October 2015 - Diminishing expectations

Paris, 16/10/2015


Eric Chaney

 Chief Economist AXA Group, Head of Research AXA IM 



What's new in the October Blue Book? 

The global economic outlook

The last three months have been disappointing, for the global economy and the financial markets. The Chinese slowdown earlier this year and its side effects on global trade and commodity producers, were underestimated and are probably still so in GDP estimates. The diverging paths or monetary policies in the US and China, illustrated by the move towards a more flexible exchange rate regime for the yuan in August, has rattled the markets, even though the move has been very limited so far. In the short term, signs of stabilization, perhaps of slight acceleration, from China, are reassuring: the world is not slipping into recession and, if the Fed refrains from acting in December, as markets believe, risk assets may benefit from yet another oiling. Yet, let's face it: the long rally enjoyed by equities and other risky assets since the depth of the 2009 recession is probably coming to an end, because growth and therefore earnings prospects are diminishing.

Gone are the days when all policy makers in the world united to fight the risk of a global depression. We are now in a world where the most important central bank has not made up its mind about monetary normalization while the others are still in full monetary expansion regime. We are also in a world where, despite monetary policies all geared to avoiding a deflation spiral, inflation is stubbornly low, challenging the credibility of policy makers to deliver their objectives. A school of thought brilliantly represented by former Fed Chairman Ben Bernanke opines that there is a global demand gap and that fiscal policies should be summoned to close it, instead of relying on incrementally less effective monetary policies. If this view is correct, then we have reasons to be worried, because we know there will be no significant fiscal action coming from individual but significant players such as the US, China or the euro area, let alone from some sort of global coordinated action. To add insult to injury, a lasting demand gap implies less productive investment than otherwise and, therefore, slower potential growth. In other words, one doesn't need to have a negative view on technological innovation to come to the conclusion that ‘secular stagnation' might already be reality.

This rather sober outlook does not imply that we should already prepare for a global recession and implement protection strategies for financial assets. Assuming that the euro area has successfully contained its own systemic risk, i.e. a break-up of the single currency –a fair assumption at this stage-- a recession could only come from serious policy mistakes in the US or China. On balance, the latter deserves attention because of the large build-up of Chinese corporate debt in the last 6 years and also because China's capital account is much more porous than we had assumed so far. Yet, the risk of a hard landing in China, caused by a deleveraging spiral eluding the control of policy makers, is very remote: Chinese authorities have many macro and micro economic levers at their disposal. Their most recent decision to borrow from the ECB's toolkit its LTRO scheme in order to target regions and companies that are credit starving is a good example. In the end, the Chinese leadership has a clear strategic goal -- keep ruling China. Do not doubt they will do whatever it takes to stay on this course.

Crossing the Pacific, what about the possibility of a policy blunder in Washington DC, bringing this atypical cycle to an early end? Setting aside a disastrous government shutdown followed by a default –to which we assign a close to zero probability— a possible policy mistake could stem from a false inflation alarm, convincing the markets that the Fed is behind the curve. In response, the Fed may opt for a rapid tightening to regain tis credibility, which would send bond yields much higher than currently forecasted and re-ignite the rise of the US$. This double whammy would be enough to throw an economy already cruising at slow speed into recession. Again, the probability of such outcome looks thin, so cautious about the state of the economy and of its labour market is the Fed, starting with chair Yellen.

In conclusion, the global economy seems trapped in a sub-optimal equilibrium, implying low returns but not the end of the current expansion phase. Animal spirits will come back but we won't know before we see the consequences of their comeback.

We have explored some of these themes in the Blue Book's Features of the Month. For instance:

• What if the Fed's FOMC did what it says? Mind the recession (p. 6)
• Global equities: enjoy the year-end rally if any, then take profits (p. 7)
• China: how bad is it, Doctor? (p. 8)
• China: how bad is it? A leaking capital account (p. 33)
• Debt overhang in Emerging Markets? It is China, mostly (p. 9)
• Bonds term structure: term premia trending down slowly (p. 17)

And, also, the more traditional global macro assessment for bullet-points addict:

• We cut our 2016 global growth forecast from 3.3% to 3.1%. The global economy cooled  in the first half, because of a sharp slowdown in China. Global growth is now stabilising
• The US economy is on a subdued but resilient, growth path, driven by consumer spending. With the capex cycle peaking, we cut our 2016 growth forecast from 2.5% to 2.2%.
• The Chinese economy is improving, with Beijing over-ruling local governments to stimulate growth. Yet, because of a construction overhang, we cut our 2016 f 'cast from 6.5% to 6.3%
• The €-area is recovering, thanks to domestic demand. On the back of the VW scandal we trim our 2016 forecast by 0.1pp to 1.4%. Weak foreign demand points to downside risks
• The US/China monetary divergence plus a leaking capital account explains why the PBC moved towards a more flexible FX regime. A further CNY/USD depreciation is possible
• Fed: paralyzed by low-flation and a weak international backdrop, the FOMC has become less predictable. After the September employment report, markets see the first hike in 2016
• ECB: has levelled the ground for an extension of QE beyond Sept 16. With inflation expectations falling, more action may be needed. In any case, no lift-off before 2018.
• Emerging markets in the dollar zone at large will be stressed by the Fed monetary cycle. Idiosyncratic risks (Brazil, Turkey) may amplify capital outflows. Asia now looks attractive. Debt overhang in EMs is overstated: it is mostly a Chinese story
• Risks: Geopolitical risks are more local than global (ME, South China sea) but might turn global. An unexpected acceleration of inflation in the US could trigger a large bond sell-off

There are also some important topical issues the Blue Book doesn't deal with, but which the AXA IM Research team has investigated. From the UK-EU negotiation to the TPP or the possible fallout of the VW scandal, here is our Research Vault.