Interview in CNBC commenting on the challenges of miners ahead of a “lower for longer” commodity environment.
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Global slowdown or outright recession?
One of the most dangerous statements we usually hear is that “fundamentals have not changed.” They change. A lot.
If we analyze the global growth expectations of international organizations, the first thing that should concern us is the speed and intensity of downward revisions. In the US, for example, we had an expectation of growth of 3.5% revised to 2% in less than six months. If we look at the revision of the estimates for the fourth quarter of 2015 of the major economies of the world, they were downgraded by 40% in less than twenty days.
Not surprisingly, the IMF and the OECD have cut their expectations for 2016 and 2017 growth already in January. Can they be wrong? Yes, but if we look at history, they have mostly been optimistic, not cautious.
This downgrade process is not over.
China is one of the key reasons. The global economy has geared itself to justify huge investments to serve the expected Chinese growth, ignoring its fragility. China, with an overcapacity of nearly 60% and total debt already exceeding 300% of GDP, has a financial problem that will only be dealt with a large devaluation, many investors expect 40% vs the US dollar over three years, and lower growth . That landing will not be short. An excess of more than a decade is not resolved in a year. This exports deflation to the world, as China devalues and tries to export more, and when the “engine of the world” slows down because it ends an unsustainable model, we are left with the excess in global installed capacity created for that growth mirage. Commodities fall and mining and energy dependent countries suffer.
Consensus economists have overestimated the positive effects of monetary policy and expansionary fiscal measures and ignored the risks. Emergency measures have become perpetual, and the global economy, after eight years of expansionary policies shows three signs which increase fragility.
First, excess liquidity and low interest rates have led to increase total debt by more than $ 57 trillion, led by growth in public debt of 9% per annum, according to the World Bank.
Second, industrial overcapacity has been perpetuated by the refinancing of inefficient and indebted sectors. Governments do not understand the cumulative effect of this overcapacity because they always attribute it to lack of demand, not misallocation of capital. In 2008, there was a problem mainly in developed countries. With the huge expansion plans in emerging markets, overcapacity has accumulated and been transferred to two-thirds of the global economy. Brazil, China, the OPEC countries, and Southeast Asia in 2015 join the developed nations in suffering the consequences of investment in huge white elephant projects of questionable profitability “to boost GDP.”
Third, financial repression has not led to the acceleration of activity from economic agents. Currency wars and manipulation of the amount and price of currencies makes the velocity of money slow down. Because the perception of risk is higher, and solvent credit does not grow, as the average cost of capital is still greater than expected returns, causing debt repayment capacity to shrink in emerging and cyclical sectors below 2007 levels, according to Fitch and Moody’s.
Since 2008, the G7 countries have added almost $ 20 trillion of debt, with nearly seven trillion from expansion of central bank balance sheets to generate only a little over a trillion dollars of nominal GDP, increasing the total consolidated debt of the system to 440% of GDP.
A balance-sheet recession is not solved with more liquidity and incentives to borrow. And it will not be solved with large infrastructure spending and wider deficits spending, as Larry Summers requests.
Offsetting the slowdown from China and emerging markets with public spending is fiscally impossible. We have exceeded the threshold of debt saturation, when an additional unit of debt does not generate a nominal GDP increase. Global needs for infrastructure and education are about 855 billion dollars annually, according to the World Bank. All that extra expense, if carried out, does not make up for even half of the impact of China, even if we assume multipliers that are more than discredited by reality, as seen in studies by Angus Deaton and others.
China is about 16% of global GDP, its slowdown to sustainable growth cannot be compensated with white elephants. It is not pessimism, it is mathematics.
The monetary “laughing gas” only buys time and gives the illusion of growth, but ignores the imbalances it generates. Financial repression encourages reckless short-term borrowing, attacks disposable income and is accompanied by tax increases that affect consumption.
In the United States, following a monetary and fiscal expansion of over $24 trillion, the economy is growing at its slowest pace in three decades, real wages are below 2008 figures and labour force participation is at levels of 1978. Its total debt is nearly 340% of GDP. The economy´s fragility is such that the impact of an insignificant rate hike -from 0% to 0.25% – is phenomenal.
The odds of a recession in the US have tripled in six months. Although I find more plausible a scenario of poor growth, indicators of consumer and industrial activity show a clear weakening.
The capital misallocation created by excess liquidity and zero rates have led to a credit bubble in high yield that issued at the lowest rates in 38 years, masking their true ability to repay. Looking at the figure globally, maturities of corporate and sovereign bonds to 2020 are nearly $20 trillion. Up to 14% of those are considered “non performing”.
With all these elements of fragility, it is normal to assume we face an environment of low growth, but there is reason to doubt a global recession.
The Chinese problem is mostly in local currency and within its financial sector, reducing the risk of contagion to the global financial system.
Dollar reserves in emerging countries have only fallen by 2% in 2015 and remain at record levels.
Although default risks in emerging markets, mining and commodities has risen recently, the total combined fails to reach a fraction of the extent of the real estate bubble risk in 2008.
Additionally, it is unlikely that a global financial meltdown effect will happen when it did not occur in 2015, with the perfect storm of devaluations, falling commodity prices, terrorism, Greece and growing geopolitical risk.
Consumption continues to grow due to the growth in the global middle class and the effect of technology, which provides efficiency and good disinflation.
This is a slowdown from oversupply, not a credit crunch led by financial risk, and as such it puts in question the possibility a global recession. But increased consumption will not compensate for the saturation of the obsolete indebted industrial growth model.
For more than a year I have warned of a long period of weak growth, but we should not confuse it with a global recession. Repeating the mistakes of these past years will not change the landscape. It will perpetuate it.
Negative real rates do not stimulate investment. They slow lending to the real economy and encourage short-term speculation.
The exit from a balance-sheet recession is not going to come from the same mistake of increasing public spending and adding debt. It will only be solved when we recover as main policy objective to increase disposable income of households, not attacking it with financial repression.
Daniel Lacalle is an economist, author of Life In The Financial Markets and The Energy World Is Flat, CIO of Tressis Gestion and professor of Global Economics at the Instituto de Empresa, UNED and IEB.
@expansion
Video: Spanish Elections. Conservatives Win, Left Wing Coalition Risk (CNBC)
Courtesy of CNBC
Fear of a Portuguese-style “left wing” losers’ coalition seems small as PSOE (Socialists) would need to agree with up to 11 different parties. Challenges for PP (Conservatives) to reach a government agreement despite the victory.
– Conservative party wins with small majority (123 seats) despite austerity backlash, but loses absolute majority, while Socialists get worst result in Spain´s democracy history.
– Vast majority of Spanish citizens voted for moderate, centre parties (PP, PSOE and Ciudadanos)
– Neither PP+Ciudadanos nor PSOE+Podemos+Communists reach clear majority for government.
– Key to stability and growth will be to find a coalition between Conservative PP and Ciudadanos and maybe PSOE.
– Biggest risk is a coalition of populist radicals Podemos with PSOE and other radical and nationalist parties looking for constitutional changes and anti-EU measures
– If a left-wing coalition unwinds all reforms made by the PP and starts a constitutional change it could mean 0.7%-1% impact on GDP and zero job creation.
– We can expect a few months of uncertainty, affecting investment, growth potential and investor confidence.
Read my article (here)
It was difficult to think that Spain would make a comeback in 2011 when the Conservative Party (PP) won the elections. The challenges were too large.
The previous administration, PSOE, Socialist, had left a deficit of 9% of GDP after promising a maximum 7%.
When the crisis started, the socialist government consciously decided to substitute the bursting real estate bubble with a massive civil works stimulus. It spent 3.2% of GDP, debt ballooned by 350 billion euro and destroyed more than 3 million jobs. On top of it, in the period from 2007 to 2009 the average annual trade deficit was around 6% of GDP and at one point in 2008 reached 9% of GDP.
Spain was a Keynesian dream becoming a nightmare.
When the socialist government left office, Spain had more than 40 billion euro in unpaid invoices from the public administrations to the private sector, the public savings banks presented a capital requirement of 100 billion euro and the regions and municipalities faced a bailout of 125 billion euro.
It was an unsurmountable situation.
However, after a large austerity plan that was split 50% in tax increases and 50% in spending cuts, and a very substantial set of reforms, including the financial sector, labor market, entrepreneurship programs and early payment schemes, Spain recovered.
Between 2014 and 2015 Spain started to grow well above the EU average. It led job creation in the Eurozone, with more than one million jobs, and brought unemployment rates back to September 2010 levels. It went from a massive trade deficit to a balance by 2015.
In summary, Spain undertook the largest adjustment seen in an OECD economy, 15 points of GDP, and managed to do so growing and creating jobs.
Despite critics´calls of a recovery fuelled by the ECB QE and low oil prices, these claims are easily refuted as Spain is growing more than countries with a similar sensitivity to interest rates and oil prices, like Italy or Portugal, and has recovered with no increase in total (public and private) debt.
However, all is not well and many challenges remain.
– A high unemployment rate, despite the reduction and the evidence that many jobs are hidden in the underground economy and counted as unemployed.
– A large fiscal deficit. Despite the massive adjustment, Spain´s deficit is well above the EU stability pact target.
– External debt remains at 100% of GDP and public debt at 97%.
The austerity plan helped bring Spain out of the living dead, but did not create social stability. Despite the conservatives´efforts to maintain social spending, the population perceived that the cuts were unacceptable. Public debt increased to 97% of GDP partially due to the bailout of the regions and savings banks as well as taking care of unpaid bills, but increasing pensions and keeping unemployment benefits didn´t please part of the public, as real wages fell. As in Greece, fringe parties started to appear fuelled by “magic solution” promises of default, massive increases in public spend and interventionist “miracles”.
In any combination, the new government will not have a strong majority, and most of the likely agreements may only come with parties who promise more spending.
The risk of Spain falling under the QE trap, putting all the bets on the European Central Bank, as it did in 2008, and go back to the same mistakes of deficit spending and public sector white elephants to “boost growth” is not small. Halting reforms and going back to past failed measures will likely give the same results. Less growth, less jobs, more debt.
Spanish political parties tend to mention the Nordic nations and Obama as examples, yet they support the rigidity and intervention of France and Greece, not the economic freedom and flexibility of the leading economies. And when you copy France and Greece you get the growth of France and the unemployment of Greece.
Let us hope the decision is not to bet on repeating 2008.
– Daniel Lacalle is an economist, CIO of Tressis Gestion and author of Life In The Financial Markets and The Energy World Is Flat (Wiley)
Macrocosm Conference in Stamford, CT 18th Nov 2015
Proud to join some of the top investors in the world to debate about global macro issues.
