The global economic zeitgeist has shifted.
A decade on from the financial crisis, the world economy can at last see over the hill and make out the features of the “Promised Land” called normalisation.
There is a palpable sense that the world economy has crossed three important lines.
First, that it is finally achieving synchronised growth across the globe, from the US, to the Eurozone, to China and Japan.
Second, that it has attained escape velocity, by which I mean the commercial banking system is deemed strong enough to sustain economic recovery, as flows into global bond markets by leading central banks turn from positive to negative.
Third, that the very gradual transition from quantitative easing to tightening will be manageable, and eased as investors reduce bond allocations and move into buoyant equities.
The difficulty with this story is that it fails to capture the complete picture. Significant downside risks to the global economy remain, and could indeed be intensifying.
There are three cautionary points I’ve made before in this column: the so-called Shiller CAPE (cyclically adjusted price earnings ratio) is on a par with the record levels seen in 1929, and the dotcom boom-bust in 2000; US stock market statistics show margin debt relative to GDP is at record highs; and price-earnings ratios for tech giants such as Amazon are at mind-blowing levels.
Space forbids a detailed analysis. These indicators are not without challenge, but none of them give any real indication of timing. Indeed, my expectation is that we will see more and more froth this year, with yet more records broken, as investors move away from bonds, but are scared to go to cash for fear of looking foolish.
This is a scenario written for Donald Trump. The danger of course is that financial markets will begin to believe their own rhetoric as well.
There is a fourth factor as well to consider. Over the past decade, Chinese non financial sector private debt has increased from $6 trillion to $29 trillion – 260 per cent of GDP. This is an astonishing increase, which almost certainly doesn’t fully capture exposure in the shadow banking system either.
Prior to the financial crisis, it was countries such as Spain and Ireland that displayed equivalent explosions in debt-to-GDP ratios, and were hardest hit subsequently. Here also of course there is a counter argument. China’s current account surplus and high savings rates mean that, unlike Spain’s experience for example, it is lending to itself. But debts still need to be serviced.
I’d be very surprised if any of these four factors impacted negatively in 2018. My fear is that an even bigger global bubble could burst in 2019.
The more immediate issue at home is what to do with interest rates. The Bank of England’s conditioning path for UK interest rates foresees a further 25 basis point increase this year and next. This gentle upward path assumes that inflation won’t surprise on the upside and will return towards the two per cent target in 2018-19. This is an entirely sensible view, reinforced by the fact that broad money supply growth M4x is currently around five per cent (year-on-year) – and strongly suggestive of benign inflationary pressures.
Yet again, though, there is more to the story. Post-Brexit sterling weakness could return if EU negotiations worsen or expectations of a populist Corbyn government increase. Faster global growth could send oil prices higher, with Brent crude increasing above $70 per barrel.
And on top of all these, the Phillips curve could re-assert itself in some form over 2018-19, despite evidence to the contrary thus far. The last time UK unemployment was at current levels, inflation stood at 24 per cent.
So what’s the takeaway? The global and UK economies don’t worry me this year, but I have real concerns about both next year.