Market Jitters: Global Economy Not as Strong as It Looks

Governments misdiagnose and mistreat financial problems

A trader on the floor of the New York Stock Exchange in New York, on Feb. 5, 2018. Reuters/Brendan McDermid

A few months ago, I wrote an article for the World Economic Forum called “A Yellow Card for the Global Economy.” I intended it to serve as a warning about the rising imbalances of the emerging and leading economies. Unfortunately, since then, those imbalances have continued to rise and market complacency has reached new highs.

Last week, financial markets were dyed red, and the stock market reaction added to concerns about a possible impending recession.

The first thing we must understand is that we are not facing a panic created by an economic black swan, but rather by factors that few could deny are evident:

• Excessive valuations, as $20 trillion of monetary stimulus have inflated most financial assets
• Bond yields rising as the U.S. 10-year yield reaches 3.2 percent
• The yuan devaluation, which is on its way to surpass 7 yuan per U.S. dollar
• Global growth estimates trimmed for the sixth time in as many months

Therefore, the U.S. rate hikes—announced repeatedly and incessantly for years—are not the cause; neither is the alleged trade war. These are just symptoms, excuses to disguise a much more worrying illness.

Disproportionate Valuations

We are experiencing the saturation of excesses built around central banks’ loose policies and the famous “everything bubble.” Therein lies the problem.

After $20 trillion of reckless monetary expansion, risk assets—from the safest to the most volatile and from the most liquid to the unquoted—have skyrocketed without the anchor of sustainable value creation.

In Europe, no investor would buy bonds of eurozone countries with these low yields and high risks in a normal environment.

That is the creation of a huge bubble instigated by central banks with the reckless policy of ignoring the risks that they encourage in the markets.

With more than $6.5 trillion in bonds with a negative yield, the global bubble remains huge. Stock markets are on fire, valuation multiples soaring, and junk bonds at the lowest yields in 35 years.

And last week, we saw the first signs of trouble in the markets since early February.

China in Trouble

China reminded us that the tale of synchronized growth was false and that what we have been seeing in recent years has been synchronized growth of debt.

When China devalues the yuan and introduces the biggest tax cut in 38 years and a constant monetary stimulus to bail out its banks, what is it really telling us? That everything is fine? No, that things are not going well with the Asian giant.

No economy launches a massive undercover bailout of the financial sector, cuts rates, implements huge tax cuts, and devalues the currency if everything is going smoothly.

The realization of the fallacy of synchronized growth has also brought down expectations of global growth—and with it, corporate profit estimates.

Markets, suddenly, look as expensive as many have warned when the combination of China devaluation and soaring U.S. yields show the extent of the accumulation of risk of the past years.

The cracks in the building always appear first with currencies. Countries that have become accustomed to the idea that “this time is different,” and that debt does not matter, have started to multiply their indebtedness in foreign currency.

In the first three months of 2018, global debt rose 11 percent to a record of $247 trillion, according to the Institute of International Finance, and that of emerging markets soared by $2.5 trillion to an all-time high of $58.5 trillion.

When the lowest risk bond, the U.S. 10-year, went to 3.1 percent, the synchronized growth and complacent veil lifted, and many assets showed how risky they truly are.

Rates Do Rise

Markets woke up to a reality that we had decided to ignore: Rates do rise, making it harder to refinance, and finance in the first place.

And if the safest bond gives a return of 3.2 percent, am I willing to buy bonds from much riskier countries with negligible spreads?

The inevitable devaluation of the yuan, which soared to almost seven per dollar, a magical line in the sand which the Chinese regime had never let it cross before.

Am I willing to buy emerging markets and commodities when China exports its imbalances sending disinflationary pressure to the rest of the world?

The U.S. 10-year shows us the risk in the assets that we perceive as “safe.” The yuan reminds us that China exports global disinflation and warns of impossible growth expectations.

This reminds us that this time is not different. It is the same as all the previous ones. A bubble created from monetary policy gives way to a deep hangover.

The U.S. technology sector, which soared thanks to very low rates and high liquidity, began to show signs of weakness, and the U.S. market reacted by losing support levels as a continuation of the five-year lows in China and emerging markets as well as ongoing weakness in Europe, showing that the United States was not immune to the problem of excesses in other markets and that “value” in Europe or emerging markets is not existent.

These markets fell with the United States—and more in some cases. The U.S. market might be expensive, but others are optically cheap yet very expensive in reality. As such, they fall in tandem.

Problem Starts With Wrong Diagnosis

If we look at the 180 most important economies in the world, only six have an evident improvement of their fiscal and commercial imbalances in their forecasts for the next few years. In other words, almost no government in the world plans to reduce the rate of debt increases, let alone the public debt.

If we look at the corporate sector and households, the situation is much better, because private debt is somehow more contained—except in China—and especially in terms of solvency, compared to profits and assets.

Given that it is more than likely that central banks will continue to Japan-ize the economies through financial repression, these “red cards” are becoming more frequent and, in addition, there comes a point at which the saturation of monetary and debt measures stops working even as a placebo.

Governments and their central banks always start from a wrong diagnosis. They always believe that the problems of their economies are due to lack of demand and that turmoils are caused by external enemies, not by their policies.

By appointing themselves as a solution to the problems they create, they only perpetuate the imbalances, and the solution is increasingly complex.

Above all, the tools that central banks and governments have always used—lowering rates, increasing liquidity and increasing spending—generate very evident diminishing returns. In the past eight years, for every $1 of GDP, there were $3 of debt created.

The incentive to continue inflating the risky assets is high. However, we already have had several warning signs, and we keep ignoring them. Even worse, episodes of volatility are being used to increase imbalances and generate further problems in the long-term.

When societies are based on promoting spending and debt, not saving and making prudent investments, we are always going to throw ourselves into a bigger problem based on the conviction that nothing bad is going to happen.

When it bursts, governments and central banks will blame anyone except themselves. And repeat.

Daniel Lacalle is chief economist at hedge fund Tressis and author of “Escape From the Central Bank Trap,” published by BEP.