If you thought you were merely on the fence about being confused on the topic of the global economy, and how the Fed may be on the verge of a rate hike when on both previous occasions when financial conditions were here the Fed was launching QE1 and QE2, here is JPM's chief economist Bruce Kasman to make sure of that.
Something happened
The August turbulence in global markets has produced significant shifts, including a 6.6% fall in equity prices. The currencies of emerging market countries have depreciated substantially against the G-4, while emerging market borrowing rates for sovereigns and corporates have moved higher. Global oil prices have been whipsawed as have G-4 bond yields.
The speed and magnitude of these movements is reminiscent of past episodes in which financial crises emerged or the global economy slipped into recession. However, nothing appears to be breaking. Global activity indicators have, on balance, disappointed but remain consistent with a modest pickup in the pace of growth. Additionally, despite the turbulence in financial markets, there is no sign of unusual stress in short-term funding markets or of a credit crisis in any large EM economy.
And just to ease the confusion somewhat, here is Kasman's attempt at explaining what many others had foreseen months, if not years, ago:
While the global economy is not breaking, the events of recent weeks have prompted a reassessment of the risks to global growth and financial market stability. Three related factors tied primarily to EM economies, lie behind this reassessment.
- US and China not giving expected boost to EM. We have noted the widespread expectations (including our own) that a demand boost from the US and China would help to fuel a growth bounce-back across the EM, similar to what happened last year. However, recent activity data from China have uniformly disappointed, reversing a modest firming that took place into mid-year. The US and other DM economies look to be generating solid growth, a point underscored by this week’s impressive revision to 2Q US GDP. However, the positive impulse this is providing to the EM is limited— partly because the composition of G-3 growth appears to be shifting toward services—and so far has been insufficient to offset the sharp deceleration in EM domestic demand.
- It’s not a war, but currency moves hurt. Against a backdrop of divergent business cycles, shifts in FX rates can be a constructive force that promotes rebalancing. To a large degree, the dollar’s rise against the euro and the yen over the past two years reflects this dynamic since this was accompanied by ECB and BOJ easing. However, the recent declines in EM currencies signal a sense of heightened risk and, in some cases, concerns about policy credibility— further constraining EM policymakers’ ability to ease even as local financial market conditions have tightened.
- The elephant in the room is the EM credit overhang. The risks associated with weaker growth and tighter financial conditions in the EM are magnified by the large overhang of EM private-sector credit. Our estimates suggest that overall EM private sector debt stands at about 130% of GDP, about 50%-pts above the 2007 level. This pace of increase is unsustainable and the risks of a disruptive deleveraging have increased.
While recent developments have raised the specter of past EM financial crises, EM governments have taken steps to limit these risks over the past 15 years. In most cases, EM public sector balances are in good shape and FX reserves have risen significantly. What’s more, the role of short-term interbank financing has been limited in this cycle. Thus, the risk of a crisis that begins with EM sovereigns or the banking sector appears limited.
That said, EM governments’ capacity to offset the effects of an adverse shock to the corporate credit supply is limited. And the risk of this deterioration is real given the interaction of weak growth, reduced pricing power for goods and commodity producers, and rising local market borrowing rates. The downtrend in many EM FX rates will add to the pressure on corporates that have significant FX liabilities. A tightening in EM credit already is under way. Data through
June show bank loan growth has slowed by one-third in recent years.
The immediate concern for the EM economies seems to be that the credit supply may tighten further, possibly sharply, adding to the downward pressure on growth and capping global growth at a pace much closer to the economy’s potential 2.6%, which is significantly below our current forecast.
And a pop quiz: at a time when a sharp contraction in the credit supply is the top global growtth fear by Wall Street's most "respected" bank, does the Fed: i) hike or ii) ease more. This is not a trick question.
