Ignacio de la Torre. Professor. IE Business School
29 February 2016
As on many previous occasions the market is reacting by selling first, and asking questions later, when in reality the world is not heading for recession.
Robert Farrell said: “There are no new eras - excesses are never permanent.” We often try to explain changes based on variations in the price of assets. Sometimes they coincide, but sometimes they don’t. They don’t coincide when we shift from a market dominated by efficient market theory (pricing based on essentials) to a market dominated by behavioral finance, in which feelings take precedence over essentials (to cite an example, rainy days tend to explain stock performances that are worse than on sunny days). I have always maintained that in the short term markets can be very affected by “behavioral finance,” but are efficient on a long-term basis. It’s true that a long-term investment is one that would lose money in the short term… but this article is about trying to explain if current market movements indicate that a recession is imminent.
In my opinion, the answer is no.
First, the weakness of China, the US, and many emerging countries has pushed the level of world growth down to 2.8%. It’s a disappointing rate alright (The historic average stands at 3.4%), but it’s not a recession.
Second, the world growth base is shifting from Asia to the west. In a context in which a large number of central banks are printing money and bringing interest rates to rock bottom, the FED’s less aggressive policy has rendered the dollar extremely strong, damaging exports. This, coupled with other factors that are currently in the mix (particularly weak levels of investment), has resulted in lower than expected growth levels in the US. But despite all this, almost two thirds of America’s GDP depends on consumption, and consumption depends on employment. Hence, very low levels of unemployment (less than 5%) mean that consumption levels are not expected to drop. Meanwhile, trends like the falling dollar and oil prices, which have shored up export and investment, will have an impact on comparisons with previous years. The US will grow very little, but the risk of recession is limited. The FED will have to react by applying more rises in interest rates, possibly until next year, if the evolution of salaries permits.
Third, Europe, although it hasn’t grown that much, seems like an oasis in the midst of swathes of instability. With a rate of growth which currently stands at 2%, I would go so far as to forecast that Europe will grow faster than the US in 2016. In the current scenario, the Euro will keep getting stronger, and the European Central Bank will disappoint by announcing measures that are less aggressive than what the market is discounting.
Fourth, the banking sector’s fragile state is a result of low profitability (courtesy of the high levels of capital required by new regulation), low growth in terms of income, fear that banks could be exposed to the expected bank crisis caused by emerging debt and, in some cases, monetary policy. Given all these factors, it is unfair to compare the current situation of the banking sector with that of 2007. Banks today are much better capitalized, and the areas of risk (energy and emerging debt) are much less relevant than those that caused the banking crisis of 2007, particularly housing. Nevertheless, the instability of banks explains why in the face of possible shocks, like the one now coming from emerging countries, the market reacts by selling first and asking after. It’s a reasonable enough attitude, but in my opinion there is a difference between that and expecting a world recession.
Fifth, we will see a banking crisis in the emerging block, particularly in China, which will continue to see its growth dwindle, which in turn will serve to maintain levels of capital flight at some 100 billion dollars a month. This process will only be stemmed by a strong devaluation of the yuan and by using reserves to recapitalize Chinese banks, which will suffer big losses due to granting loans in dollars to Chinese firms with revenues in yuans (approximately a trillion dollars of a total of two trillion dollars was incurred by emerging firms in recent years). Nevertheless, there is marked growth in India (7.3%), and although Russia and Brazil are still in recession, the drops in GDP will be much softer than 2015. Both countries should be back to positive growth levels in 2017.
Sixth, the imbalance fuelled by raw materials, particularly oil, is circumstantial. We will see more and more adjustments in terms of supply. Nobody wants the oil price situation to lead to a threat of recession and enormous geopolitical tensions. If necessary there will be cuts in production and the price per barrel will go back up, which will stymie excessive pessimism in the markets.
Economic growth, wages, and wellbeing, cannot depend on central banks. Said banks should soften cycles using monetary policy. A reduction in interest rates or quantitative expansion cause, in theory, a situation in which future demand is brought forward to the present, and through the resulting depreciation of the currency, exporters in other countries or regions are “robbed” of demand due to a possible rise in exports from the country that has depreciated its currency (the weaker currency makes the home country more competitive). Nevertheless, we have all seen the limitations of such monetary policy measures. They’re powerful at first but if they’re used regularly their effectiveness wanes. Moreover, due to the fact that we cannot trade with Mars, if practically all central banks adopt such measures it would make it impossible to rob demand for exports from other countries. Given that it would not be possible to attract demand from extraterrestrials, the only other possibility would be to rob a bit of the US market, which is currently seeing a rise in the dollar because its central bank has stopped printing money and fixing interest rates at negative levels. In view of all these factors, if we continue to rob demand from the US, we would be condemning the US economy to the same kind of weakness, and that isn’t in anybody’s interest because it has the highest level of marginal consumption. If the US sneezes, the rest of the world will suffer, and this scenario gives more cause for concern than playing with negative interest rates.
Let’s not kid ourselves, wages and wellbeing depend on productivity, and monetary policy cannot sort out productivity because it requires structural reform. It’s time we took responsibility for our expectations and it’s also time that our politicians (not economists) took more responsibility too. The only way to aspire to greater levels of growth and wellbeing is by electing politicians that are brave enough to attack the root of the problem of low productivity, starting with education. The question is whether or not voters and the people they vote in want to tell each other the truth, or if they prefer to continue to play what appears to be game of deception. I’m pessimistic about this.
Coming back to recession, the model used by New York’s FED, based on the best predictor in existence (the differential between ten-year bond profitability and that of the two-year bond), states that the probability of recession stands at 4.56%.
Hence, there will be no recession - only mediocrity.