SINGAPORE (Jan 8): The new year has started well, equity markets are up and a rash of strong economic data, across both developing as well as developed economies, has boosted the upbeat mood. None of us has a crystal ball that can tell us whether this bullish mood will last. But, what we can do is identify the significant forces and work out how they might shape the landscape over the course of the year.

What emerged from that exercise are warning signs that the good news may not last. Certainly, the cyclical outlook is much stronger than anyone had expected. But, beyond that, three key trends could cause trouble for all of us: financial market vulnerabilities, the threat to the world trade regime and the political vacuum created by the Donald Trump administration’s global strategy.

Global economy should surprise on the upside
The cyclical uplift in the global economy should continue well into 2018 as the economic data has been very strong across the board. In particular, the latest Purchasing Managers’ Index (PMI) surveys that came out in the new year recorded multi-year highs in manufacturing and services activity in diverse parts of the world. Even the long-suffering Japanese economy looks robust. Most encouragingly, the indicators that have a good record of predicting the course of economic activity — the Organisation for Economic Co-operation and Development lead indicator, overall new orders and new export orders — are all signalling continued vibrancy. Technology demand is also strong, with global sales of semiconductors soaring 21.5% y-o-y in November 2017 to their highest level ever.

In short, the stars are aligned for Asia: Not only is the global economy continuing on a trajectory of slightly-above-trend growth, more of that growth is nourishing the world trade and technology demand that power Asian exports.

There are two reasons why we challenge the prevailing consensus view that this year’s growth will taper off simply because last year’s strength produced a high base:

  • First, capital spending is emerging as an additional engine of global growth. In developed countries, it looks like pent-up demand for new plant and equipment is being released as business confidence returns. The tax reform in the US will also help give another leg-up to capital spending since it contains incentives for businesses to invest. Within developing economies, capital goods imports in Asia are gaining momentum, suggesting that an investment upcycle is taking shape in our region as well. Also, more mega projects under the banner of China’s ambitious Belt and Road Initiative will be implemented this year; and
  • Second, large emerging economies outside China, and which now account for close to 20% of world GDP, are reviving. India, for instance, which has been underperforming for the past two years, showed clear signs of reviving. There is also good news for Brazil, Russia and Turkey. 

But, good economic news could be bad news for markets
The trouble is that there is more happening than just the deluge of good economic news. There is also evidence of growing speculation in asset markets where valuations have risen significantly. The frenzy over bitcoin is one example of such speculation. Other trends are less extreme but also disturbing as they reflect possible herd behaviour. One example is the way global investors have continued to pile into emerging market sovereign bonds despite a series of downgrades signalling rising risks in that asset class. All this suggests to us that financial conditions are far too easy, encouraging speculative or careless investment behaviour that will pose risks for financial stability in the long term.

In fact, these financial imbalances mean that upside surprises to economic growth could actually pose risks to financial markets. As economic growth accelerates, labour markets will tighten and capacity utilisation will increase. That points to accelerating wages, especially in the US, as well as greater pricing power for companies after years of price restraint. In short, inflation could well surprise positively. Even if that does not happen, the asset market frenzy will tend to reinforce the concerns of the more hawkish policymakers, strengthening their case for a faster pace of monetary tightening.

As it is, the current policy stance is already causing liquidity to tighten. By some estimates, central bank buying of bonds in developed economies will turn negative by 3Q of this year. If policy tightens even faster than expected, this liquidity tightening will be worse for financial markets. In addition, as global economic activity, especially capital spending, picks up, corporate borrowing will be stepped up, diverting more liquidity out of financial assets into the real economy. That can only spell trouble for asset prices. We could get a reprise of the taper tantrums which in 2013 caused havoc in emerging markets.

Slow asphyxiation of global trade regime will intensify
The backlash against free trade has gathered more political support in the past year, and we think it can only worsen. As discussed in previous columns, the main threat to the liberal world trade regime which so hugely benefited Asia comes from the nationalist impulses of the Trump administration in the US. The evidence of this threat to world trade is now multiplying:

  • The administration’s obstructionism at the World Trade Organization risks neutering the organisation’s dispute settlement system, which protects smaller trading nations, such as those in this region, from being bullied by the larger economies;
  • The US is also taking uncompromising positions as it renegotiates trade agreements such as the North American Free Trade Agreement and its free trade agreement with South Korea. There is a rising chance that Nafta could falter;
  •  Last week, the US did not renew its commitment to the generalised system of preferences, which gives the poorest developing countries easier access to the US market; and
  • The US has also lashed out at China for its industrial and trade policies, paving the way for more trade restrictions to be levied against the latter. Under President Trump, the US will not necessarily precipitate outright trade wars; rather, the strategy seems to be to slowly suffocate some key components of the open-trade regime.
There has been some pushback by other countries that are trying to salvage globalisation and an open-trade regime in the face of such protectionist tendencies. Japan has taken the lead in trying to revive a version of the Trans-Pacific Partnership without the US. China is leading efforts to bring the much larger Regional Comprehensive Economic Partnership to fruition. The European Union has completed free trade agreements with Canada and Japan, and will step up trade engagement with Asia. In Latin America, countries favouring freer trade have banded together under the Pacific Alliance which has now secured support from several Asian countries as well.

However, these are defensive moves which can at best mitigate only some of the damage likely to be done to free trade as the US steps up trade restrictions. For Asia, this threat to free trade is the single biggest economic challenge it faces in the coming years.

Political tremors will keep us on edge, but not in areas we have been worrying about 
Geopolitics has taken centre stage in the past year. There has been much hand-wringing about North Korea’s nuclear programme and the South China Sea disputes. However, our view is that these particular flashpoints, while a worry for the longer term, are unlikely to turn critical in the near term because:

  • If one looks beyond the rhetoric over North Korea, the fact remains that no party wants to allow tensions to accelerate to breaking point, while none of them have a viable military option to advance their interests. Indeed, the thaw in relations between the two Koreas in recent days supports this view. For all the extravagant claims made by the US administration about its determination to stop North Korea’s nuclear weapons development, the hard reality is that in the end, the US will have to accept North Korea as a nuclear power and learn to deter and contain it; and
  • Similarly, in the South China Sea, having secured most of its objectives in the disputed areas, China can now afford to adopt a softer diplomatic tone that will cool tensions for now while continuing to gradually expand the quasi-military facilities it has built. Neither the US nor the Asean nations that are also claimants to the disputed areas can do a thing about this, given the disarray in US policy and the divisions within Asean.
The real danger to us lies in the political vacuum created as the US cedes its leadership position in global affairs.

There is much that can go wrong in domestic US politics. In the past few days, the controversy over the Trump election campaign’s links with Russia has been reignited. Special Counsel Robert Mueller’s investigation into this issue will start producing results in the coming months. These could be discomfiting for Trump, perhaps much worse. On current trends, the mid-term elections in November could cause Trump’s Republican party to lose control of the House of Representatives. Trump’s uncompromising implementation of a conservative agenda on taxes, social spending, environmental regulation, sensitive cultural issues and healthcare will eventually produce a backlash.

The risk is that as political pressures grow and the November mid-terms approach, Trump will double up on his nationalist, anti-trade, and anti-Muslim stance while pushing through a domestic agenda that placates his base but enrages others. As the US becomes absorbed in its own domestic difficulties, its rivals such as China and Russia will have a freer hand to push their agendas — China in East Asia, including the South China Sea, and Russia in eastern Europe and the Middle East. That can only be bad for Asia.

The second area where geopolitical tensions could hurt our part of the world is the Middle East: Ructions there can create problems for Asia via rising oil prices and collateral tremors within local Muslim communities. Already, the unexpected outbreak of violent protests in Iran has caused oil prices to rise as fears grew over potential supply disruption. Even if the domestic unrest in Iran subsides as expected, other trends in the Middle East are unsettling: Despite the defeat of the Islamic State extremists, Libya, Syria, Yemen and Iraq remain failed states marked by violence. Tensions continue between a Saudi-led alliance and its opponents, such as Iran and Qatar. The occupied Palestinian territories are seething with the kind of anger and despair that eventually causes a political explosion.

Conclusion: A year of ups and downs
The bottom line is that there will be loads of good economic news that make for a good start to the year. But, as the year progresses, more unpleasant developments are likely to make for a bumpy ride through 2018.

Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy

This article appeared in Issue 812 (Jan 8) of The Edge Singapore.

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