If somebody had just descended from Mars, and seen how global markets have been roiled over the last week, they would have been excused for thinking that the world had suffered a calamitous economic or political shock. Global stock indices lost 7 per cent of their value, US stocks suffered their worst fall in six years, $4 trillion of investor wealth was wiped out in a week, and the global volatility index VIX (also known as the “fear index”) reached its most elevated levels in 2.5 years. Was China experiencing a hard landing? Was the Euro Area unravelling? Had tensions with North Korea reached a breaking point?
Of course, none of these fears underpinned the sell-off. Instead, all it took was one jobs report in the US to indicate that average hourly earnings for US workers had increased by 0.3 per cent month-on-month. This, along with revisions to previous months, meant that wages in the US had grown by 2.9 per cent year-on-year, the largest such increase since 2009. To be sure, expectations were 2.6 per cent, so all it took was a 0.3 percentage point miss. Hardly the stuff to induce global panic, one would think? So, this was panic not borne by economic weakness but, perversely, by economic strength. This in itself is mighty revealing. The unprecedented accommodation by advanced-economy central banks — even in the wake of strong economic data over the last year — and the desire of some central banks to bend over backwards to ensure they do nothing to roil markets, has expectedly led to perverse consequences and a significant mispricing of risk.
Global markets have become so complacent that nothing would spoil the party, that massive amounts of froth have built up. Furthermore, investors are so busy enjoying these self-fulfilling gains — convinced that central banks will not take away the punch-bowl even in the midst of a rollicking party — that they have progressively become sceptical of fundamental economic relationships: That diminishing slack would eventually lead to higher wages and prices, force central banks to normalise sooner, which would ultimately slow growth. In other words, markets have become so conditioned to being propped up by a ventilator (central banks) that there are concerns that when the support stopped, the patient’s lungs would not be healthy and functional, out of sheer disuse.
But to understand why one jobs report became the trigger, it’s important to understand the context. The global economy has seen a sharp and synchronised upturn over the last year. US consumption has been solid for the last few years. What changed in 2017 was the disinflationary drags from emerging-market demand and the collapse in commodities faded. Consequently, corporate profits rose, which in conjunction with healthy household demand, meant that the long-awaited corporate investment cycle finally commenced. Suddenly, the global economy had two engines of growth: Consumption and capex. The capex lift, in turn, meant that global trade relationships resumed, with emerging markets — particularly in Asia — seeing strong exports fuelled by developed-country capex demand. China’s growth consistently surprised on the upside in 2017 and Europe becoming a growth engine was no longer an oxymoron. The spill-over meant 65 per cent of emerging markets saw growth upgrades of more than one standard deviation. All this led to a positive, self-reinforcing loop with growth driving positive sentiment which eased financial conditions as equity prices surged, credit spreads narrowed and risk assets benefited which, in turn, fuelled more growth.
Given these improving fundamentals, it was understandable that equity markets surged in 2017. But if the run-up was only because of stronger growth it would have been understandable. Instead, markets began pricing in a goldilocks outcome, that despite strong growth, wages and prices would not rise commensurately, and central banks would continue normalising ever so gradually. It was this belief that that prompted both stocks and bonds to rally in tandem between March and September 2017 — something that we had worried about on these pages as early as last April (‘Boom, bust’, IE, April 19, 2017).
Beneath this cyclical lift, however, is a global economy mired in structural malaise. Powerful demographic forces continue to slow labour-force gains in developed markets, as older workers move toward retirement age. Second, productivity growth around the world has seen secular weakness after the global financial crisis and with developed-country labour markets approaching full employment productivity, growth can be expected to fade further as the quality of incremental employment gains decline. As a consequence, we believe global potential growth is a full percentage point below the actual growth witnessed over the last year.
When surging demand confronts a weak supply side, it’s inevitable that slack quickly gets eaten into. The unemployment rates in advanced economies are at their lowest levels in more than 20 years. It was inevitable that wages and prices would eventually rise, forcing central banks to tighten faster, and pull down growth towards the lower potential. But markets were unbelieving. Until recently, only two rate hikes by the US Fed were priced in 2018, despite the Fed delivering three hikes and balance sheet normalisation in 2017 and the unemployment rate falling further. It is against this backdrop that the increase in wages in January jolted the markets back to reality.
So, where to from here? Some believe the sharp fall in markets triggered automatic de-risking in algorithmic trading, which accentuated the decline. So markets may partially mean-revert as value investors come back at current levels. But the larger writing is on the wall. Despite the unemployment rate at 20-year lows, policy rates are almost 300 bps below their previous cycle highs. Even if one assumes potential growth — and therefore the neutral rate — has declined by 100 bps, central banks will stay have to raise rates substantially. We expect the Fed to hike four times this year, but markets are still only pricing 2.5 hikes. There is, therefore, another shoe waiting to drop.
What does all this imply for India? That the benign global backdrop of 2017 is likely to be replaced by much more volatility this year. With the run-up in oil prices, the current account deficit is on course to print at a six-year high. Furthermore, the fiscal slippage was uncharacteristic of this government. It’s therefore important that policymakers double-down on achieving this year’s deficit, keep a close eye on the current account, and do nothing to give the signal that macroeconomic stability will be compromised in the pursuit of higher growth. That would be the surest form of self-insurance amidst the gathering global storm.