Global Recession? Almost Certainly No

2016 began very poorly for share markets. In the first week, the US share market had its worst week since September 2011, with the S&P500 index tumbling by 6%. One probably has to go back to the postwar period to find a worse start to the calendar year. The Australian share market fell by 5.8%. The rest of January wasn’t much better, with the Australian market down by 5.5% for the month and the US share market, as measured by the S&P500 index, down by 5.1%.

The fundamental causes of this malaise are both well-known and inter-related. They include concern about weakness in the two largest economies – the United States and China – as well as worries about oil prices and exchange rates.

In particular, there was increased speculation in January that the world may be about to return to recession after six years of only sluggish growth. The performance of the share market and of commodity prices, particularly oil, were taken as evidence of this: the “canary in the coal mine” theory.

What’s interesting about this, however, is that there is precious little evidence of a looming recession in the “real” (non-financial) economies. Of course, there are pockets of weakness. The manufacturing sector in the US, for example, is struggling under the influence of both the oil price and the strong US dollar.

That’s right, the spectacular fall in the oil price is taken not only as a symptom of economic weakness, but also as a cause. This goes against decades of economic teaching; it was always contended that falling energy prices were good for growth as consumers took their savings at the pump and spent them elsewhere.

So what’s different now? Part of it may be a question of timing: the oil-producing economies are feeling the direct effects now, while consumers may be waiting to spend their gains. In particular, the US is now so much more self-sufficient than it was because of shale oil. But the latter requires considerable capital spending, and the lower price means that much of this spending just stops. Indeed, mining structures investment dropped by 35% in 2015, enough to take 0.3 percentage points from overall GDP growth.  Elsewhere, Azerbaijan, Brazil and Venezuela are all reeling from the lower oil price.

In addition, the global economy is suffering from too-low inflation, and falling energy prices are exacerbating this.

Of course, it’s not just the weakness in oil prices causing weakness in US manufacturing; it’s also the strength of the US dollar. On a broad trade-weighted basis, the dollar has risen by about 20% since mid-2014. This obviously makes it hard for manufacturers.

It turns out that the exchange rate and oil price problems are inter-related. Consider that the oil price is determined worldwide but conventionally measured in US dollars. If the US dollar appreciates, all other things being equal the oil price goes up in other currencies. If this pushes it past its equilibrium global price then the price in US dollars will come down. Indeed, the exchange rate of the US dollar and the oil price have been remarkably closely correlated in recent years (see chart).

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And then there’s China. People have agonised over the gyrations of the Chinese share market for a long time. I have said this before: the Chinese share market is a casino. It tells us nothing about anything. It’s true that it’s come off a long way in recent months, but this was after an unsustainable boom. The Shanghai market is down by close to 50% from its June 2005 peak, but that leaves it close to where it was in late-2014.

Which brings us to the Chinese economy. First, the share market movement is very unlikely to cause any economic weakness; the linkages are very small. Second, a lot of policy stimulus has been thrown at the economy. It’s true that it has slowed, but there is little evidence that it is on the way to a hard landing. During January it was announced that the Chinese economy had grown by 6.9%–a 25-year low—in 2015. Of course, given the increase in the size of that economy, 6.9% growth is more in quantum terms than 10% growth used to be a few years ago.

But hardly anyone believes the official figures, thinking that the economy has slowed to a much greater extent. And it almost certainly has. There is a range of other hard indicators (retail sales, industrial production, electricity consumption to name a few) that can be used to construct an activity proxy. This suggests that growth is probably only between 4 and 4.5% (the bad news) but that it isn’t currently slowing further (the good news).

In all, the idea that the world economy is again teetering on the brink is unsubstantiated. This is important because smarter heads than I calculate that the US share market, for example, is currently factoring in a 60% chance of recession. If the chance is actually less than that, then equity markets are almost certainly good value right now.

This likelihood is also enhanced by the fact that policymakers are reacting to the growth slowdown. Japan has just cut its cash rate to less than zero, the ECB has adopted a strong easing bias for its next meeting in March, and the US Federal Reserve appears to be backing away from its December plan of more rate rises over the course of 2016. Previously, it appeared likely that the fed would raise the Fed funds rate again in March; the market’s probability of such a move now is about 16%.

Meanwhile back in Oz

So where does that leave us? The Australian economy got two very important pieces of news in January, relating to the labour market and to inflation. The data show that employment has increased by 301,000 (2.6%) in the year to December 2015, led by a very strong New South Wales. The unemployment rate has fallen from 6.1% to 5.8%. No cause for concern there! Meanwhile, inflation continues to be remarkably quiescent. Over the course of 2015, the CPI rose by just 1.7%, held down by falling petrol prices, while “underlying” inflation came in at 2%. One could argue that inflation is, if anything, too low, but petrol prices are going to stabilise and then rise, and it is reasonable to think that some effects from the weaker currency will show up over the course of the year. So the RBA is best served if it simply ignores inflation. Many will recall the surprise rate cut in February 2015, but this is unlikely to be repeated this year. Another rate cut remains a possibility in the months ahead, but it wouldn’t be my forecast.

Over the course of January, the $A fell from 73 US cents to a low of 68.7 US cents before recovering to 71.3 cents. My end-of-year forecast remains 67 cents.

On 11 January, after the carnage of the opening week, I cut my end-of-year ASX200 forecast from 5750 to 5500. That remains my forecast for the time being.

 

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