If a spark does set off a bonfire on world markets, New Zealand will feel the heat. Photo / NZME
OPINION:
Nobody likes to preach doom and gloom. Talk up the markets? Not a problem, even if you are later proved wrong. But highlight negative factors? Tread carefully.
Negative economic predictions can themselves drive markets lower. Even if the predictions are accurate, they will not be welcomed by market participants. Who wants to hear bad news?
Worse still, the negative predictions depress markets, but turn out to be wrong. This guarantees author unpopularity.
With such warnings front of mind, there are nevertheless occasions when the degree of economic concern compels discussion. Arguably the world has now reached that position.
How to discuss gathering economic storm clouds? Commentators generally describe a two-step process.
First, economic concerns develop. A stack of dry economic firewood accumulates. The economy and markets depart from long-term trends and fair value - whether inflation, share prices, debt levels, house prices, or commodity prices (especially oil and gas). The key factor here is: the greater the departure from fair value, the more heightened the risk, and the larger any potential resultant correction.
Having identified a stack of incendiary economic conditions, step two: a spark sets the stack ablaze. A shock occurs which stampedes markets. What that trigger event could be, and when it may occur, is impossible to predict. Perhaps the spark never occurs, and the economic imbalances slowly self-correct.
No economic model can ever predict what event will sufficiently panic world markets to set off a conflagration. It is even less possible to predict when such a spark may occur. In 2008 the collapse of Lehman Brothers provided the spark for the GFC.
So, let's examine the world's current stack of firewood. How large is it, and how dry is the wood?
The IMF's World Economic Review of 26 July 2022, says: "The world's three largest economies... (USA, Europe and China)... are stalling, with important consequences for the global outlook. Inflation is a major concern. The global economy... is facing an increasingly gloomy and uncertain future. Many of the downside risks flagged in... April... have begun to materialise. Higher than expected inflation... is triggering a tightening of global financial conditions. China's slowdown has been worse than anticipated... Global output contracted in the second quarter of this year... The risks to the outlook are overwhelmingly tilted to the downside... The... synchronised monetary tightening across countries is historically unprecedented... The outlook has darkened considerably since April. The world may soon be teetering on the edge of a global recession."
Compare the careful (almost coded) language normally used by central banks with this IMF report. Has a major world economics body ever delivered such a strong economic warning?
The World Bank's Global Economic Prospects report of June 2022 had a similar message: "The world economy continues to suffer from a series of destabilising shocks... Numerous risks could further derail what is now a precarious recovery."
Why are the three largest economies "stalling"? First China, which achieved 8.1 per cent growth in 2021. In 2022 the IMF predicts 3.3 per cent growth: Goldman Sachs 3 per cent and Japanese investment house Nomura 2.8 per cent. Causative factors for China's slowdown: prolonged and continuing Covid lockdowns, a recent heat wave stressing energy supplies, supply chain disruptions, and a major downturn in its property sector (long a key driver of Chinese growth).
Estimates put the number of unoccupied apartments in China between 50 and 100 million. Nomura on 23 August said recent measures to help the Chinese property sector, including several modest interest cuts, "... are not able to turn around the heavily-hit property sector yet... main factors behind slumping new home demand are declining trust in developers' commitment in delivering homes, slowing income growth, rising unemployment and... the zero Covid strategy". The Hong Kong share market index (which includes many mainland Chinese companies) peaked at 30,644 on 19 February 2021. Today it is under 20,000. China is in its worst economic shape for decades.
Europe is stressed by energy and debt. Russia has curtailed gas supplies. Gas in Europe currently costs around $85 per million BTUs (British Thermal Unit); $57 in the UK; and $9.75 in US - less than one-eighth the European price. Higher gas prices drive higher European electricity prices. The Financial Times said: "... the rise in European... [gas] prices to more than 14 times their average of the past decade may crimp industrial production in mainland Europe, and put the region into recession... the Euro... breached parity with the US dollar... reflecting concerns about the energy crisis".
High energy prices also drive inflation. But Europe still has low interest rates. Commentators suggest the European Central Bank (ECB) has been slow to raise rates, because of concerns for heavily indebted member countries. Raise rates and stress Italy and Greece? Or suffer excess Euro inflation? No easy options for the ECB. Europe is in economic difficulty.
The US has just completed two quarters of negative growth. It has a strongly inverted yield curve - usually a reliable recession predictor. While inflation dropped to 8.5 per cent in July, chairman Jerome Powell confirmed last weekend the Federal Reserve will continue to hike rates aggressively. Further declines in the US real economy seem unavoidable, despite a significant US sharemarket recovery in July. The US economy has issues.
The main positive offsetting these worldwide economic weaknesses: very high employment levels around the world. You can't have a recession with record low unemployment, right? In previous economic cycles: true. But this time, post-Covid, with many workers having "disappeared" from the labour market - who knows? The Herald (22 August) said the significant labour shortage "... is the strangest prelude to a possible recession imaginable, and it is happening all over the world". US economist John Mauldin (6 August newsletter) said: "Between retirement, Long Covid, less labour force participation... it is entirely possible... unemployment won't resemble past recessions".
Overall: the world's stack of economic firewood looks worryingly large and dry. If over the next year a spark does unfortunately set off a bonfire on world markets, all world economies, including New Zealand's, will feel the heat.
- David Schnauer is an economist, retired lawyer and the author of Covid, Catalyst for Change.
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