Wealth Insights (December 2016/January 2017)

The end of certainty

Richard Jerram
Chief Economist
Bank of Singapore
Member of OCBC Wealth Panel

Global growth has been remarkably stable over the past five years, once the rebound from 2008-09 recession had faded. Each year produced growth in the 3 to 3.5 per cent range compared to the cyclical swings of previous decades.

Our expectation was that the next couple of years would see a similar pace of growth. Certainly, deflationary risks were fading and were set to nudge higher, but none of this seemed particularly transformational.

We could characterise the past few years as being an “age of certainty”. It might not have felt like that at the time, given the stresses and concerns in the system, but we had the promise (and sometime reality) of policy support to guard against downside risks.

At the same time there was little prospect of resolving the structural problems that constrained growth, especially as in some cases (notably China) there was the prospect of stimulus being withdrawn whenever growth was comfortably buoyant. This “stop and go” world was stuck with an acceptable but unimpressive rate of growth.

Stable growth also created the environment for us to promote a broadly pro-risk asset allocation stance, although this has become more nuanced over the past couple of years as valuations became strained.

Through this cycle, spare capacity combined with loose policy to produce the expectation of continued recovery. Recessions are typically caused either by external shocks or by overheating that produces the need for monetary tightening. Neither seemed very likely so we could expect the world to continue to grow at 3 to 3.5 per cent. Now both are possible.

Financial markets have focused on the possible benefits of President Trump driving business-friendly deregulation, tax cuts and infrastructure spending.  There are two problems with this view.

First, the US economy does not have the spare capacity absorb significant stimulus as it is already close to full employment. This situation would be worsened by plans to deport illegal immigrants and to restrict new entrants. Growth could see a short-term boost but this would probably accelerate the pick-up of inflation that is already emerging and bring forward the schedule for Fed interest rate hikes. That gives the prospect of boom followed by bust.

The second problem is that we cannot selectively cherry pick and believe in the policies that seem market friendly and ignore the ones that could bring disaster. The unpredictability of the president elect and the poor quality of many of his advisors mean that we have to treat all of the policy positions seriously.

This means that we have to consider the risk of aggressive tariff barriers against imports from emerging markets (especially Mexico and China). Even without retaliation this could be a shock to emerging market growth, especially when combined with higher U.S. interest rates. It is also bad for U.S. growth as resources will be diverted towards less-productive areas that substitute for imports, while consumer spending will be hurt by higher prices. 

A broader point is that even though the chance of downturn has seemed relatively low in recent years, the cost of a recession would be high because of the lack of a viable policy response. This is why central banks have been much more concerned about the downside risks to growth rather than the upside risks from inflation, because the next downturn could be very painful.

Another recession would exacerbate populism and intensify pressure for trade protection, which would accelerate the fragmentation of the global economy.

There is not much clarity on the probable policy choices of the next U.S. administration. We are likely to learn more in coming weeks, but we should recognise that the certainty of recent years is over.