Will EM Troubles Derail Global Expansion?
The Fed is trying to create a “just right” Goldilocks solution.
Despite the fact that we are in the tenth year of this expansion, job growth is robust.
Fed policy makers have been saying they will not go into panic mode if Core PCE moves modestly above 2.0%.
The government has gone against trend and increased their spending at the same time that the rate of growth of tax revenue has stabilized, thus widening the deficit.
Last year’s optimism about synchronized global growth has been replaced by trade fears and emerging-market troubles. Rising uncertainty, higher interest rates and a strengthening U.S. dollar have led to a modest tightening of global financial conditions, and exposed vulnerabilities that had, until recently, been masked by plentiful global liquidity. Still, the global economy has been resilient and we remain optimistic that a broader crisis is not imminent.
The events overtaking Turkey in recent months have been building for years and should not come as a surprise. To the detriment of macroeconomic and financial stability, the government under President Erdogan for years has prioritized short-term growth at all costs. That includes foregoing interest rate hikes needed to contain runaway double-digit inflation and to support a plummeting lira. It also has meant relying heavily on foreign-currency debt, mostly short term dollar denominated, to finance deficits, massive government spending and company borrowing.
For the better part of the past decade, Turkey has been one of the main beneficiaries of historically low interest rates and the unprecedented monetary experiment of quantitative easing. The problem is that these dollar-denominated obligations will become increasingly difficult to service as the U.S. Fed moves toward a policy of monetary tightening and an unwinding of its QE program. Paying off a $100,000 loan at the start of this year would have required 379,000 lira. Now, that same loan would take more than 660,000 lira. All in all, the Institute of International Finance estimates that the foreign-currency debt of Turkish firms, financial institutions and households now stands at 70 percent of annual economic output. Turkey’s banks are in a particularly precarious position: with over $100 billion in external debt falling due over the next year, there is a real risk of systemic defaults.
Turkey relies on foreign-currency debt more than any other major emerging market, but it’s not alone. Elsewhere, Argentina, Brazil, South Africa and Indonesia are also struggling with high capital account deficits, and at a wider level, Greece and Italy also have troublesome characteristics. Though technically developed economies, both have large amounts of debt in a currency they don’t control, high debt to GDP ratios, weak banks burdened by problem loans and governments that are resistant to economic reforms.
As of now, the IMF, if necessary, has sufficient resources to handle a first wave of crises. Argentina already is negotiating a $50 billion rescue package. Still, there are good reasons to believe a full-blown global debt crisis is relatively unlikely to erupt and that the crisis will not spread. Emerging markets have evolved quite a bit over the past two decades, and the current crop of trouble cases are the exception rather than the norm. On the whole, emerging economies are much better managed these days, and key improvements, such as higher foreign currency reserves, flexible exchange rates and lower inflation, have made them more insulated from the risk of contagion.
Despite a recent softening of European performance, the overall global economic picture remains strong, with most regions of the world still growing briskly. But, in the event that financial crises spread further through EM economies as they did in 1997-1998, exposure of advanced economies, particularly the U.S., appears limited. Exports to developing countries make up a relatively small share of GDP in major economies, while exposure of the banking systems as a share of financial assets is also relatively small.
The U.S. economy especially is doing quite well. Last quarter, GDP topped 4% and underlying growth appears to have sustained much of its recent momentum at the start of the third quarter. Fiscal stimulus due to the tax cut and increased spending should offset economic hardship from the current stage of EM problems.
Perhaps the most important reason for optimism is that global long-term real interest rates are still extremely low. Even with all the drama surrounding Fed tightening, 30-year inflation-indexed Treasury bills are paying about 1% — far below long-term real returns, which have averaged closer to 3%. As long as the underlying global interest-rate picture is fairly benign, it is hard to see a wave of bond defaults coming just yet.
Of course, fears of a spreading currency and debt crisis shouldn’t be dismissed entirely out of hand. The economic downturn in distressed countries will cause some level of negative feedback loops. And there’s always a possibility that risk aversion becomes more deep seated and impacts other markets. However, the structure of the global financial system today, which includes stress tests for banks and more floating exchange rates to absorb some of the financial pressure, should be able to contain the damage from this episode until it gets resolved.
As expected, the Fed left interest rates unchanged at its August 1 meeting. However, it does plan on raising rates at its September and December meetings, fulfilling its plan to gradually increase the federal funds rate and bringing it to a more “normal” range. The median federal funds rate is currently at 1.875%. At the end of the year, it should be 2.375%. The current projection of the Fed is to continue to raise this rate in 2019 and 2020, with a terminal rate of 3.4% (see Figure 3).
At the recent Kansas City Fed’s Economic Symposium in Jackson Hole (what some have dubbed “Fed Camp”), Chairman Powell gave a middle-of-the-road speech that reiterated and defended the Fed’s position of gradually raising interest rates, which it sees as a risk management strategy. With the economy growing at a pace above trend (around 3.0%), the unemployment rate below estimates of longer-term normal, inflation that has recently firmed near the Fed’s target of 2.0%, and the growing shadow of concern regarding trade policy, the Fed is trying to create a “just right” Goldilocks solution. To the Fed, that means a steady and predictable rise in interest rates.
The recent job report is a continuation of strong hiring gains that have been in place since October 2010: a record 94 months. More impressive is the recent resurgence in job gains, following three years of decreasing gains (see Figure 4). Despite the fact that we are in the tenth year of this expansion, job growth is robust. So far this year, the average monthly gain in payrolls has been 215,000, which compares favorably to the average of 200,000 in each full year of continuous job gains in this expansion. Also, it is important to note that the manufacturing sector has yet to appear to be affected by the trade tensions. Manufacturing employment grew 37,000 in July, the largest monthly gain this year and one of the strongest monthly gains of this expansion, which has averaged growth of 9,000 manufacturing jobs per month.
The unemployment rate, which is based on a different survey, fell to 3.9% from 4.0%. The cycle low is 3.8%, which was reached this past May. The reason for the slight increase in the rate from the cycle low is due to the increased growth in the labor force. It seems that the strength of the economy is encouraging workers to join the group looking for work by pulling them out of the “woodwork.” The employment growth is running faster than the labor force.
Normally, we do not spend much time focusing on the producer price index (PPI), the measurement for wholesale prices, since it is relatively volatile compared to consumer prices (see Figure 5) and doesn’t have much predictive value for forecasting consumer prices. But with the enactment of recent tariffs, it is one of the places we can look to see if there are any “upstream price pressures.” The July report came out, and we did not see any broad-based price pressures from the tariffs. That does not mean they don’t exist; if they do, they are being absorbed by businesses. As time moves forward, if the tariffs are still in place, they may have some economic impact. We will be watching.
City National Rochdale does not believe the current higher levels of inflation in PPI or CPI will alter the Fed’s current plan of rate increases. You can see in the chart we have had higher levels of these inflation measurements in the past, and it did not alter their plans at the time. Furthermore, Core PCE is the Fed’s favored inflation measurement, and it is still below the target rate of 2.0%. In addition, for years Fed policy makers have been saying they will not go into panic mode if Core PCE moves modestly above 2.0%. We expect the Fed to continue their gradual pace of raising interest rates back to “normal.”
The history of the federal government balancing revenue and expenditures is not very good. In the past 25 years, the federal government ran a deficit for 21 of them—and those four years with a surplus were a bit of a surprise. The primary reason behind these surpluses was hefty influxes of revenue from the large capital gains due to the dot-com stock market rally and, to some extent, a slower rate of growth in federal spending. Looking back further, in the past 100 years, a deficit occurred 77 times. As for the 23 years of surpluses, the bulk of them happened in the 1920s.
In the past 50 years or so, a cycle has developed. During recessions, the budget deficit gets larger (due to lower tax revenue and larger expenditures, usually for social programs and stimuli). Then, as the economy breaks out of the recession and begins to expand, the size of the deficit shrinks as the government slows down spending and tax revenues pick up (see Figure 6). The current expansion started the same way, but in the past couple of years, the government has gone against trend and increased their spending at the same time that the rate of growth of tax revenue has stabilized, thus widening the deficit. The recent tax cut is expected to make it even wider, and the deficit this year is expected to exceed $1 trillion.