King dollar and the global economy
Now that the Greek crisis has died down, we can return to surveying the global economy for clues as to whether global growth will continue unabated. My sense right now is that the major theme to watch remains policy divergence, with the US still in tightening mode. Given weakness in emerging markets like China and Brazil, the prices of commodity exports will remain under pressure, putting a squeeze onto emerging markets dependent on commodity markets with high US dollar corporate indebtedness.
Let’s start in the US, where the tightening is occurring. The macro data have been middling. After the disastrous Q1 numbers, the US economy seems to have done better. When I wrote about the US growth path last month, I wrote that “I am basically in the camp that says real wage growth is high enough to support a continued middling upswing, with deviations due to inventories, trade and capital investment taking these numbers sometimes into negative territory.” The middling path we are on has enough volatility to it to throw in negative GDP prints as we saw in Q1, but I believe the overall path remains in the 2 to 3% range.
This is enough for the Fed to hike rates. If you listen to Fed officials, we are still on course to hike rates this year. Yesterday, St. Louis Fed President James Bullard told Fox Business News, “I see September having a 50% probability right now”. Janet Yellen told Congress last week that “If we wait longer it certainly could mean that when we begin to raise rates we might have to do so more rapidly,” suggesting she wants to be ahead of the curve. So it is clear that, barring a large dip in the pace of growth or non-farm payrolls, we will see 25 basis points this year. But I do not believe 25 basis points is going to make a big difference in US markets or the real economy. The concentration in the US will be on the pace of rate hikes.
But outside of the US, weakness abounds. For example, in Europe, where Germany is seen as the economic powerhouse and engine of the eurozone economy, while growth is picking up, it is weak. The Bundesbank says the pace of growth picked up in Q2 but is still expecting only 1.5% growth for 2015 and 1.7% for 2017. And remember, this is with a massive current account surplus, rates at zero percent, and a weak euro. In fact, the euro is so weak that even the Czech Republic is being forced to intervene in currency markets for the first time since 2013 to prevent its currency from appreciating against the euro.
It is emerging markets where the rubber hits the road, however. China came out with 7.0% growth figures for the most recent quarter, bang on target. No one believes these figures. Citibank believes the real numbers are closer to 5%. But no matter, what counts is the degree to which the slowing in China is having an impact on demand for industrial commodities and oil. Right now, commodities are at a 13-year low and oil prices dipped under $50 a barrel yesterday for the first time in months, after trading in a range around $60 a barrel for an extended period.
This is very bad news for emerging markets for a number of reasons. First, the renewed dip in oil prices means trouble for oil exporters because it suggests that the initial dip into the 40s was not an aberration, an overshoot and that $60 price is not a floor. Rather $60 could be a medium-term ceiling. We are now one year into the oil slump and that means there wil have to be big markdowns to oil assets on balance sheets because proved reserves are based on the price of extracting oil relative to the price over the preceding year. With prices now below $50 a barrel, many proved reserves are economically ‘unextractable’ and will need to be written off, reducing loan collateral ratios and borrowing capacity. I believe we are likely to see market death on a mass scale starting later this year and into 2016.
Second, the dip in other commodity prices will also hit emerging markets. This is both a demand issue and a strong dollar issue since commodities are prices in US dollars. With the Fed tightening this year and demand remaining soft, there is little hope that commodities are going to come back anytime soon. And that means export revenue for commodities-dependent emerging markets will be reduced significantly.
Third, the dip in commodities prices also implicitly tells us that China is weakening since China is the swing buyer of industrial commodities. And as the debt problems in China have mounted, we should expect the Chinese to be more concerned with preventing a hard landing than boosting growth back to pre-crisis levels. A recent article at Bruegel shows the scale of the debt problem that has resulted from China’s attempts to boost demand in the face of a souring global economy over the past eight years. If you look at China’s gross public and private debt relative to output, it is amongst the highest in the emerging markets. Notice that Russia and Mexico look good here despite their reliance on oil exports.
And when you look at private debt, you see that private debt has increased sixfold in the period from 2006 to 2014, with most of the debt in corporates rather than with households.
The problem for China then is mostly about non-household private debt at this point. And then the question goes to how much of this is contingent liabilities for the government and how much of these losses can be socialized to prevent a hard landing. Hard landing or not, a reduction in credit growth will necessarily slow growth and that is negative for emerging markets dependent on China.
One last aspect, related to China that is worthy of attention is capital flight. The South China Morning News says that more Chinese are considering foreign property after the rout in shares. At the same time, the paper says that Hong Kong home sales are expected to fall. The question therefore is whether the turmoil in the Chinese equity markets will hasten capital flight or cause Chinese investors with foreign assets into forced liquidations. My sense is that the former will dominate in the short-term but that over the medium term, the latter will become prominent. And that could negatively impact property markets in Australia, Canada, the US and elsewhere. Just something to keep an eye on
Let me finish by saying that this whole king dollar phase due to policy divergence has consequences. US dollar debtors sell what they can to make good on their dollar liabilities. And this means contagion into unrelated asset classes as always happens in crisis. The drop in gold prices may be a symptom of asset sales of this nature as much as it is of dollar strength. Overall, we should expect the US economy to continue its middling growth run. And that means rate hikes. Those rate hikes will have global implications, particularly in emerging markets. And when the US dollar debtors are forced to cry uncle, we should expect another emerging market mini-crisis to develop. It is just a matter of time.