In 2017, every prominent economic forecasting entity was shouting from the rooftops about “synchronized global growth.” This was a reference to the fact that not only were certain economies growing, but they were all growing at the same time.
Chinese GDP growth had come down but was still substantial at 6.85%. U.S. GDP growth was posting solid gains of 3.0% in the second quarter of 2017 and 2.8% in the third quarter. Japan and Europe were not growing as quickly as the U.S. and China, but growth was still accelerating from a low level.
Synchronization was a big part of the story. Growth was not isolated and episodic. Growth was fueling more growth in what seemed to be a sustainable way. The world economy was firing on all cylinders.
Then in 2018 the global growth story came screeching to a halt. Japanese growth went negative in the third quarter of 2018. Germany also went negative. Chinese growth continued its drop (6.5% in the third quarter) instead of stabilizing.
The U.K slowed partly because of confusion around Brexit. French growth slid amid riots triggered by a proposed carbon emissions tax. Australian home prices declined precipitously because export orders from China dried up and Chinese flight capital slowed to a trickle due to Chinese capital controls.
The U.S. economy held up fairly well in 2018, with 4.2% growth in the second quarter and 3.5% growth in the third quarter. But much of that growth was inventory accumulation from foreign suppliers in advance of proposed tariffs.
That inventory growth will likely dry up once the tariffs are either imposed or abandoned early this year. Fourth-quarter growth in the U.S. is currently projected at 3.0%, continuing the downtrend from the second quarter.
What happened?
Much of the global slowdown has to do with the high degree of interconnectedness of the global economy and the extent of global supply chains. The flip side of synchronized growth is a synchronized slowdown. Just as growth in one economy can lead to increased exports for trading partners, a slowdown leads to reduced exports.
Still, why has growth slowed down at all?
The answer has to do with debt, Fed policy, political developments, as well as trade wars. Specifically, the U.S. and China, the world’s two largest economies, are discovering the limits of debt-fueled growth.
The U.S. debt-to-GDP ratio is now 106%, the highest since the end of the Second World War. The Chinese debt-to-GDP ratio is a more reasonable 48%, but that figure is misleading because it does not include the debts and guarantees of provinces, state-owned enterprises, banks, wealth management products and numerous other entities that the government in Beijing is directly or indirectly obligated to support.
When that additional debt is taken into account, the real debt-to-GDP ratio is over 250%, about the same as Japan’s.
Debt-to-GDP ratios below 60% are considered sustainable; ratios between 60% and 90% are considered unsustainable and need to be reversed; and ratios in excess of 90% are in the red zone and will produce negative growth along with default through nonpayment, inflation or other forms of debt repudiation. The world’s three largest economies — the U.S., China and Japan — are all now deep in the red zone.
European growth is also slowing down. While the causes may vary, growth in all of the major economies in the EU and the U.K. is either slowing or has already turned negative.
What is striking is the speed with which synchronized global growth has turned to synchronized slowing. Indications are that this slowing is far from over. While growth can create a positive feedback loop, slowing can do the same.
The interconnectedness of global growth was summarized in this quote from Stephen “Sarge” Guilfoyle, director of floor operations for the New York Stock Exchange in a recent column for TheStreet’s Real Money:
There is an old adage, “When America sneezes, the world catches a cold.” What if the world’s two largest economies (U.S. and China) sneeze at the same time? Wait. I can top that. What if the U.S., China, the EU, Japan and the U.K. all sneeze at the same time? What if all mentioned are either involved in trade disputes, and/or the perverse use of both fiscal and/or monetary policies while suffering from heightened political risk? Oh, and at least temporarily, the U.S. faces a partial government shutdown as well. That’s a strong sort of fiscal/political mix.
Well, we already have the partial shutdown, now over two weeks old. On the political front, it’s sufficient to say that the dysfunction is getting worse, not better, and it will have an adverse effect on investor portfolios.
Democrats took charge of the House of Representatives last week on, Jan. 3, and they will use their committee control to launch literally dozens of investigations into “Russia collusion,” Trump’s business dealings, Trump’s inaugural financing, Trump’s tax returns, campaign finance, regulatory reforms, appointments and much more.
But Republicans continue to hold the U.S. Senate. They will use their committee control to hold hearings on FBI corruption, Intelligence Community abuse of spying powers, Hillary Clinton’s private server that held classified information and Democratic coverups on Benghazi, tea party IRS attacks, the Clinton Foundation “pay for play” deals with former Secretary of State Clinton, false accusations related to the confirmation of Justice Kavanaugh and more.
In short, it’s war.
Some of these hearings are political stunts just for show. They will make great headlines over a one-day (or one-hour) news cycle but won’t lead to any substantive charges or changes. Yet other hearings could have grave consequences — especially those that may result in criminal charges, including the Clinton Foundation case.
Hanging over all of this is the specter of impeachment. The impeachment process begins in the House of Representatives. If the president is impeached, the matter is referred to the Senate for a trial. If convicted in a Senate trial, the president is removed from office and the Vice President (Mike Pence) becomes president.
Conviction in the Senate requires a super-majority of 67 votes to remove the president. Republicans currently hold 53 Senate seats. Assuming all 47 Democrats vote to remove the president, 20 Republicans would have to switch sides and vote to remove President Trump from office. This is extremely unlikely to occur.
The worst case for impeachment is that the House impeaches Trump but the Senate does not vote to convict him so he remains in office. The best case is that the House makes noise about impeachment, holds hearings but in the end does not vote to impeach.
Either scenario will be positive for Trump’s reelection chances in 2020. Americans may dislike a lot about Trump’s day-to-day demeanor, but Americans are also fair-minded people on the whole.
They will see impeachment as another over-the-top move by Democrats (like the made-up “Russia collusion” story) and actually begin to sympathize with the president. Trump is also a master at turning attacks around on his opponents.
Whether impeachment happens or not and whether Trump benefits or not is unimportant for investors. What is important is the impact of political dysfunction and uncertainty on portfolios.
There the news is not good.
Regardless of the outcome of impeachment, investors should be prepared for a bumpy ride as headlines swing from good to bad and back again for Trump.
Meanwhile, the Fed is raising interest rates and reducing its balance sheet. The Fed’s balance sheet has been reduced by $375 billion in the past 14 months. That balance sheet is scheduled to fall by another $600 billion this year and $600 billion the following year until the balance sheet reaches a level of $2.9 trillion by the end of 2020.
This kind of extreme balance sheet reduction is entirely experimental. It has never been attempted before in the 106-year history of the Federal Reserve.
Analysts estimate that reducing the balance sheet by $600 billion per year (the current tempo) is equivalent to increasing the fed funds target rate by 1% per year. This implied rate hike comes on top of the 0.25% rate hikes the Fed has been announcing every quarter. QT and actual rate hikes taken together are increasing rates by 2% per year from a 2.5% base, an extreme form of monetary tightening.
The Fed is tightening into weakness and will have to pivot towards easing once it becomes obvious. But it may very well be too late.
The bottom line is that uncertainty reigns and it’s not going away anytime soon. Investors can profit from this with a combination of long-volatility strategies, safe-haven assets, gold and cash.
