ECONOMISTS’ ROUNDTABLE: ‘The crisis has a very long tail’

What do two senior asset management economists and a McKinsey expert think about the world economy now and in the next few decades?

Neil Williams (group chief economist, Hermes Investment Management)
Tera Allas (senior fellow, Mckinsey Centre for Government)
Keith Wade (chief economist, Schroders)

Funds Europe – Which are the strongest and weakest regions in the global economy?

Neil Williams, Hermes – Ten years on since the first glimpse of the global crisis, the major economies have now recouped their GDP, but within that there are still two soft spots that determine the strongest and weakest. The first one is nominal GDP recoveries. These have been predominantly led by one thing: output. Output hasn’t generated enough inflation for central banks to instigate their usual reaction function. This could mean we’re going to have yet another two years of negative real policy rates in the US, UK, Eurozone and Japan.

Secondly, we have a two-speed recovery. In the lead are the US and even the UK, with the dollar bloc also leading the way, but below them are Japan and the Eurozone. Although they are scrambling out of the hole quickly, they are barely back to square one, so it is little surprise these countries are still running fairly aggressive quantitative easing (QE).

But behind the scenes even the US and the UK are still throwing in cash. The big four central banks since the end of the US recession have pumped in close to $14 trillion and economies are taking only the smallest baby steps, led by the Fed in the US, to even begin to address that.

It seems the next few years will still see very low rates. This will be a challenge for investors, who are still in search of yield, as the two-speed process continues.

Tera Allas, McKinsey – It’s hard to say that there are stronger or weaker regions. It’s more a case that those regions are strong or weak for different reasons. In the long term, we are quite optimistic about China, Europe and North America – but also Africa, though the reasons for each are quite different.

There’s huge potential for productivity improvements in each case, but in some cases demographic trends will drag down growth potential – for example, ageing populations in China, Europe and North America. The demographic dividend of the past will not be there.

Africa is an exception. African countries have many young people entering the job market and jobs are being created at a very significant rate.

A complication from a fundamentals point of view is that quite a lot of that potential productivity and jobs growth – and therefore investment and consumption – depends not just on monetary policy or fiscal policy, but structural policy. It’s difficult to predict which countries and regions will actually reform labour and product markets and to what degree protectionism will hinder global growth and trade.

Keith Wade, Schroders – Economic forecasts show the world economy has definitely improved. Balance of growth is seeing a shift towards Europe and slightly away from the US. Japan is also doing pretty well and all of that’s feeding into emerging markets.

However, on most conventional measures of capacity and output gap, you would expect higher inflation.

The remarkably weak inflation numbers coming through could suggest something is going on that we’re not picking up, and for me, this could be the impact of technology.

In the US, the so-called ‘Amazon effect’ is quite powerful. Recent results for mainstream retailers were pretty horrendous. Despite consumption holding up, employment and wage numbers show about 10% of the retail sector is experiencing downward pressure on jobs and wages.

Low inflation reinforces the low interest rate environment. This is a great backdrop for markets, which people call the ‘Goldilocks environment’, but when I look back a year ago, the continued global recovery means we ought to be getting worried about inflation by now, and that hasn’t happened.

Funds Europe – What do you feel then are the biggest headline risks to the global economy at present?

Allas – Geopolitical uncertainty and Brexit mean investment levels are not at a level needed for greater productivity and changing demographics mean we will not get growth from increased employment if we do not get it from productivity.

It would seem that we are in a secular stagnation scenario. This isn’t a shock as such. But with the world becoming more and more interconnected through digital technology and data flows, the global financial system and economies are much more vulnerable to shocks.

For example, 80% of China’s economic profit comes from financial services and this raises some question marks about what happens there in terms of how any destabilisation would radiate across the whole economy.

Wade – We talk about the risk of stagnation with our clients because the weakness of inflation in some ways is consistent with the secular-stagnation hypothesis.

Other headline risks include North Korea but it is difficult to say anything particularly sensible about that except for it is increasing the tension between China and the US, with the US now beginning to introduce more protectionist measures.

Protectionism remains a big concern. I would say that’s probably my biggest risk at the moment. But there is also the impact of monetary policy normalisation in the US and Eurozone. Markets seem very sanguine about it, yet QE had a big impact on the markets and so we can’t assume that withdrawing it won’t.

It may be that Eurozone tapering is the more important event. The impact of European Central Bank (ECB) action was significant on portfolio changes and shifts in capital flows. The Bund market, for example, became incredibly squeezed and we saw negative yields along the curve for quite a period. So I think there is more risk related to this than markets may think.

Williams – The US has achieved its third-longest-ever expansion since 1854, so the question I have is what would stop it achieving its longest-ever expansion? There are two points I would highlight – the first is the p-word: protectionism. Mr Trump was very vocal about protectionism in his campaign and there is a risk that this will come crashing into place.

The second thing are the central banks. Have they now got themselves into a jam whereby ultra-low rates and cheap money are part of the problem, not the solution?

The idea for QE back in 2009 was to send money down two channels and generate inflation. The first channel was through asset prices, which I would argue has happened; but the second one was that cash would land in pockets and people would spend it. This latter channel hasn’t happened.

So what did the central banks do when it wasn’t working and growth stuttered? They did more of it. Central banks have to kick the drug but I’m not convinced that they’ll be able to do that.

Wade – The US appears to want to roll back some of the regulation resulting from the financial crisis. It is as though they’re acknowledging we can’t get growth from conventional measures and regulation of the banking system is now seen as part of the problem.

Donald Trump will have a big say in who gets appointed at the Fed and in terms of the way regulation gets rolled back. It might be that they’re saying we need to go back to pre-crisis free lending by banks and so on, and that’s a concern for the longer run.

Williams – It’s almost as if policymakers realised at some point they couldn’t solve the problem so they changed the word ‘problem’ to ‘solution’! For example, in the UK’s March 2013 Budget, the then-Chancellor Osborne gave various subsidies towards the housing market – and if there’s one thing that gives a feelgood factor in the UK, it is buoyancy in house prices. It seems to me that about three or four years ago when UK and other policymakers realised they couldn’t get us to kick debt, they encouraged us to take on more of it to get the growth that central banks need so they can behave more conventionally.

Allas – A lack of deleveraging back to more normal levels of indebtedness is creating vulnerability, given that all other engines aren’t quite operating at full speed. Ideally this debt overhang would have been managed down by now and economies would be able to grow faster.

This is a challenging situation.

Williams – After years of monetary policy, we haven’t generated a strong recovery. Even the recovery that we’ve had is deceptive in many ways because a lot of people have not experienced real income gains. Central banks know there’s little inflation, but if real incomes are weak and the political environment is febrile, it’s difficult for central banks.

It is unlikely that the Bank of England would want to raise rates whilst Brexit negotiations are going on.

Funds Europe – Is the financial and economic crisis not behind us, therefore?

Allas – In some ways maybe we were never going to get out of it. It was such a big shock that it was bound to leave structural damage, so yes, in terms of normalisation, we’re probably not quite over it. The crisis has a very, very long tail. However, some of the structural factors were already happening before the crisis. For example, productivity was already slowing, so which bit of the current stagnation is to do with the pre-crisis trend as opposed to the crisis itself? It is not really possible to accurately separate these effects.

Williams – We have to accept the crisis has shifted us to a different place and this new normal is a world where interest rates no longer run above inflation and inflation itself is the wrong sort, hitting us in the pocket through costs rather than leading us to the shops to spend.

Also, as a result it’s a new situation where investors really have to scramble hard to find a positive real yield.

Allas – Take a step backwards and look at the last 30 years and what happened to inflation and interest rates. It’s never going to happen again. Interest rates went from close to 14% to 2% or 0% over a 30-year period and that was massively beneficial for asset prices.

The only place they can go now is up; they might not do, but they’re certainly not going to go down by 15%.

Similarly inflation, whether it’s the right or the wrong kind, it’s not going to give us the boost we had in the past. Declining inflation tends to feed into corporate profits and EPS [earnings per share] growth, valuations and asset prices. That’s not going to happen again any time soon, though there may be some kind of future cycle when we’ll be able to come down that slope again and benefit from it.

Wade – There was a period just after Donald Trump was elected when the reflation trade came back, and we saw bond yields rise quite sharply. Of course, a lot of that was based on hopes that there would be a big fiscal package.

That doesn’t now seem to be likely for various reasons, not least because even within the Republican Party they can’t agree on what’s needed.

When the crisis started, the Reinhart and Rogoff analysis, ‘This Time is Different’, talked about financial repression. That’s exactly what we’ve had – and it’s what we’ve still got. The financial repression after the Second World War lasted up to the 1970s, nearly 20 years, so we could still see quite a long period of this.

Funds Europe – Is it time for central banks to start raising interest rates?

Williams – I’d like to see the banks that can, to start closing the liquidity tab, like the Fed, even if that just means ‘draining the sink’ a little. The good thing is that central banks have two levers to push: raising rates and lowering the balance sheet by selling bonds. But before they even get to that stage, banks can just simply stop reinvesting income from the bonds that mature.

If the Fed proceeded along this path of non-reinvestment – tightening by doing nothing – then by 2019, they could preclude the need for five further rate hikes, 130 basis points on the Fed Fund’s target, in which case they’re doing the right thing, they’re using both levers. I would like to see the Bank of England, the ECB and ultimately one day, Japan, do the same thing.

Linked to the notion of financial repression, surely nine years on QE has distorted not only the financial system, but also the labour market.

Possibly one reason why UK employment data shows the strongest gains at the senior end is because those deferring retirement probably do so due to ultra-low savings. This could be one reason why wages aren’t going up.

There is an increasing participation rate in many major economies and you could argue that’s actually indirectly being caused by central banks keeping their foot on the gas for so long.

Allas – The very low-rate environment hasn’t actually stimulated the amount of investment that everybody thought it would. Raising rates might not have any substantive negative impact on business investment, but of course then you have to consider the household sector. Because of indebtedness, raising rates actually hits consumption, which is just starting to increase.

Wade – The case for US rates to go a little higher is probably the clearest. Using the conventional Taylor Rule model, you could argue that interest rates should at least in real terms be zero. Janet Yellen has alluded to the idea of a long-run zero interest rate rather than 2%, which is always what the thinking was in the Taylor Rule. I personally think the timing for further rate rises is currently difficult because of understanding what low inflation means. The view at Schroders
is that inflation will gradually pick up again next year, but clearly the Fed
is standing back from that.

The second thing is the balance sheet reduction. I do think they want to do that, but there could be quite a long pause before the Fed starts to tighten again. There is a case for the ECB to taper, but for the ECB it is not just about the immediate impact on the economy. The ECB has been addressing problems with the euro and at the periphery of the Eurozone, such as Greece. The ECB’s QE has helped to compress peripheral yields, aiding countries at the periphery, so what happens when the ECB begins to unwind? Do we start to see peripheral yields in Europe begin to rise? If we do, then in countries like Italy with very high levels of debt, you quickly get into a situation where that becomes unstable.

It begs the question about what level of interest rates is sustainable in Europe. Clearly Germany could sustain much higher rates, but in a common currency zone you’re pretty much driven by the lowest common denominator, which means effectively that some of the peripheral economies would not be
able to withstand interest rates of 3% or 4% because their debt dynamics would really deteriorate.

So, yes, it is time for the US and certainly time for parts of Europe to start seeing higher interest rates, maybe around zero in real terms, 2% nominal. But there are pockets that are going to keep interest rates very, very low.

Japan’s economy looks better, but there is still a huge debt issue. They’re not really in a position to significantly raise rates.

We are stuck with the new normal, meaning much lower interest rates.

Funds Europe – There is a tension between globalisation and nationalism. Does globalisation have a future?

Allas – At McKinsey we looked at ‘global interconnections’. This means global flows of goods, services, money, people, and data and we see very different trends between them in the short term.

Flows of goods and services have not grown quite at the rate they used to do. Yet flows of people are the highest and flows of data have grown 45-fold in the last decade. This suggests that globalisation continues to happen but is changing in nature.

Digitalisation, technology and further global interconnectedness could mean that smaller and smaller businesses
can take part in global value chains. However, technology is also resulting in some effects in the bigger value chains, for example re-shoring, because automation means companies don’t need cheap labour.

So, we don’t think globalisation is coming to an end and there are still lots of benefits to countries that are either selling or buying global goods and services. The nature of the exact industries and where production takes place is changing gradually and the footprint of different firms and different activities could change significantly.

Take the UK’s situation, which looks very positive as the second-largest services exporter in the world. As emerging-economy consumption matures, there’s going to be a very significant increase in demand for services. A lot of those will be local services, but some of them will allow the UK to improve its export potential significantly.

Wade – Clearly technology is continuing to drive globalisation, but I do feel in many ways that politically globalisation is reaching the limits. The globalisation theory works pretty well regarding international trade and so on, but the problem is that it creates displacement for existing workers who have not been able to find equivalent work for similar salary and other benefits.

I think this also manifests itself in the weakness of productivity growth that we see. If you hollow out manufacturing in say, steel and heavy industries which are highly productive, you won’t get the same levels of productivity unless the people who are displaced can find similar jobs. That’s all part of the shift in the economy, but I think we have to recognise that’s created a huge amount of political dissatisfaction and is behind a lot of the protectionism that we see.

Having said that, though that story applies very strongly to the US and to some extent the UK, I don’t think it really applies quite so much in Europe, certainly with the election of Macron and likely re-election of Merkel. I feel that the liberal, globalisation agenda’s probably going to remain pretty strong. Then there is China, which in many ways seems to have picked up the baton of free trade and is encouraging all kinds of free-trade deals. It is a very mixed picture.

Allas – I’m not entirely in agreement about the political limits. It’s easy for 

us here in London to forget that the fastest-growing global flow is south-south trade – China and the rest of South Asia trading with Africa and Latin America. All of that is continuing to grow in the old sense of globalisation, because for those countries there are very significant gains still to be had.

You could also argue that even in the absence of globalisation, technology would have the same kind of effect in displacing workers. People will still be feeling somewhat left behind, and that means wages can’t grow, it means consumption doesn’t grow, and so we might get two-speed economies within national economies as well.

Wade – A study has shown that about 80% of manufacturing job losses in the UK were due to technology rather than the impact of foreign trade, so I would agree. And that is difficult for politicians to grasp.

Williams – The IT revolution means that some degree of globalisation, thankfully, will continue. But preserving that is not without cost and one of those costs for the UK, it seems, is that in order to preserve what we have, we are going to be made an example of in Brexit so that smaller Mediterranean EU countries don’t get the message that the EU is easy to leave.

I’m slightly less optimistic than you, Tera, in terms of the impact on the UK. It seems to me Brexit’s going to take seven years, not just a few.

The alternative to globalisation is protectionism and that is unthinkable, but it is possible. Look at the 1930s when Canada, Great Britain and parts of Europe retaliated against US protectionism even though we were the US’s biggest partners.

Funds Europe – How will technology impact the global economy in the next decade and will it affect the balance between the developed world and the emerging world?

Wade – As mentioned, there will be downward pressure on low-skilled wages and it will increase pressure towards inequality. There are 3.5 million truck drivers in the US. What happens when we’ve got self-driving trucks?

But if we always saw technology as being an obstacle we would still have hundreds of thousands of people working in agriculture. Clearly, robotics is going to become a huge industry and that will present opportunities for investment. There will be growth there and incomes generated, followed by spending.

It does present this near-term challenge of disruption, which in democratic societies can lead to political outcomes that might not be what you might have hoped for.

Technology has to be thought of for its benefits, like green energy as well as for the economic problems.

Allas – I agree 100%. We have carried out work called ‘Disruptive Dozen’, which looks at the micro level at all the different technologies that are going to change value chains and people’s lives. The conclusion was that between $14 trillion and $33 trillion of global economic value could be created and a big part of that will be consumer surplus. So, the overall story is very positive.

We also find higher productivity at the macro level, which is what we’re all looking for in a secular stagnation scenario. This is actually good for jobs. Higher productivity leads to lower costs, higher incomes and therefore more demand. This means more, not fewer, jobs overall.

But there is also a bipolarisation between of frontier companies and the rest as the winner-take-all companies are now able and willing to invest literally billions of dollars into the next stage of data, artificial intelligence and robotics. Overall the picture is positive, but it will be challenging for governments to manage.

The balance between the developed world and the emerging world is a very complex question. The improvements from manufacturing exports that emerging economies have seen over the last 30 years will slow down because suddenly the Western world won’t need to offshore all its low-cost labour because robots here will replace those jobs. There’s a question mark around those countries’ long-term growth in that sense.

Funds Europe – Other than the headline risks mentioned, what underlying trends give you the most concern for the long term?

Wade – Climate change. Schroders did a big piece of work a couple of years ago looking at its impact. This is where the emerging markets suffer considerably because that’s where the most acute changes will take place in the environment.

Unless there’s huge investment, there will probably be great migration. That will produce a huge challenge in a world that is, as we’ve been discussing, becoming a bit more protectionist and less willing to accept migration.

Allas – My chief concern is rising inequality inside countries, which is only going to be exacerbated by technology trends, and I don’t think any government has figured out an actual practical agenda for dealing with that on the ground in terms of re-skilling people or figuring out how to redistribute the spoils of capitalism in a way that’s actually productive. That will cause further volatility in the political environment, causing uncertainty and lower investment.

Williams – Climate change and, linked to it, poverty. The question is the extent to which central bank policy is just making the gap between the haves and have-nots even wider. I say that because surely the one thing we’ve learnt, at least in the UK, is that QE got to the people who needed it least, the ones with assets.

So, after eight years of running the tap, and very few signs that the tap’s going to be closed and the sink is going to be drained, it is not going to be solved any time soon.

Funds Europe – Briefly sum up why you are mostly optimistic or mostly pessimistic.

Wade – I’m generally an optimist. A lot of what we’ve said has been focusing on the downside, but technology means a better quality of life. People are living longer and a lot of serious diseases have been reduced and eliminated. GDP statisticians are not good at picking these points up. For increased life expectancy, for example, they will focus on pension deficit pressure, so perhaps we are not measuring everything in the right way.

I feel optimistic about the outlook, but there are huge challenges in that transition period.

Williams – There are two things that keep me awake. With protectionism, it remains to be seen how much more combative the US and China become. China could retaliate to any US protectionism through pushing the currency down and Southeast Asia will follow, which will put into question the commitment of China to holdings of US treasuries. However, there is a nice symbiosis between the US and China, which hopefully will win the day.

The second thing is how central banks kick the debt drug. The only real precedent we have was the US running QE unbroken for 14 years to get out of the Great Depression. On that basis, we are little more than halfway through.

Allas – Life expectancy has increased across all 42 countries that we have looked at in depth. Most of these countries have improved their public safety and transport, so quality of life is continuing to increase.

Also, hundreds of millions of people are being taken out of poverty because of globalisation, meaning there are all kinds of macro reasons to be positive. Although negative stories can be built around globalisation, urbanisation, industrialisation, technology and ageing, these are also all positive developments.

For example, ageing means workforce participation can stay higher for longer and we need this because birth rates are down.

Urbanisation and industrialisation present a big boost to productivity.

Technology also means a huge boost to productivity and the quality of products and services is constantly improving. Technology is going to help solve some of the trickiest problems on the planet, such as health issues and climate change. I’m an optimist, but we need businesses and governments to manage the bad and capture the good.

On balance, this can all work.

©2017 funds europe



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