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A Review of the World Economy

By William R. Rhodes – President & CEO | William R. Rhodes Global Advisors, LLC |
Remarks given on January 19th at the Lotos Club

Let me give you a brief rundown of how I see the world economy, concentrating ON the US and China.  First of all, let me give you the Good News.

  • The world economy is likely to continue in 2018 to display the significant economic growth that emerged in 2017. This results from improved investment, strengthened world trade from what has been low levels, improvements in business confidence – all supported by very accommodative central bank policies that have kept interest rates very low.
  • In October, the International Monetary Fund forecast 2% growth for the leading developed industrial economies and 4.9% for the emerging market economies – when it releases its new forecasts next week, I expect the IMF to forecast stronger numbers.
  • While the pace of the recovery from the Great Recession of 2008/’09 has differed from one country to another – with the United States doing better than most when it comes to returning to full employment – it is evident that we are now seeing economic strength across most of the globe.

This is the good news.

CONCERNS

  • But set against this bright picture is the overlapping concerns of multiple political uncertainties and financial market “irrational exuberance.” It is this combination that leads me to believe that a decline in the U.S. stock market of between 10% and to 20% is probable before the end of 2018, as I have stated in an op-ed that came out today from Reuters, copies are available here tonight.
  • I am most willing after my remarks to answer questions on any individual country situations, but right now let me focus on three aspects of the global 2018 outlook: the two global giant economies – the United States and China; and, then the considerations we need to be mindful of as we look at the outlook for financial markets.

UNITED STATES

  • The new tax cuts will add some short-term stimulus to economic growth. Overall, I expect that U.S. growth in 2018 will be around 2.5% – 3% and inflation will be moving upwards, but probably not exceed 2%. Labor market conditions, which are already tight in many parts of the country, are likely to tighten still further.
  • The recovery has been substantial. Corporate profits have done well. The banking sector is strong and, overall, in far better health than the banking system of continental Western Europe. Indeed, the U.S. economy is an important engine once again powering global economic growth.
  • But, as we enter the ninth year of economic recovery we need to ask: is this sustainable? 
  • The tax cuts are unprecedented as they come at a time when the U.S. economy is doing well and we basically have full employment. From the perspective of economists, there is no justification to use fiscal policy now to add stimulus to the economy. The cost of the tax cuts, according to conservative estimates, is an addition to our national debt over 10 years of $1.5 trillion.
  • As Milton Freedman once said: “There is no such thing as a free lunch.” The rising deficit adds to interest costs that the government must pay to service the debt. These costs will be all the greater because interest rates in this country may be raised three or four times in 2018 by our central bank, the Federal Reserve Board.
  • Securing the economic recovery and then stimulating growth was the Fed’s top priority over the last decade – it produced a vast rise in the amount of cash pumped into the economy. The Fed’s balance sheet now stands at around $4.5 trillion. The Fed is intent on lowering this amount by reducing quantitative easing and correctly so. It will also continue to raise interest rates to offset expected increases in inflation due to the heating up of the economy.
  • The prospect of rising deficits and rising interest rates will influence business and consumer confidence as the year progresses and may suggest a slow-down in economic growth as we enter 2019. It is not clear that Congress will be able to legislate major infrastructure spending this year, which could further stimulate growth, but also add further to the budget deficit.

Moving on to CHINA

  • Which is the world’s second most powerful economy, and which saved the world from a great depression rather than the great recession we experienced in 2008, due to a stimulus of over $850 billion. China is now growing at about an annual rate of 6.5%. I believe that the rate will slow in the course of this year as the government addresses significant financial difficulties. This slow-down will also influence growth rates in many emerging market economies and possibly Japan and Europe, which are major trading partners of China, as is our own country.
  • The world’s most important global political event in the last year was the 19th Communist Party Congress in Beijing that saw President Xi Jinping consolidate his political power. Today, his hold over all institutions of power from the military to the Communist Party to the governmental bureaucracy is very substantial and unprecedented since the days of Deng Xiaoping and Mao Tse Tung.
  • I believe that President Xi delayed action on needed financial sector reform in order to enhance his prospects of increasing his political power, which he has now achieved. The financial sector must now be addressed:
  • The Chinese have been struggling to stabilize the exchange rate and in so doing they reduced their foreign exchange reserves by a trillion dollars in 2016 and were forced to introduce capital controls – the debt-to-GDP ratio has soared from around 150% of GDP in 2008 to 280% today and it is still growing. This is not sustainable.
  • We see excessive borrowing by industries, municipalities and by real estate developers the latter of which are adding to an existing housing bubble. There has been a formidable rise in credit extension both by banks and the shadow banking sector, which alone represents about 87% of GDP or around $9 trillion.
  • China’s authorities need to take a series of actions that include: writing-off non-performing debts at banks and ensuring the recapitalization of some banks; bringing under rigid control the liquidity tap used by major public sector borrowers; closing zombie enterprises in steel, coal, shipbuilding and other areas; and introducing legislation to regulate the expanding shadow banking sector.
  • How the Chinese authorities deal with these financial challenges will determine the future level of China’s GDP growth, which in turn will greatly influence China’s trade with the rest of the world. This is one of the largest uncertainties facing the world’s economy this year

OUTLOOK FOR FINANCIAL MARKETS

  • There are many signs of excesses in the markets today: the valuations of many individual stocks are starting to reflect overly optimistic earnings expectations. There’s a bubble in Bitcoin and other crypto-currencies, art prices are soaring, and valuations for collectibles like fast cars, as well as real estate, are becoming ever more staggering. But a fear of missing out on the boom means that investors are paying little regard to an array of warning signals. Prudent considerations are being pushed aside in an ever more frenzied reach for yield. 
  • The situation now is similar in some respects to early 2007 when I wrote an article for The Financial Times publicly warning of the dangers of a major market correction. Another such correction is coming, and a decline in the U.S. stock market of between 10 and 20 percent is probable before the end of 2018.
  • The correction will reflect the issues that I have highlighted with regard to the U.S. and Chinese economies, as well as likely rises in interest rates and reduction of quantitative easing, for example, in Europe and in Japan. There will also be special negative factors, such as a likely rise in oil prices due, in part, to the increasing political crisis in Venezuela.
  • But, there are also abundant political uncertainties. Here at home, the U.S. Congressional elections in November may see the Republicans lose power. That would fuel concerns of a confrontation between President Trump and the Democrats on Capitol Hill and increase uncertainty about the outlook for a host of fiscal and regulatory policies. There is also the confrontation between North Korea and the United States, the impact of “Brexit” on Britain and the European Union, clashes between Saudi Arabia and Iran, and terror threats. 
  • Apart from the election of President Macron of France, and his introduction of needed economic reforms, like in the labor area, rarely has there been so many political uncertainties in Western Europe. The U.K and the European Union are locking horns in what will be increasingly tense “Brexit” negotiations. The ability of German Chancellor Angela Merkel to secure and then sustain a governing coalition will be challenging. Italy will be holding elections in March and the outcome is unclear. In Spain, the Catalan independence issues are a major distraction for a government that still has a lot of work to do to reduce unemployment. And then, Hungary, Poland and the Czech Republic are all likely to threaten European Union harmony as they pursue more authoritarian policies. Further, I cannot recall a time when political relations between Western Europe and Turkey have been more fraught with difficulties. 

CONCLUSION

  • 2018 opens with the world economy in good shape. But at the economic, international and national political levels this is a time of mounting tensions. It is a time for prudence and caution.

Compliments of William R. Rhodes Global Advisors, LLC , a member of the EACCNY