The global economy has been slowing for some time. The question is whether we are heading for a soft landing or something worse.
Financial markets last week raised the odds on ‘something worse’. Investors sold riskier assets, including equities, for safe havens such as gold and government bonds. Markets were reacting to alarm signals from two of the world’s most important economic indicators.
First, the yield curve, a gauge of future growth prospects, inverted last week in the US and in the UK. The yield curve measures the gap between the interest rate, or yield, on ten-year government bonds and shorter-maturity debt. Central banks largely set short-term interest rates while long-term yields are driven by market expectations for growth and inflation. When ten-year rates fall below three-month rates, as they have done in the US and the UK, the curve inverts signalling that short rates are too high and growth prospects are weakening. The fact that each of the last seven US recessions were preceded by an inverted curve explains why the equity market took fright last week to the inversion of the yield curve.
The second worry relates to the devaluation of the Chinese renminbi. What started last year as a trade conflict between the US and China over exports of metals has widened, taking in consumer goods and technology. Earlier this month a new front in that conflict opened with the renminbi falling through the symbolic threshold of seven yuan to the dollar for the first time since the financial crisis. The US interpreted the fall as an attempt by the Chinese authorities to gain unfair export advantage, prompting the US Treasury to name China as a currency manipulator. Markets worry that the trade war could be morphing into a currency war. That conjures up the spectre of the competitive devaluations which accompanied, and reinforced, the Great Depression of the 1930s.
A run of weak economic data has added to market anxieties. GDP growth in Germany and the UK unexpectedly contracted in the second quarter of the year, prompting talk of recession. Chinese industrial activity has slowed markedly, to the lowest level in 17 years. Growth in global export volumes has almost ground to a halt. The risks of recession are creeping up.
The New York Federal Reserve’s model, based on the slope of the yield curve in July, put the risk of a US recession in the next 12 months at 32%, the highest level since the financial crisis. This may understate the dangers. The US curve has become more inverted in recent weeks so the current recession probability is probably higher. And given that the average gap between yield curve inversion and the onset of a US recession is 18 months the real risks are likely to lie in late 2020 and 2021, not over the next 12 months.
Central banks are alive to the risks. Markets assume that the Federal Reserve and the European Central Bank will ease monetary policy over the coming months to try to bolster growth.
There’s more talk too of governments increasing spending to support growth. Borrowing costs for governments are at ultra-low levels and a quarter of all government bonds are offering a negative yield. We are in a remarkable situation where investors will pay many governments, including Germany’s, to lend them money. Low productivity and inadequate public infrastructure add to the case for debt-financed public investment. Further economic weakness would add to the pressure for governments to ease fiscal policy.
It’s not all bad news. The absence of many of the usual harbingers of recession – weakening labour markets, tighter credit conditions and financial stress – means that most forecasters think the West will avoid recession. The general view among forecasters is that growth will continue at more subdued rates.
Much will depend on the actions of central banks and governments. In the euro crisis the president of the European Central Bank, Mario Draghi, vowed to “do whatever it takes” to arrest the downturn. This reassured markets and the ECB’s subsequent actions saved the day, preserving the euro area and boosting growth. Today it’s not so much a question of whether central banks have the necessary will – and more a question of whether, with interest rates at such very low levels, monetary policy still has the power to reboot growth.