What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
Last week there was a sharp drop in equity prices in major markets around the world.1 It began in the United States on Wednesday when equity prices fell more than 3 percent in one day, with shares on the technology-heavy Nasdaq exchange falling more than 4 percent. By Thursday, prices were falling sharply in Asia and Europe, with shares down 5 percent in China and almost 4 percent in Japan. Prices in the United States continued to fall on Thursday, but at a more moderate pace. On Friday, however, prices rebounded somewhat as investors took profits. What happened? There are a number of possible explanations.
Meanwhile, there are some interesting aspects to what is happening in financial markets.
However, saying so does not make it so. Moreover, in the last month, the PBOC’s foreign currency reserves fell by US$22 billion,8 indicating that the central bank probably sold reserves in order to prevent a further decline in the value of the renminbi. Thus, it appears that there is already downward pressure on the currency. And from China’s perspective, that is not necessarily a bad thing. A modest depreciation will help to offset the impact of tariffs imposed by the United States. Indeed, Chinese exports of aluminum to the United States are soaring despite a 10 percent tariff.9 This may be due to the 7 percent drop in the value of the renminbi against the US dollar in the past year. Nonetheless, too large a depreciation would be inflationary and would inflame already fraught relations with the United States. Meanwhile, China retains capital controls meant to suppress outbound flows of capital that can cause downward pressure on the currency. The capital controls are intended to prevent a sharp drop in the renminbi.
Why does China want to be paid in renminbi rather than dollars? The answer is that China is increasingly vulnerable to the trade policy of the United States. The United States wants to reduce its trade deficit with China by limiting Chinese imports. This might work, although the overall US trade deficit will not be influenced by such policies. Meanwhile, China’s surplus with the United States is partly offset by a deficit with the rest of the world. China accumulates dollars by exporting to the United States, and then spends some of those dollars on imports from other countries, especially commodities from emerging countries. If China’s surplus with the United States falls, it will have to borrow dollars in order to pay for commodity imports. If the renminbi becomes a global trading currency, then China will no longer have this problem. It will possess what the United States already has—the “exorbitant privilege” that comes from having a widely traded currency.
Meanwhile, as the Chinese renminbi has fallen relatively sharply against the US dollar, US Treasury Secretary Mnuchin has expressed concern, suggesting that the Chinese government’s economic policy might be contributing to the decline. He also said that the value of the currency must be part of any trade discussion between the United States and China. He said, “We are going to absolutely want to make sure that as part of any trade understanding we come to that currency has to be part of that.”11 Given that governments cannot target exchange rates without giving up monetary autonomy, it is unlikely that China’s government will agree to any exchange rate mandate.
Rebecca Porter, an economist at Deloitte in London, explains the results of “Deloitte CFO Survey: 2018 Q3,” which is Deloitte’s latest survey of British chief financial officers (CFOs).12
The results of Deloitte’s latest survey of British CFOs, released today, show that mounting concern over a “no-deal” Brexit is weighing heavily on business sentiment. Brexit was rated by CFOs to be by far the biggest threat to their business over the next 12 months, ahead of weak UK demand, trade wars, and geopolitics. Their negativity about the effects of the United Kingdom’s departure from the European Union (EU) is at a higher level today than at any time since the EU referendum in 2016. They have also become more pessimistic about the long-term effect of Brexit, with 79 percent expecting it to lead to a deterioration in the business environment, up from 60 percent a year earlier.
The International Monetary Fund (IMF) warned that protectionist policies will cause a slowdown in economic growth around the world. It also said that efforts to offset this through fiscal expansion could create new risks. Regarding the impact of trade restrictions, the IMF’s World Economic Outlook said that “escalating trade tensions and the potential shift away from a multilateral, rules-based trading system are key threats to the global outlook. Since the April 2018 forecast, protectionist rhetoric has increasingly turned into action, with the United States imposing tariffs on a variety of imports, including on US$200 billion of imports from China, and trading partners undertaking or promising retaliatory and other protective measures. An intensification of trade tensions, and the associated rise in policy uncertainty, could dent business and financial market sentiment, trigger financial market volatility, and slow investment and trade.”
The IMF was particularly critical of the United States, saying that, if the United States follows through on various threatened tariffs, long-term growth will decline by 1 percentage point per year in the United States and by 0.5 percentage point globally. On the issue of government spending, the report said that “fiscal policy should aim to rebuild buffers for the next downturn. In countries at or close to full employment, with an excess current account deficit and an unsustainable fiscal position (notably the United States), public debt needs to be stabilized and eventually reduced.”13
Indeed, the United States was targeted on this issue, with the Fund calling US fiscal policy “unsustainable.” It said that pro-cyclical fiscal policies, like that of the United States, create imbalances in the global economy. Although the Fund warned against increased spending, it made an exception for Germany which it said ought to invest more in infrastructure. Germany has a budget surplus. The IMF downgraded its economic growth forecast for the global economy as well as for growth in the United States, Eurozone, UK, and Latin America.14 It upgraded forecasts for oil exporting countries such as Saudi Arabia and Russia. Other emerging markets, such as Argentina and Turkey, saw a sharp downgrade, not surprising given their recent crises. The Fund said that, although the global economy is currently growing at a healthy pace, there are increasing risks. It noted that the world is in “an environment where financial conditions could tighten suddenly and sharply.”
At the start of 2016, consumer price inflation in Mexico was running in the range of 2 to 3 percent. Then, following the dramatic drop in the value of the peso, which was related to fears about the future of North American Free Trade Agreement, inflation soared to more than 6 percent during 2017, peaking at a 17-year high of 6.8 percent. Then the central bank tightened monetary policy, the peso stabilized, and inflation fell to 4.5 percent by May of this year. Since then, however, inflation has gradually accelerated once again.
The government reports that consumer prices were up 5.0 percent in September versus a year earlier.15 This was the highest rate of inflation since March and well above the central bank’s target of 3.0 percent. The good news is that the central bank, which is responsible for fighting inflation, retains its independence and that incoming President Lopez Obrador intends to appoint a fiercely independent economist to the central bank’s board.16 This suggests that the new president wants to inspire investor confidence and avoid the kind of financial turmoil that sometimes greets the ascension of a leftist government.
The central bank left the benchmark interest rate unchanged recently, despite the fact that inflation is accelerating. The board evidently believes that, with the currency stable, there is reason to expect inflation to ultimately abate. Moreover, given the uncertainty as to whether and when the US Congress will approve the new trade deal, the central bank might have decided to wait until this issue is resolved before taking any action that might inhibit growth.
The latest employment data from the US government confirms that the economy remains strong, yet the data also indicates a slowdown in employment growth.17 The headlines last week were focused on the fact that the unemployment rate fell to the lowest level since 1969. That was based on a survey of households. Yet the establishment survey found that there were 134,000 new jobs created in September,18 far below the 270,000 new jobs growth in August and the slowest job growth in 12 months. However, the government noted that Hurricane Florence had a negative impact on employment in the leisure and hospitality industry, which lost 17,000 jobs in September after having gained 21,000 in the previous month. The report also indicated continued strong wage growth, with average hourly earnings up 2.8 percent from a year earlier. This was only slightly lower than the 2.9 percent growth seen in August, which was the strongest since 2009. Yet wage growth was only marginally higher than the rate of inflation. As such, consumers did not see a meaningful gain in purchasing power. The separate survey of households found that the unemployment rate fell from 3.9 percent in August to 3.7 percent in September,19 the lowest in almost half a century. The participation rate remained unchanged.
Investors interpreted the report as indicating continued strong job growth. Even though employment growth decelerated, it remained above the level needed to absorb new entrants into the labor force. The result was that bond yields continued their ascent and equity prices fell. The yield on the 10-year US government bond hit the highest level since 2011.20 The rise in Treasury yields could be due to either expectations of higher inflation or expectations that the expected sharp increase in the supply of government bonds will mean that the government will face more competition from a robust private sector in the market for loanable funds. Interestingly, the 10-year breakeven rate, which is an excellent proxy for inflation expectations, has been relatively flat. Thus, it appears that inflation expectations are not yet changing. At the same time, the yield on Treasury Inflation Protected Securities (TIPS) has increased considerably. The principal on TIPS moves in line with inflation. Consequently, the yield is an after-inflation, or real, yield that reflects expected supply and demand conditions in the bond market. If investors expect businesses to borrow more in competition with a government that is already borrowing with abandon, then they will likely bid up yields. That appears to be what is happening. Yet if investors got this idea from the latest job market figures, they may be missing the bigger picture. After all, the US government reports that new orders for non-defense, non-aircraft capital goods actually declined in August.21 That probably bodes poorly for growth of business investment. In addition, new orders for computers and for information technology declined as well, suggesting weak growth of industrial output.
Meanwhile, US equity prices plummeted as bond yields rose.22 Equity investors are likely recalculating valuations based on an expectation that the present value of future profit streams will be lower due to a higher interest rate at which such future profits are discounted. Also, many investors might expect that Federal Reserve tightening will have a negative impact on profitability.
What does all of this mean for Federal Reserve policy? The Fed is already on a path of boosting short-term interest rates in order to avert a sharp increase in inflation. If new data suggests that the economy is stronger and likely to face more bottlenecks, it could lead the Fed to tighten faster. If investors are confident that the Fed will be successful in holding down inflation, then bond yields will not rise very sharply. In that case, we could wind up with an inversion of the yield curve in which case short term rates exceed long term rates. When that happens, banks have less incentive to lend money. At the same time, Fed Chairman Powell recently said that he sees no evidence that the tight labor market is fueling inflation risk.23 In a speech, he said, “Removing accommodation too quickly could needlessly foreshorten the expansion.”24 Thus, it is possible that the Fed will be cautious about raising interest rates.
The price of oil has hit the highest level since 2014, with Brent crude rising above $80 per barrel. Some analysts are now talking about oil hitting $100 in the near future. The rise in the price reflects the decision by Saudi Arabia and others to not boost production as previously expected. It also reflects a sizable drop in Iranian production following the re-imposition of US sanctions. Reports suggest that Iranian exports are down by about a third since June.25 However, there remain reasons to believe that the current surge in prices will be only temporary and that there could soon be downward pressure on oil prices. Here is why:
In Italy, the yield on the 10-year government bond has reached a level not seen since 2014.27 This is due to investor concern about Italy’s plans to run a budget deficit larger than the European Union (EU) would prefer. Indeed, EU officials have expressed concern, especially given that the leaders of the two main coalition parties say that they intend to stick by their fiscal plans. The government plans to run a budget deficit of 2.4 percent of gross domestic product (GDP) next year. This is based on a forecast of 1.6 percent economic growth, considerably more than the 1.0 percent growth recently seen or the 1.1 percent forecast of the European Commission.
Thus, many analysts are concerned that the expansive spending plans of the government will actually lead to a deficit in excess of the EU’s cap of 3.0 percent of GDP. Italy’s constitution requires a balanced budget and the president has the power to reject a budget proposed by the government. However, if the current president, Sergio Mattarella, rejects the budget, it could provoke a constitutional crisis. Mattarella has criticized the government’s spending plans. Another possibility is that the European Commission could reject Italy’s budget—something that has never happened before. Such action could lead to the EU imposing sanctions on Italy for violating fiscal rules. Yet politically this would be troubling, especially given that the EU did not sanction Germany or France when their budget deficits previously exceeded the cap.
However, that was in the context of a weak economy. Italy’s fiscal policy comes at a time of economic strength in Europe. This is when governments are meant to be fiscally responsible. Many investors worry that conflict between the EU and Italy could lead to a crisis similar to what transpired several years ago with Greece, at which time Greece just barely avoided default. Still, it is worth keeping in mind that, at 3.4 percent, the yield on Italy’s 10-year bond remains far below the peak of 7.5 percent reached in Italy during the Greek debt crisis in 2012.28
Chinese direct investment in the United States has plummeted. According to data from Mergermarket, Chinese outbound investment in the United States fell 92 percent in the first nine months of 2018 from its peak two years earlier, and fell 55 percent from a year earlier.29 Why was there such a large decline? There are several possible explanations.
Meanwhile, inbound direct investment in China has fallen as well in recent months.30 This reflects the fact that much inbound investment is related to building export capacity. In any event, while outbound investment in the United States has fallen sharply, outbound investment in Canada has risen sharply, Chinese investment in Canada’s key energy sector was up six-fold in the first nine months of 2018 versus a year earlier.
The managing director of the International Monetary Fund (IMF), Christine Lagarde, says that “there has to be a fresh look at Abenomics,”31 the economic policy of Japanese Prime Minister Abe. The policy was meant to entail fiscal and monetary stimulus as well as structural reforms, such as market liberalization and new free trade agreements. Yet the reality is that, for the most part, Abenomics has mainly entailed an expansionary monetary policy, which has suppressed the yen and boosted inflation.
Moreover, on fiscal policy the government is now committed to raising the national sales tax in 2019 after having twice postponed an increase. Lagarde, however, worries that this will cause a recession (which is what happened the last time the tax was increased). She said, “We believe that the fiscal stance should remain neutral, at least for the next two years.” Prime Minister Abe says he intends to go ahead with the tax increase. Lagarde says that, at the least, this should be offset by a temporary increase in spending. The tax increase is widely seen as necessary in order to preserve the solvency of the nation’s pension system at a time when the population is rapidly aging. Lagarde agrees that, in the long run, the tax must be increased. The IMF has also called on Japan to increase the availability of childcare in order to encourage more women to enter the labor force. This would help to boost the ratio of workers to retirees.
Many analysts criticized the RBI, saying that the decision will make it harder to act decisively later. Yet RBI Governor Urji Patel said, “We are not bound to increase rates at every meeting. That is not required given our inflation outlook and forecasts at this point in time.” He noted that the RBI had increased rates at its last two meetings, the first time this had happened since 2014. Patel also said that the 15 percent drop in the value of the rupee over the past year was relatively “moderate” compared to some other currencies. He noted, “There is no target or band around any particular level of exchange rate, which is determined by market forces.” It appears that Patel is more concerned with maintaining strong growth than with stabilizing the value of the currency. The problem is that, if investors push the rupee down further, it will exacerbate inflation and boost the cost of imports such as oil. In fact, the government lately imposed tariffs on “nonessential” imports in order to suppress imports. At the same time, a weak currency will likely be helpful for export competitiveness.
If US President Trump were to announce that he intends to raise taxes by about US$80 billion in 2019, there would likely be loud protest, especially from his own party. But that is precisely what he is doing. Referring to China, Trump has said, “We’ve taxed them US$50 billion—that’s on technology. Now, we’ve added another US$200 billion.”37 However, the United States is not actually taxing China. Rather, the US government is taxing its own people. When a US retailer buys a wireless modem from a Chinese company to sell in the United States, the imposition of new tariffs means that it will now pay a tax to the US government on that product. It can choose to raise the prices it charges consumers, or it can take a hit to its profit margin. Either way, it is a tax increase. The United States has already imposed a 25 percent tariff on US$50 billion in imports from China. It added a 10 percent tariff on US$200 billion on September 24, which will automatically rise to 25 percent in January 1 in the absence a new trade agreement.38
In addition, the US administration has taxed imports of aluminum, steel, washing machines, and lumber. The government will collect about US$80 billion from these tariffs, or about 0.4 percent of gross domestic product (GDP). This will likely reduce economic activity from what would otherwise be the case. It can be argued that, because of last year’s tax cut, the economy is likely to grow strongly next year, in which case the negative impact of the tariffs will not be notable. However, if the economy slows in 2020, as many expect, the tariffs could make the difference between modest growth and no growth at all. But that is not all. China has retaliated, imposing tariffs on US$110 billion in imports from the United States, thus likely having a negative impact on the US export growth. In addition, the administration says that it may tax another US$267 billion in imports from China, and it may tax all automotive imports.
Also, there is anecdotal evidence that businesses are potentially delaying major investment plans until there is greater clarity about future trading rules. Indeed, findings of a survey of CEOs by the Business Roundtable in the United States revealed that the new tariffs on China will have a moderately or significantly negative impact on business investment spending in the coming six months.39 In addition, Federal Reserve Chairman Powell has said that the Fed’s discussions with business leaders also indicate that many investment projects are being put on hold. Thus, it is easy to see how the current trade war could significantly harm US economic growth, not to mention growth in China and elsewhere.
Meanwhile, China’s government announced that it will cut tariffs on non-US imports.40 The goal is to relieve Chinese businesses from the higher prices that will come about as a result of new retaliatory tariffs on US imports. This action will partially immunize China’s economy from the trade war. It is also a way to enhance trade liberalization with the rest of the world at a time when the United States appears to be turning inward. Still, the net effect will be relatively modest. The average tariff level for China will, as a result of this action, fall from 9.8 percent to 7.5 percent. The biggest drop in tariffs will apply to machinery, thereby enhancing the ability of Chinese manufacturers to remain globally competitive.
The eleventh hour deal came about after the United States and Mexico agreed on a bilateral deal and encouraged Canada to join.42 Canada resisted some of the provisions, and the final deal involved a compromise in which the United States agreed to retain a dispute resolution process while Canada agreed to open its dairy market to competition. The deal ends the uncertainty about the future of North American trade and, consequently, was greeted with a degree of euphoria, or perhaps relief, by financial markets. However, the deal involves more managed trade rather than free trade. It will likely lead to higher prices of automobiles sold in North America, thereby having a negative impact on overall consumer spending.
On September 27, the US Federal Reserve boosted the short-term benchmark interest rate, the federal funds rate, by 25 basis points. The move was not unexpected and is part of what likely to be a steady pattern of rising short-term interest rates. The Fed is acting in order to avert a sharp rise in inflation. Notably, the Fed’s comments no longer used the world “accommodative” to describe policy. At the same time, Chairman Powell suggested that economic conditions are relatively benign, saying, “Our economy is strong, growth is running at a healthy clip, unemployment is low, the number of people working is rising steadily, and wages are up. Inflation is low and stable. All of these are very good signs.”45 So why raise interest rates further? The answer is that there are reasons to expect inflation to accelerate. These include a tightening labor market with rising wages, evidence of bottlenecks in the economy, excessive credit growth, and a fiscal policy that promises to stimulate an already overheated economy. In the absence of a tightening of monetary policy, inflation could become a problem.
The People’s Bank of China, China’s central bank, left interest rates unchanged after the US Federal Reserve raised rates.46 Thus, the gap between US and Chinese rates is increasing. This is likely to stimulate an increase in capital flows from China to the United States, thereby putting downward pressure on the renminbi, all other things being equal. But all other things are not entirely equal. That is, China retains capital controls that reduce investors’ ability to shift funds from China to the rest of the world. Thus, it can prevent a sharp drop in the currency without raising interest rates. China’s authorities have lately eased monetary policy in order to maintain steady growth amidst the threat of a worsening trade war. Thus, it is clear that China is reluctant to take actions meant to stabilize the currency if that means slowing the economy. Of course, a further drop in the value of the renminbi would likely exacerbate tensions with the United States. Plus, an easy monetary policy risks exacerbating the problem of excessive debt.
Regarding debt, much has been written about the sharp rise in debt owed by state-owned companies, local governments, and property developers—debt that is seen as a threat to financial stability. Yet it appears that household debt has risen sharply as well. A report estimates that household debt is now 49.1 percent of GDP, up almost 20 percentage points in the last five years.47 In a country famous for its frugal consumers, this is notable. By contrast, the figure for the United States is about 80 percent. The increase in China was due to both a surge in mortgage debt as well as a surge in non-mortgage consumer debt. The latter was fueled by a sharp rise in online shopping, much of which takes place through credit cards. Despite the rise in debt, consumer spending remains relatively low as a share of GDP, at 39.1 percent compared to nearly 70 percent in the United States and 55 percent in Europe. However, the Chinese figure has risen over the last few years as consumer spending has played a dominant role in driving economic growth. If household debt becomes too onerous, it could stymie further growth in consumer spending.
In the 19-member eurozone, headline inflation remains relatively elevated, but largely due to the lagged effect of the surge in oil prices during the past year. Underlying inflation, however, appears to be decelerating. Here are the details: According to the European Union (EU), consumer prices were up 2.1 percent in September versus a year earlier, slightly higher than in August and the same as in July.48 Overall inflation has not been in this range since early 2012, and the current surge is largely due to oil prices, which were up 9.5 percent in September versus a year earlier. When volatile food and energy prices are excluded, however, core prices were up only 0.9 percent in September versus a year earlier. This is the lowest level since June. This means that the continued aggressive monetary policy of the European Central Bank (ECB) does not yet appear to be causing a boost to underlying inflation.
The policy is, however, having a positive impact on credit creation. The ECB reports that, in August, bank loans to households were up 3.1 percent from a year earlier, the biggest increase since February 2009. Loans to non-financial corporations were up 4.2 percent, also the highest in more than a decade.49 For a long time, easy monetary policy failed to translate into strong credit growth. That was mainly due to the continued troubled balance sheets of many banks.
While those problems have not completely disappeared, the latest data suggest that the problem could be abating. This means that monetary policy is likely having a more positive impact on the economy than at any time since the global financial crisis nearly a decade ago. It also means that the ECB decision to wind down asset purchases makes sense. Such purchases were meant, in part, to circumvent the banking system in order to boost liquidity because the banks were not responding to traditional monetary policy. That has now changed. The ECB still intends to retain very low interest rates as long as underlying inflation remains below the ECB’s target of 2.0 percent. The low inflation reflects continued high unemployment in many eurozone countries.
The strong Japanese economy has generated a tight labor market. In August, the unemployment rate was 2.4 percent, roughly in line with the experience of the past year, and in a range that has not been seen since the 1990s. In addition, the job-openings-to-applicant ratio remained at 1.63 for the second month, the highest ratio since early-1974.50 Moreover, the tightness of the labor market has generated an acceleration in wages due to a shortage of labor. That shortage has led many women to enter the labor market. In fact, the government reports that the share of working age women participating in the labor force has reached an historic high of 70 percent—higher than in the United States. This is up from 61 percent as recently as 2013. The share of both men and women participating in the labor force also reached a record high of 77 percent.