The Chief Economist’s Note

There’s a growing tension at the heart of global markets

The attention of markets remains fixed on the economic fallout from the coronavirus in China and beyond. This is understandable. The spread of the virus – or more accurately, the effort to contain it – poses the biggest near-term threat to global growth.

We have launched a new page on our website to track the spread of the virus and its impact on China’s economy. The headline figures are stark. Passenger volumes in China have fallen by more than 50% on the same period last year and provinces accounting for around two-thirds of the economy were effectively shut last week following the Lunar New Year holiday.

We’ve cut our forecast for first quarter growth in China from 5% y/y to 3% y/y (on our CAP measure). The inherent uncertainty surrounding the spread of the virus makes it virtually impossible to quantify the wider impact on the world economy. But China’s role at the centre of global supply chains increases the likelihood that the disruption spreads to other countries. Economies in Emerging Asia look most vulnerable, as do firms operating in both the tech and electronics sectors.

For now, the assumption baked into markets seems to be that there will be a significant but temporary disruption to activity. Equities fell sharply as news of the virus broke but have since bounced. The recovery in risky assets has been helped by a fall in bond yields.

It may be that this assumption proves to be wrong and there is a longer-lasting impact on growth. (As our Chief Asia Economist, Mark Williams, has noted, the key thing to watch for is whether factory shutdowns result in workers being laid off.) But even if it’s ultimately right, the market response highlights deeper vulnerabilities that will have implications for the outlook well beyond the next couple of quarters.

The story that has played out over the last week or so is now familiar: the global economy experiences a growth shock, risky assets sell off, investors anticipate that central banks will respond by loosening policy, market interest rates and bond yields fall, and this helps to put a floor under risky assets.

This response feeds a narrative that “markets are hooked on cheap money”. But it makes sense if you believe, as we do, that the world over the next couple of years will be one of low but positive growth, extremely low rates of inflation and continued low interest rates. In this environment, there is scope for a continued rise in asset prices supported by lower equilibrium interest rates.

But this carries risks. The first is that interest rates rise unexpectedly which undermines asset valuations. The second is that interest rates don’t rise but that a hunt for yield in an environment of low returns causes bubbles to inflate in some corners of the market.

Viewed this way, we’re walking a tightrope between interest rates remaining low enough to support current asset valuations and economic growth on the one hand, and markets being able to allocate capital efficiently in a world of continued low rates on the other. The longer it goes on, the more difficult the balancing act will become.

There are two reasons why interest rates might rise. A benign scenario is that productivity growth starts to pick up, causing equilibrium interest rates to rise. This would be bad for bonds, but may be good for most other asset prices and, of course, economic growth. (I discussed this in a note a few weeks ago.)

An altogether more malign scenario, however, is that fears that a pick-up in inflation will force a policy response from central banks cause real interest rates to rise. This would have echoes of the early 1980s, when the Fed tightened policy to squeeze inflation out of the system but at the cost of a recession between July 1981 and November 1982 and – initially at least – a sharp fall in all asset prices.

Neither scenario in which interest rates might rise is inconceivable, but nor do they look particularly likely to materialise over the next few years.

The bigger risk therefore is perhaps the second one – that an extended period of low interest rates justifies a further melt-up in asset prices in the near-term but at the risk of inflating bubbles in some pockets of the market that then burst, plunging economies into recession. This would have echoes of more recent downturns in the early 2000s and in 2008.

Where should we look for signs of excess? On balance, we would argue the current risks are still moderate rather than extreme. But corporate credit spreads are now close to the lows reached before the 2008 financial crisis and look excessively tight given the backdrop of falling credit quality in the corporate bond and leveraged loan markets. We are also concerned about excessive leverage in the Chinese property market (which, incidentally, could be exposed by the economic disruption caused by the coronavirus). And, while the outcome of the presidential election in the US this November is unlikely to have a significant direct bearing on the economic outlook, a victory for either Bernie Sanders or Elizabeth Warren could trigger a sharp fall in the stock market. Equally, a victory for Trump would allow him to install a more dovish Fed Chair from 2022, thus exacerbating the risk that loose policy eventually inflates bubbles. If problems do emerge over the next year or so, these are the places to look.

So where does this leave us? The fallout from the coronavirus remains the biggest challenge facing the global economy over coming months and, as things stand, it is unclear how events will play out. But the market response to the virus reveals a deeper vulnerability at the heart of the global economy. The current goldilocks environment of low but positive growth and low interest rates justifies the high valuation of asset prices. But the longer it continues, the greater the risk that it sows the seeds of the next major economic downturn.

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