Economic Soufflé at Risk of Implosion

Europe is stagnating and global demand remains inadequate

The prospect of higher interest rates remains the bête noire of financial markets, judging by their recent performance. Weak growth and low inflation data have spurred strong stock and bond market gains, more than offsetting July’s sell-off. Rather than worrying about sharply higher rates, though, investors should focus on the risk of a flatlining global economy.

The state of the global economy resembles nothing so much as a soufflé on the brink of implosion. While the production side of the US economy appears robust, the same cannot be said for the rest of the world. The US consumer remains quiescent, dramatic increases in Asian debt levels preclude a robust economic recovery there, while Europe stagnates. Global demand remains inadequate.

The US Federal Reserve clearly wants to exit quantitative easing. Politically, it fears being caught in the cross hairs of the upcoming presidential campaign. Economically, the Fed worries that, should the economy show real dynamism, it could come under immense pressure to sharply raise rates, risking a policy mistake.The world lacks an economic locomotive; at best one can ask whether the US economy is strong enough to keep the global growth soufflé aloft. Recent UK experience may be instructive here. Surprise UKeconomic growth led quickly to higher interest rates and a stronger pound, resulting in weakening exports and a rapidly cooling housing market. These natural growth governors – high relative rates and a strong currency – are now becoming visible in the US.

Properly executed, the end of QE and the beginning of rate normalisation could benefit all parties. The Fed could reduce threats to its political independence, begin to build a rate cushion against the flatline risk and assist Europe andJapan via likely US dollar appreciation. Will investors be discerning enough to distinguish between good, patiently implemented, front-end rate hikes and bad, sudden, long-end rate backups?

Of course, it is not only about the Fed. The Bank of England would like to begin to normalise its rate structure. The Bank of Japan is likely to do more QE, not less.

In Europe, both European Central Bank president Mario Draghi and German finance minister Wolfgang Schäuble are pressing the political class to assist monetary authorities in generating an economic recovery. What are the possible catalysts for a global economic descent into flatline territory?

A US recession is one, either from old age (the recovery is already more than five years old), offshore weakness or an overly aggressive Fed. Another could be European recession and deflation, assisted by continued disputes betweenRussia and Ukraine. Finally, there is the potential for an oil price spike; while not readily apparent it would deal a crushing blow to a weak global growth outlook.

Europe is most worrying. For Europe to work the financial sector has to right-size itself. The good news is that the sector has been busy on both the distressed debt/deleveraging and debt/capital raising sides. Credit conditions are easing as bank funding costs have declined by close to 80 per cent since 2011 peaks, while year to date debt issuance is 70 per cent ahead of last year’s levels.

Now it is the ECB’s turn to take centre stage, first via its targeted longer-term refinancing programme rollout this month, followed by the asset quality review results in October. The recent unexpected rate cuts and the announcement of the plan to purchase asset-backed securities are steps in the right direction. One can expect QE to follow. Germany’s sudden growth collapse is a game changer, making it politically palatable for Chancellor Angela Merkel to support QE given that its likely outcome of a weak euro will be positive for German exports. Europe already runs a trade surplus, so while ECB QE is likely to be positive for European financial assets, on its own it will have limited effect on the issue of insufficient global demand.

Investors should prepare for a stronger US dollar by hedging European and Japanese currency exposure. The formula “weak economic growth = low financial asset volatility = spread trades” remains a key mantra. Investors want but are unlikely to get continued QE around the world, but they are likely to invest in a “lower for longer” global growth economy that supports risk assets.

As the Rolling Stones once sang: “You can’t always get what you want, but if you try sometimes, you just might find, you get what you need”.

This article originally appeared in the Financial Times on September 17, 2014.