Not the end of the world

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It is never easy to determine what lies behind turmoil on financial markets, but we should at least try to understand. I think there are a couple of factors. First, the extent to which oil prices have fallen is causing various sorts of stress: investment spending in the sector is down sharply, credit risk in the sector has increased and sovereign wealth funds are dipping into their reserves, selling a variety of securities. Second, markets are now fretting over the question whether or not the US economy will fall into recession. And third, I think many market participants are wondering if policymakers have run out of ammunition should they need some.

On balance, I understand the many worries investors may have. But the outlook for the global economy does not justify the fear that seems to be haunting financial markets. This is certainly not the end of the world. Han de Jong Han de Jong Chief Economist

  • Financial markets fear the effect of the low oil price, the risk of a US recession and wonder if central banks have bullets left
  • Oil prices are too low to sustain current output
  • US recession fears are overdone
  • Central banks are not out of bullets

Oil prices are too low

Our view on oil has not changed. True, oil production is still exceeding oil use. But the cost of producing the amount of oil the world needs is higher than the current price. As a result, one should expect output to be cut at some stage and the market to rebalance. While it is clearly taking longer than we thought, the principle cannot change. And with short positions in the oil futures market at very high levels, a price reversal could occur anytime.

US has weak spots

The fear for recession in the US seems overdone to us. Sure, there is always a risk that a recession will occur. And, true, the US economy is characterised by some weak elements. The energy sector is clearly suffering from the low oil price and investment in the sector is down sharply. In fact, the industrial sector as a whole has been soft for some time, I think as a result of the appreciation of the US dollar over the last two years and weakness in world trade growth. After years of growth, US corporate profits are now under some pressure, which is clearly also a negative. In addition, the US has experienced a sustained tightening of monetary conditions during the last two years. Apart from the stronger dollar, the end of the Fed’s QE programme in the course of 2014, the December rate hike, the widening of credit spreads and the fall in the equity market are contributing to this tightening.

Recession unlikely as long as the consumer is firm

But there is one crucial factor that is clearly positive. The US consumer, who makes up two thirds of total spending, is in a comfortable position. The consumer is supported by decent employment gains, modest income improvement, low inflation and rising home prices, while households have strengthened their balance sheets in recent years, resulting in a material drop of debt ratios. It is no surprise then that consumer confidence is high.

It takes something special to push the US economy into recession. Historically, that has been aggressive monetary tightening, some sort of shock or excessive debt levels. None of these are now in play. If consumer spending does not weaken sharply, a recession is virtually impossible.

Are central banks out of bullets

Perhaps the biggest worry is that policymakers might be out of bullets. When the crisis started, the US Fed funds rate was over 5% and could be slashed. But what can be done from current levels? I think the answer is that policymakers can still do a lot. Interest rates can still be lowered and in a number of countries official rates have entered negative territory. There is clear theoretical support for that. Given the state of the economy and the low inflation rate, the ‘natural rate of interest’, which is the interest rate at which the economy is in balance and using all the resources available is probably below zero in a range of countries.

Central banks can also continue, step up or restart their asset purchase programmes. Sceptics argue that QE has not helped. I disagree. But what we must realise is that QE by the US Fed has affected many other countries. In a sense, the recovery of the US economy and the easing of imbalances there have happened at the expense of creating imbalances elsewhere as loose monetary policy was forced onto many other central banks and credit growth accelerated in many emerging economies. These imbalances need to be unwound before the world economy can cope with any sort of tightening. I think the Fed’s rate hike was premature. Fed chair Yellen’s recent testimony to Congress was disappointing, in my view. While she seemed to indicate that a March rate hike is unlikely, she did not acknowledge that US monetary policy affects the rest of the world and that the problems in emerging economies in 2015 and into 2016 have something to do with the Fed’s effective tightening since late 2013. But I think that the Fed will eventually realise this and further rate hikes will be taken off the table in due course, unless the global economy and financial markets were to stabilise soon.

The ultimate weapon against the threat of a deflationary recession and depression
At least in theory, there is an effective weapon against a deflationary recession turning into a depression. Ben Bernanke alluded to this in a speech as long ago as 2002: helicopter money. The way this may work is that government spending is increased and monetary financing used to pay for it. This is an ultimate weapon and it is certainly not going to be used any time soon. In the eurozone, monetary financing of budget deficits is actually illegal. But that is not the point. The point is that they instrument is available in theory and should be effective. Central bankers must not necessarily use this weapon, but they must convince people that they could. It is like a nuclear deterrent.

On balance, I understand the many worries investors may have. But the outlook for the global economy does not justify the fear that seems to be haunting financial markets. This is certainly not the end of the world.


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