The global economy seems to be fragmenting. While the US continues to look anything but stagnant, incoming data suggest that growth in the rest of the world economy, Europe in particular, is much more pedestrian relative to expectations. Many commentators are convinced that the rest of the world will drag the US back into the mire – “we’re all doomed,” while others see the US as resilient, but the rest of the world in trouble – “most of us are doomed.”
We think both of these scenarios understate the importance of the US and the US consumer to the world economy. The statistics admittedly tell us that growth in global trade has slowed in the wake of the great financial crisis; however, it has still been growing. Because of the impossibly complex interweaving trade flows, it becomes very difficult to make pat statements about who will benefit when and how. However, the US remains the world’s largest and most important capitalist economy by a distance – its consumer is the single biggest marketplace for global plc. The US economy, with well over two-thirds based on consumption, is both reasonably well-insulated from problems overseas and also incapable of feeding this beast on its own.
That does not of course mean that the US is either immune from crises born overseas or that the rest of the world can’t suffer while the US prospers; it only means that a strong US recovery makes it easier to be sanguine about some of the risks in the rest of the world economy. The strong demand pull of the US consumer can help smooth over a lot of the economic cracks appearing elsewhere in the world.
Data and third-quarter corporate earnings reports out over the last few weeks in the US have delivered repeated rebuffs to the latest slogan of some of the world’s most highly regarded dismal scientists. This week it was the turn of the ISM manufacturing and non-manufacturing surveys. It is the former that has the longer track record as a reliable cyclical lead indicator, but both sit at elevated levels relative to trend, with the new orders components telling us that better times lie ahead. If the current levels are sustained through the fourth quarter, the subdued consensus on GDP will have to be revised dramatically higher, much as was the case with third-quarter GDP. A perkier corporate investment picture, notably absent for much of the recovery, finally seems to be materialising.
As already noted, this is not just good news for the US, but also the world economy. We have pointed to the high level of explanatory power the ISM Manufacturing survey has with regards to the level of both US and Global GDP on several occasions, and its importance as an indicator for equity markets.
Inflation, or the lack of it, is helping to fuel the idea of secular stagnation and is one of the subjects dominating the investment debate at the moment. It is a notoriously tricky subject to convincingly nail down. The forces that pull or push aggregate prices up and down are fluid, and measurement is often more art than science. As a result, commentary on the subject, particularly the monthly fluctuations in the data, can be confusing and contradictory. Take a step back, however, and the picture becomes less cluttered. No matter what items feature in the statistical basket of goods – painstakingly designed and constantly updated to keep pace with our ever-changing tastes – the final determinants of where prices move tend to be grouped into two categories – “demand pull” and “cost push”. The former is more commonly characterised as ‘too much money chasing too few goods’ and can arise from excess liquidity – if central bank quantitative easing had leaked more visibly into the high street through demand for credit, for example. A fuller employment picture could have similar side effects. On the other side, “cost push” inflation tends to arise from supply shortages, of labour or commodities.
The two types of inflation do not have to be as distinct as the text books tell us. In the US and UK at the moment, unemployment has fallen close to levels suggested by economists and central bankers as normal. Most of the people looking for work are managing to find it, but at the same time, the number of job openings is increasing. Somewhat simplistically, this suggests that employers will soon have to offer more attractive rewards if they want to continue luring skilled workers. There are demographic trends that have important influences on such trends at the aggregate economic level, for sure. In the UK, a surge in labour supply, a function of labour market reform policies, has no doubt helped keep a lid on wage inflation, for example. Alongside this, the bargaining power of labour forces in the UK and US has been on a downward trend since the Thatcher and Reagan years. However, incoming employment data tell us that labour is getting scarcer in these two economies, and as the labour market gets more confident on the prospects of both getting employed and conversely not getting made redundant, demand for credit will likely continue to unevenly increase.
This is important, because while the inflation picture remains so visibly benign, neither the bond market nor the central bankers are going to feel much pressure to change their tune, no matter how strong the ISM survey. For many investors, particularly those still seeing good value in bond markets, deflation still presents the more plausible threat. To cite just two items high on investors’ checklist, we have the euro zone, where growth and inflation forecasts continue to fall, and a Chinese economy still seemingly teetering on the edge of a deflationary housing bust, but the absence of more visible real wage growth to date is probably at the top of that list.
As noted above, we suspect that a livelier wage inflation picture may only be just around the corner in the US and UK. In both economies, this will likely coincide with an effective tax cut from falling gas/petrol prices and unevenly improving access to credit. The prospects for consumption growth therefore look strong, and we still suspect the benefits will not be limited to just the US and the UK. As already noted, it remains very difficult to plot exactly when and where this burgeoning economic warmth will be felt by the rest of the world – supply chains are just too intricate. However, we still cannot find sufficient reasons to bet against this happening. Europe’s problems will not be solved any time soon – they can’t be. Resolution requires more integration and structural reform of the peripheral – and French – economies. This will take years: nobody is in charge and voters are in no hurry.
However, the ECB can continue to provide a backstop, while a more plausible fiscal and political architecture is painstakingly constructed. Meanwhile, further evidence of thawing domestic credit markets, some important reform momentum in Italy and to date, acceptable Q3 European corporate earnings should help investors forgive some of the patchier economic data in the near term. For China, we still believe that the authorities have sufficient will and means to avert economic catastrophe. An increasingly vibrant US economy and consumer will be vital in helping these two regions continue to muddle through.
In our view, the next bout of volatility will likely come from bond yields going the other way – up – as evidence of a more pronounced wage inflation picture becomes increasingly apparent in the US and UK, dragging central bankers and bond markets into action. In the first instance, this may manifest itself in a reduction in risk appetite hitting equity markets, both developed and emerging, and some of the riskier areas of the credit complex hardest.
However, while we expect equities to bounce back from any weakness relatively rapidly as growth continues, the likely weakness in much of the fixed income space could endure for longer.
How we treat this expected volatility in risk assets will not only be a matter of deciding whether the world can digest a higher US cost of capital but also whether the US’s strength will eventually spread to the rest of the world. Are the simmering domestic issues in Europe and Asia too great for US consumer demand to overcome? As noted above, our suspicion remains that the economic warmth will spread from the US to the rest of the world over coming quarters in varying lags and that the US and UK have long been ready for an exit from monetary A&E. This in turn suggests that diversified portfolios should still be tilted to take advantage of continuing global growth.