Strategy & economics

A crisis in confidence

22/02/2016

Richard Jeffrey

Richard Jeffrey

Chief Economist

Financial markets and economic variables do not move in straight lines; they are all beset by degrees of randomness. The problem arises when volatility becomes greater than normal. The brain learns quickly to disregard low-level noise; more extreme noise is harder to ignore and can be very distressing. While I do not believe that recent volatility in financial markets is simply noise, it is questionable whether it warrants some of the more hyperbolic newspaper headlines we have read.

It is always important to look at unexpected moves in financial markets and ask a basic question: should they cause us to alter our view of the world or are they a reflection of unwarranted anxiety? On the one hand, it is all too easy for conviction to become a stubborn refusal to accept being wrong. On the other, Keynes’s famous comment, “when the facts change, I change my mind”, presupposes a degree of certainty about what constitutes a fact. So, there are fine lines between conviction and obstinacy (or complacency) and between open-mindedness and vacillation.

The post-recession environment has been characterised by much duller growth rates in the more mature industrial economies. But duller in this context means safer. In economics terms, countries are still rebalancing and a prerequisite for this process is that growth is at a sustainable rate – a rate that does not require the support of rising debt levels and that is not characterised by widening trade imbalances. By definition duller is also less exciting; moreover, it seems to have less of an in-built safety margin. When the UK was growing at rates of 3% and more, a loss of momentum did not seem particularly threatening. Growth at 2% leaves us with a distinct impression of vulnerability. Given this, it is unsurprising that when faced by something new and with possibly negative consequences, markets react nervously. 

If slower growth in the West is one key post-recession characteristic, another is over-supply amongst emerging manufacturers and commodity producers. Prior to the recession, excess demand in the West was very attractive if you happened to have an economy located somewhere along the supply chain. In effect, overheating in the industrialised world prompted other countries to start industrialising faster, and also encouraged resource producers to invest heavily in new capacity (a process that continued post-recession). 

For emerging manufacturers, the environment now is far less comfortable. They are experiencing much slower growth in demand for their exports, heightened competition and downward pricing pressure. Similarly, raw material and energy producers are also being forced to confront duller demand trends, greater competition amongst suppliers and downward pressure on prices. This situation has been exacerbated by some producers trying to maximise revenues by raising output. The consequences can be seen most obviously in the oil market, which has been further destabilised by the emergence of the US as a meaningful producer (albeit, further development there will not take place at current price levels).

This raises a key question: to what extent will developments in emerging economies have a detrimental impact on the West? While some Western countries are oil producers, the much stronger influence on Western growth from weakness in energy and commodity markets (and also from depressed manufactured goods prices) is through the demand channel. In effect, lower import prices provide a stimulus to real domestic spending – most obviously through stronger growth in household demand. Other sectors of the economy will also have benefited from declining fuel and raw material prices. For instance, heavier corporate users will have seen a reduction in input costs, potentially benefiting profit margins.

Were prevailing developments in China and other emerging economies to have an appreciably detrimental impact on the West, it might be expected to come via one of two routes. Of lesser worry would be a negative wealth effect on spending as a result of declining financial asset prices. Having said that, if weakness in financial asset markets were to lead to falling property prices, then the impact could be greater. The second route through which Western economies could be hit is via a possible constriction in credit availability. Were Western banks to find themselves undermined by heavy and rising bad debts arising in emerging markets, this could limit their ability to lend to customers in their home markets.

In this context, some UK banks do have significant exposure to emerging manufacturers in Asia (including China). However, there is currently no suggestion that problems in those countries are changing lending behaviour here. Indeed, recent credit trends indicate that the monetary environment in the UK and other Western economies is continuing to improve. 

Overall, we would expect to see slightly stronger growth in industrialised economies in 2016 than was recorded in 2015. The UK has already decelerated to an annual growth rate that is in line with that sustainable in the longer term (about 2¼%), and we expect to see momentum maintained at this pace in 2016. Likewise, we expect growth in the US economy to continue at around 2½%. On the other hand, we expect both the eurozone and Japan to accelerate modestly in 2016, from sub-standard growth rates in both areas in 2015.

This analysis does not suggest that we have nothing to worry about. However, the heightened volatility that has been experienced in equity markets over the past few months seems to us to exaggerate the risks that are currently facing Western economies. So, rather than believing that markets are warning us that something nasty is lurking just ahead of us, I would put greater weight on the observation made by Paul Samuelson, the American Nobel-Prize-winning economist: “Wall Street indexes predicted nine out of the last five recessions! And its mistakes were beauties.”

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