globally has had a negative impact on inflation expectations; the rock-bottom interest-rate policy is per definition anti-inflationary as it reduces the velocity of money, and globalisation was also deflationary.
Remember globalisation worked to reduce prices as China and emerging-market countries started producing goods with their cheaper labour forces. This made all products cheaper, which benefitted consumers, and that in turn reduced saving, which increased deficits, which reduced growth and that way circled back to even lower rates and inflation.
Today globalisation has reached its maximum, even without the trade spat. China produces everything, so the “making things cheaper” process has run out of room. Add to that the potential trade war and massive focus on the environmental impact of all facets of consumption, from plastics to packaging, airline and sea transport pollution, and, with central banks wrongly focused on excessively low inflation, you get a perfect storm brewing that will turn the tide back toward inflationary outcomes. From anti-globalisation, higher unit cost of production due to environmental considerations, a fiscal push into infrastructure and shoring up injured global supply chains — all that creates a massive repeat of the 1970s global supply shock.
The shock this time will come sometime after the global fiscal expansion set to arrive in the third and fourth quarter. In this situation, the markets that stand to benefit the most will be commodities and real resources, infrastructure plays, wages and gold.
By the summer of 2020 – one year from now – we will have seen the end of any belief in monetary policy moving the needle, and will be witnessing extravagant spending driving inflation to levels beyond anyone’s expectations, just a couple of quarters after inflation, once again, has been pronounced dead.