Five things to look out for in economics this week

Equity markets are down – is this a correction or a signal that the long-term economic growth phase is coming to an end?

Hamish McRae
Sunday 18 February 2018 18:05
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The US Federal Reserve has a new chair, Jerome Powell, and interest rates in the country are returning to something like normality
The US Federal Reserve has a new chair, Jerome Powell, and interest rates in the country are returning to something like normality

Go away for a couple of weeks’ holiday in Africa and come back to find the world’s main equity markets have lost 10 per cent of their value. Catch your breath in the office for a couple of days and, hey presto, they have clawed back half of that fall.

That at least has been my experience this February, and it has set me wondering quite how to calibrate what has happened. My initial reaction has been one of relief. The boom in share prices was getting out of hand, and if you are going to have a correction it is much better to have one early rather than late. (By the way, I love that word “correction” – the idea that markets have made a bit of a mistake but now have seen the error of their ways and all will be hunky-dory.)

There are two broad explanations for what has happened. One is to see it as a correction – the markets getting ahead of themselves – with no wider implications for the global economy. The other is to see it as a signal not only that the long share boom is over but also that the long economic growth phase is coming to an end too – maybe not a full-blown recession but a serious slowdown.

Which is right? Well, maybe it will turn out to be some combination of the two, but for clues I shall be looking at these five things.

First, US bond yields. The 10-year Treasuries are now yielding close to 3 per cent. If they climb significantly above that level in the next three months, that would suggest that the US economy will see a slowdown next year. This would happen despite the tax stimulus, or maybe even in part because of it, for a looser fiscal policy would have to be offset by a tighter monetary policy.

Second, what does the Fed do? We have a new chair and we also have a new situation: the return to something like normality in interest rates in the US. That, on the face of it, would be a relief. But there is always a danger of a mistake, either by the Fed itself, or more likely by the markets’ interpretation of the Fed’s actions.

Third, what happens to US inflation? If you look back over the past half-century, expansions usually end in a burst of inflation. There are small signs of that in the latest numbers but it is too early to be sure what is happening. What I am sure about is that if the US goes into recession, the rest of the developed world economies will follow suit. America sneezes: Europe catches a cold.

That leads to Europe. My prime concern here is the fragility of the banking system, and in particular the high proportion of non-performing loans in several countries. “Non-performing” is the technical expression to describe loans where the borrower cannot pay the interest. You don’t need to be a financial wizard to see that if a borrower cannot pay even the very low levels of interest that Europe currently has, it has not much hope of repaying the principal. Many major European banks are in trouble, for unlike US and UK banks they have not been forced to write off dodgy debts.

It is a bit like Japan in the 1990s, when bad debts were swept under the carpet. Eventually, the economy scrambled through but at huge economic cost. Europe is currently enjoying a cyclical expansion and that is welcome. But it is not in good shape to withstand a US-led downturn.

Finally, there is politics. We will know early next month whether Germany and Italy have stable governments. If they do, well and good. If not, the odds on economic disruption in 2019 shorten sharply.

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