Will the world economy crash in 2020?

Chief Economist View

In September, Nouriel Roubini (famous for his GFC call) and Brunello Rosa published an article titled Ten reasons why the world economy will crash in 2020. The article was republished in the Australian Financial Review this week following the sharp decline in equity markets over October. Roubini’s article is a good summary of the position of the economic and financial market extreme pessimist. Below, we begin by stating Roubini’s argument (bolded), then follow with our assessment. Why nine and not ten? We agree with Roubini’s last argument that if a crash does occur monetary and fiscal policy are ill positioned to assist in a swift recovery.

#1. By 2020, US fiscal stimulus will run out, and fiscal drag will pull US economic growth from 3% to slightly below 2%. This is hardly controversial or pessimistic. It is clear that the current above-potential US growth rate of 3% is unsustainable. The consensus view is that US growth will slow to trend growth of 1.9% by 2020. While a decline in growth from 3.0% to 1.9% seems large, it is not a crash. In fact, it is a very favourable outcome that would see the US unemployment rate in 2020 at a very low 3.8% and core inflation at the US Federal Reserve’s (Fed) target of 2.0%.

#2. The US economy is now overheating, and inflation is rising above target. There very are few signs the US economy is currently overheating. The most obvious sign of an overheating economy is inflation. But core PCE inflation (the measure used by the Fed when setting monetary policy) has stabilised at 2.0% since March of this year. The low level of the unemployment rate is perhaps the only economic variable consistent with overheating. However, the US (and other global labour markets) unemployment rate is structurally lower now than in history and is generating only modest wage growth, and hence, modest inflationary pressure.

#3. Trump administration’s trade disputes with China, Europe, Mexico, Canada, and others will escalate, leading to slower growth and higher inflation. The USMCA is only marginally more restrictive than NAFTA, while recent US/Europe negotiations have defused escalation of trade disputes with that region. This leaves China. Our view is that the US/China trade dispute will escalate. However, even in a scenario where the US imposes tariffs on the remaining US$256 billion of Chinese imports, the impact on US and global growth and inflation is manageable. Our modelling, confirmed by recent IMF research, shows that tariffs on remaining Chinese imports would reduce US growth by 20 basis points per annum over the next three years. While the US economy would slow to below-trend growth of 1.7% in 2020, it hardly represents a crash.

#4. Other U.S. policies will continue to add stagflationary pressure. Supply-side bottlenecks associated with restrictions on inward/outward investment, technology transfers, and immigration are expected to cause higher inflation and interest rates and lower growth. However, Republican politicians have forced President Trump to soften his hard line on immigration, while policies on inward/outward investment and technology transfers primarily target China and will have less impact on the US.

#5. Growth in the rest of the world will likely slow down. Consensus forecasts are for China to slow from 6.9% in 2017 to 6.0% in 2020, the euro area to slow from 2.4% to 1.6% and Japan to slow from 1.8% to 0.6%. These are sizeable reductions in growth, but, as with the US, they are from above trend growth rates to more sustainable, trend-like rates. In addition, given that the market consensus is already anticipating the slowdown, its impact is already captured in current prices of financial assets and therefore unlikely to be a catalyst for sustained financial market disruption.

#6. Populist policies in countries such as Italy may lead to an unsustainable debt dynamic within the eurozone. This refers to the link between the exposure of Italian banks to Italian government debt. This is a real concern for the EU, but not one that is unmanageable. Unlike the European debt crisis of 2011-12, the issue is not one of Italian (or other major) bank solvency via exposures to bad debt, rather it is the threat to Basel III capital adequacy requirements as the prices of Italian government bonds fall. Unless the Italian government defaults on its debt (very unlikely), issues around Italian banks’ capital adequacy can be resolved through various channels without systemic threat to the European banking system.

#7. U.S. equity markets are frothy, with price-to-earnings (PE) ratios 50% above the historical average. The committed pessimist is revealed! Such a large mispricing of equities is justified by only a very special PE estimate, which relies on a very out-of-consensus view on the sustainable level of company earnings. More typical PE estimates would put the overvaluation in US equity markets currently at between 5% and 15%; with the upper range still 5% lower than a bear market.

#8. Once a correction occurs, the risk of undershooting will become more severe. This is the typical pattern of any extreme sell off in equity markets and follows logically if you accept Roubini’s implied correction in equity markets of 50%.

#9. Trump will manufacture a foreign policy crisis as growth slows. Roubini suggests Trump would provoke a military conflict with Iran to divert attention from a slowdown in US economic growth. A war with Iran, according to Roubini, would trigger a stagflationary geopolitical shock not unlike the oil-price spikes of 1973, 1979, and 1990. If all else fails to crash the US and global economy, rely on Trump.

Table 1: Financial market movements, 11 - 18 October 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,768.8

1.5%

US

3.18%

2.9 bps

US Dollar Index (DXY)

95.90

0.9%

Nikkei 225

22,658.2

0.3%

Japan

0.15%

0.6 bps

USD-JPY

112.21

0.0%

FTSE 100

7,027.0

0.3%

UK

1.54%

-13.6 bps

GBP-USD

1.302

-1.6%

DAX

11,589.2

0.4%

Germany

0.42%

-10.2 bps

EUR-USD

1.145

-1.2%

S&P/ASX 200

5,942.4

1.0%

Australia

2.73%

-0.5 bps

AUD-USD

0.710

-0.4%

Source: Bloomberg

 

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