MY Harvard guru and the world’s tallest economist Ken Galbraith is attributed to have said that the only purpose of economic forecasts is to make ASTROlogy look respectable. Before the X’mas holidays, I wrote in this column that many early guesses for the past year, 2017 had turned out to be off-base.
Still, for businesses and investors will 2018 be any different? Most are expecting the US$80 trillion global economy to enjoy a broad-based period of continuing strong growth.
At the moment, most signs ahead appear positive. There is already Trump’s “X’mas present” of US$1.5 trillion in tax cuts. It will be front-loaded with more stimulus spending on infrastructure and disaster relief. Such generous and unprecedented late-cycle fiscal stimuli (other than tax cut) have yet to be fully appreciated by the markets.
Indeed, this shift towards huge deficits during a period when the economic expansion is well advanced, stands in contrast to recent historical experience. Typically, budget deficits fall when the economy expands (US has been expanding for 10 years), and rise when it contracts.
What can go wrong? At this time when the signs are pointing towards further progress, that’s precisely when pessimists start to feel their oats.
Things to watch
As I see it, five big things that didn’t happen in 2017 could haunt us in 2018.
> Markets and politics – Politics always matters. But in 2017, the markets appeared to have risen above it. Politics proved somehow inconsequential.
The year 2017 was a blockbuster year for investor gains worldwide, with the best returns coming from countries where the political risk of war and from populism were indeed high.
Poland (threatened by right-wing nationalism) and South Korea (by nuclear brinkmanship) alongside China (the rise of a Mao-like strongman) had the three hottest stock markets in 2017 – all up more than 40% in US dollar terms.
Encouraged by continuing global recovery and ready access to easy money at record low rates, investors bypassed evolving political risks and focused their reliance instead on accelerating growth, the ongoing impressive tech-revolution, and the rise of middle-class consumers. And so, markets rose above politics – at least in 2017. Nevertheless, politics should remain a worry for investors.
> Away the punchbowl – Despite the Fed raising rates three times in 2017, it was still easy for borrowers to get credit – indeed, for longer and on cheaper terms. Surprisingly, yields on long-dated bonds fell, while global monetary conditions were helped along by the weakening US dollar.
The Fed’s financial conditions index showed 2017 to have been the “loosest” since January 1994 (when surprise Fed tightening crushed the bond markets). This is unlikely to last. The relatively bright economic future provides an opportunity for US Fed to take away the punchbowl and begin the “great unwind.” Never before has its balance sheet been so huge, interest rates so low and global debt so high.
Rising interest rates and the tax cut in 2018 could well lead to a strengthening US dollar, which could hurt many over-extended emerging market borrowers. There is also concern US tax changes would lead to a massive repatriation of offshore US dollars.
> China rising – Lest we forget, the last two significant falls in global equities (in the summer of 2015 and the beginning of 2016) were triggered by fears about a rising China. Similar dangers remain. Somehow markets stopped worrying in 2017 – about China having too much debt, even as its yuan depreciated. Then, there is China’s structural shift in its growth model to become more consumption-based. Investors worry about the lagged impact of slackening money supply and slowing growth, on debt management and on jobs creation.
Focus on the quality of growth (not the headline GDP) in the face of what the Trump Presidency’s protectionist rhetoric can do to stop a rising China could adversely affect domestically listed stocks in the course of 2018.
> Equity and bonds – Since the beginning of 2000s, bond yields had tended to move inversely with the price of equities, thereby providing investors with a cushion against losses in an equity downturn.
This worked well in 2017, with bond yields staying low (i.e. prices rising) even as shares did well. The worry is that this correction might not hold in 2018 as the link between stocks and bonds could fall back to what it used to be in the 1980s and 1990s, with rising bond yields (hence, falling price) being bad for share prices.
This could happen if inflation returns in the face of softening economic growth. Or central banks move away from easy money to ensure asset prices don’t get out of hand.
Perhaps, the time to normalise has come, i.e. to undo 10 years of monetary easing. Something, I am afraid, markets are quite unprepared for.
> US dollar lift – What could fuel a US dollar rally? Getting the US dollar right is critical as it affects all that we do. Most guessed in the past year, betting the US dollar would strengthen. Instead, the dollar depreciated 7.5% against its peers in 2017. Dollar bulls are steadfast that the tax cut will cause a “one-off surge” in the US dollar, pushing up annual GDP growth by up to 0.5 percentage point over the next two years, with unemployment at below 4%; US firms will repatriate home overseas cash of up to US$500bil through sales of foreign assets for US dollars (an exercise not unlike the tax repatriation holiday under President Bush in 2004 which brought back US$312 billion – the US dollar rose 13% in 2005).
A strong US dollar can, however, crimp risk appetite and cause FDIs to pull back from emerging markets, dimming their growth prospects.
This would force their central banks to raise rates, adding chill to the outlook. Such a large-scale retreat happened in 2013-2016, when investors pulled US$155bil from emerging equity funds; and despite the eurozone being on track to reach its highest growth (+2.4% in 2017) in a decade and lifting the euro 14% against the dollar (to US$1.20) in 2017, expectations are for the US dollar to strengthen in 2018 on the back of very strong US stimulus.
However, the US dollar could weaken again by year-end. The US is in good shape (chance of recession: ‹15%), with Europe coming steadily from behind.
So much for what can happen. Further forward, it is somewhat paradoxical that despite being surrounded by technological advances, from smart phones and cloud computing to artificial intelligence to robotics, there have been few signs of their positive impact on wages and productivity.
JP Morgan estimates US productivity (growth of output per unit of input) to be up only 1.2% in 2017. Wages (average hourly earnings) rose just 2.5% over the year with unemployment at 4.1%. Why so? The payoff indeed is slow in coming. History shows that technological breakthroughs take time to transform.
Hype always runs well ahead of reality. A recent MIT/University of Chicago study noted that electric motors were introduced in late 1800s; yet even by 1919, one-half of US factories was still not electrified.
Similarly, the integrated circuit was commercialised in 1960s; 25 years later, computers represented just 5% of all business equipment. Of course, we did witness the driving force behind the revolution in communications and data processing causing the collapse in the price of semi-conductors, which resulted in the relative price of information processing falling by 96% since 1970. On-line shopping came in the 1990s, but retailers and consumers continue to struggle to adapt. Similarly, with the design and building of autonomous cars and the use of AI in finance – initially much more labour had to be used to build vast computing power and new software which depressed productivity. Broadly, the market quickly learns of breakthrough in technologies with great hype; whereas, successful commercial breakthroughs are more often extrapolations of existing technology.
By 2017, value created by some US tech-leaders has become increasingly more evident. US S&P 500 ended 2017 up 19%, adding US$4 trillion to the index’s market value. About 25% of this value creation came from five largest US tech-companies: Apple, Alphabet, Amazon, Facebook and Microsoft – each stock was up at least 30% for the year, adding US$1 trillion in market value.
But they still haven’t as yet produced the broadest economic boom. Perhaps, they (others like them) are at a point when technology and an economy at full employment have become mutually reinforcing, and thus are able to more intensively employ wide-ranging digital skills to take full advantage of AI and other new creations.
What then, are we to do?
The year 2017 ended in good spirits: record highs in world equity markets, low market volatility, weak US dollar and low investor anxiety. Also, relative peace around the world. At a time of heightened global political uncertainties, can this last?
As I see it, political risks remain high. A global political vacuum remains at the heart of Europe’s strongest economy, Germany. There is no shortage of political flashpoints: Italy’s forthcoming elections, Brexit negotiations, threat of protectionism and trade disputes, and continuing unrest in the Middle East.
Advanced and emerging economies are already experiencing an upturn. But for many, little has changed. Wages remain stubbornly low. Inequality persists.
As we enter 2018, I am reminded that we are dealing with not just risks, but with uncertainties. Simply put – risks involve “known unknowns,” while uncertainties touch on “unknown unknowns,” i.e. things we just don’t know. Markets can (and do) price-in risks; but not uncertainties. Politics is uncertain.
Today’s markets are enjoying low volatility where underlying uncertainties are usually underestimated; indeed, often even ignored. Investors and policymakers should enjoy the calm while it lasts. But it won’t last. Just a matter of time.
For Malaysia, the ringgit remains undervalued despite recent improvements. As I see it, fair value is below 3.50/US dollar; indeed, closer to 3.00. With the US dollar expected to strengthen, policymakers can only move towards fair value through the adoption of steadfast discipline and real structural reforms. No short-cuts.
Tan Sri Lin See-Yan is a former banker, Harvard educated economist and British chartered scientist. Feedback is most welcome.
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