CFA Society Singapore
SINGAPORE (Apr 30): Recent weeks have seen investors becoming more nervous. Bond, equity and currency markets have turned more volatile. It appears that three sets of risks have conspired to hurt business and investor sentiment — signs of slower global growth, the ill-tempered exchanges between the US and China over trade and -geopolitical concerns.
But have the risks really escalated enough to warrant a more pessimistic view of the global environment? If one looks closely at each of the concerns above, the risks in most cases seem contained in the short term. Our view is that, first, the cyclical upswing in the global economy is not only set to continue after a temporary deceleration, but could even surprise on the upside. Second, we believe that, while there are real risks to trade in the long term, the near-term risks are less alarming as there is a strong chance that the US and China will sort out their differences. Finally, on geopolitical risks, we find that risks in Asia have actually diminished — but flashpoints in the Middle East look to be far more dangerous than many realise.
Global economy: Upside surprises still possible
Optimism about the strength of the global economic cycle has cooled recently. Purchasing manager surveys showed some loss of economic momentum across the globe. Data in the US suggests that economic growth in the first quarter was relatively subdued at 2% or just below. In Europe, there are mounting concerns that the strong recovery seen in 2017 is fading rather more quickly than expected.
We believe that slower growth in the first quarter is not the beginning of a trend in global growth. Far from that, we still believe that the year as a whole will be better than expected:
• First, lead indicators that have done a decent job predicting the world economy remain positive: The Organisation for Economic Co-operation and Development lead indicator was steady at 100.1 on Feb 18, remaining above the 2017 average of 99.9. Indicators for both developed as well as the large developing economies were positive, suggesting broad-based economic vigour is likely to return in the coming months. The components of the separate lead indicator for world trade such as container throughput and electronics demand are also flashing positively: That means that not only is global growth likely to bounce back, this growth will also generate export demand for Asia. Also, lead indicators for the technology spending that is so important for Asian exporters are pointing to further upside. It is unlikely that the Federal Reserve’s Tech Pulse Index would have jumped to its strongest level since mid-2008 in March if the global economy were really slowing.
• Second, these lead indicators are supported by the underlying forces in the global economy: The additional impetus to global growth from stepped-up fiscal spending in the US, Germany and developing countries should become more evident in the coming months. There are also continuing indications of improved capital spending — this will have strong multiplier effects and will support Asian exports of intermediate goods used to manufacture capital equipment. And, large emerging economies are indeed doing better. Reports by both the International Monetary Fund and the World Bank suggest that every major developing economy will be expanding in 2018, the first time since 2011 that we have seen such widespread strength in developing economies.
Sure enough, some of the early indicators for April such as purchasing manager surveys in the eurozone seem to suggest that the deceleration in the first quarter is beginning to taper off. Look for a pickup in global activity and trade in the coming months. In Japan, core machinery orders increased 2.4% y-o-y on Feb 18, suggesting that the overall capital expenditure plans are proceeding apace as the Japanese economy garners greater momentum.
In particular, the data for the US economy has been broadly uplifting. The Federal Reserve’s Beige Book indicated that all 12 Federal Reserve districts grew modestly or moderately in March to April 2018, while data on industrial production and real estate trends have also been strong. Capacity utilisation in manufacturing is at a post-crisis high, suggesting that companies will soon have to invest in new capacity. In fact, a substantial 58% of small businesses reported capital expenditure on March 18, while 26% are planning capital spending in the coming months. Most importantly, we have seen commercial and industrial loans gaining stronger momentum — growing at the extraordinarily vigorous pace of 9.3% in March, the fastest since the late 2016 election. The combination of rising capital spending with improved credit supply is powerful for future growth.
In short, the moderation in activity in the first quarter was probably an aberration that will be reversed. Once the global economy re-accelerates, we are likely to see monetary policies in the US tighten further while the eurozone is likely to adjust its ultra-easy policies in a tighter direction.
So, while economic activity is likely to perk up, we could well see financial market turbulence as rate hikes in the US, for instance, unsettle markets. The US Federal Reserve Bank has been edging towards a more hawkish stance of late. In the latest Fed policy meeting, some policymakers felt that the trajectory of rate hikes “would likely be slightly steeper than [they had] previously expected”, given the fiscal stimulus now underway.
Trade war risks can be contained in the short term but questions remain over the long term
Escalating tit-for-tat trade actions against each other by the US and China, the two most consequential economies in the world, caused alarm in financial markets and generated uncertainty for businesses everywhere. The US has also targeted Chinese companies such as ZTE — US high-technology companies are now banned from selling vital components to ZTE. So, there is certainly potential for things to go very wrong.
However, none of the major restrictions by either party has actually taken effect yet, giving time for negotiations to resolve disagreements. Indeed, over the last weekend, US Treasury Secretary Mnuchin said he might be visiting Beijing to talk through their differences over trade and related issues — something that the Chinese Commerce Ministry immediately welcomed.
China’s carefully crafted responses to the Trump administration’s aggressive trade moves also provide a basis for optimism. China’s leaders combined potentially swingeing restrictions on US exports to China such as sorghum with a carefully calibrated set of measures that addressed some of the complaints made by the US. The Chinese authorities have announced that foreign ownership limits on companies involved in electric vehicles, shipping and aircraft manufacturing will be removed by the end of this year, marking a material shift away from long-standing requirements that foreign investors could only have at most equal stakes with a Chinese partner to produce cars in China. Ownership restrictions will also be removed for the commercial vehicles industry by 2020 and on everything else by 2022. China has also promised stronger protection of intellectual property rights and a better environment for foreign investors operating in China, while also promising greater financial market liberalisation.
It looks like the US and China will eventually cut a deal. Neither side wants or is ready for a full-blown trade war. The US needs China’s help on North Korea, while China is intensifying a risky deleveraging of its economy during which it does not want any other economic challenges.
That does not mean, however, that we have nothing to fear from the recent spat. The fact is that there has been a fundamental change in the way the US as well as its European and Japanese allies view China. Their hopes that as China grew richer, its political system would gradually become closer to the Western model have been dashed. Moreover, the consensus view that free trade was generally a good thing is now being seriously questioned with many believing that China has unfairly benefited from the US and other Western countries opening up to Chinese exports. This big shift in attitudes creates an atmosphere in which fresh disputes will almost certainly arise and which makes it more difficult to amicably resolve such disputes when they do arise.
It is almost certain, for example, the US’ fiscal policies will add too much demand to an economy that is virtually at full employment, causing its current account deficit to balloon. When that happens, the Trump team is likely to blame China and other major exporting nations for the deficit rather than admitting that its fiscal stimulus was excessive and misplaced.
In other words, it is only a matter of time before a fresh round of trade-related recriminations leads to even more US trade actions against China.
Geopolitical risks easing in Asia but watch the Middle East
There has been a decisive improvement in tensions in the Korean peninsula. North and South Korean leaders will meet soon and there is excited talk about steps being taken towards a full peace agreement between the two countries, which are still technically at war. Preparations are being made for President Donald Trump to meet North Korean leader Kim Jong-un by early June. North Korea has surprised everyone with its willingness to discuss issues such as an end to its nuclear and missile development programme. There will be no quick end to the Korean imbroglio but, at least for now, diplomacy will dominate over confrontation in how the US and its allies approach North Korea.
Tensions have also cooled in other parts of Asia. Take the territorial disputes in the South China Sea: China and Vietnam have made some progress in recent talks, while the various claimant states have succeeded in avoiding aggravating actions in the area for several months now. In another encouraging development, China and India have agreed to a summit meeting soon, helping to ease tensions between the two Asian giants.
However, political temperatures are rising in the Middle East. The Trump administration appears determined to pull the US out of the agreement with Iran to curtail its nuclear programme. Israel is growing uneasy over Iran’s growing military presence in Syria and some analysts believe it is a matter of time before Israel attacks Iranian facilities in that country. In a region with multiple other flashpoints, such actions could well spiral into a much broader crisis.
That is not good news for Asia — oil prices would almost certainly spike up, hitting countries such as South Korea, Thailand and India particularly hard. Inflamed passions in the Middle East could also spur home-grown jihadists in Southeast Asia to step up violence in the region.
The net effect: Economic growth likely to firm but financial markets will be under pressure
In essence, there is a compelling case that fears of a global slowdown have been overstated while near-term downside to global trade from protectionism can be contained. However, as monetary policies tighten in the US and elsewhere, investors will become more sensitive to risks, leading to more financial market volatility.
In the longer term, there will probably be more tensions over trade and Asia’s exporting powerhouses are likely to take a hit. Over the next few months, however, the main threat will be an upsurge in violence in the Middle East, which would affect Asian economies through higher oil prices.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy
This article appears in the Viewpoints column of Issue 828 of The Edge Singapore.