Central banks might push the world into a long downturn

A protracted economic slump across large parts of the world economy is colliding with an ever more egregious credit bubble, one that looks increasingly like the subprime excesses of 2007. This strange contradiction will be resolved one way or the other soon enough.

Germany, Britain, and Japan were all in recession over the northern hemisphere winter. France escaped by a whisker, but is now introducing austerity cuts. The latest fall in the eurozone’s Economic Sentiment Indicator has smothered hopes of a meaningful recovery over coming months.

Fed chair Jerome Powell. The Federal Reserve, the European Central Bank, and the Bank of England are all talking as if the world economy touched bottom several months ago.Credit: Bloomberg

Investors are behaving as if the West is already in the early stages of a cyclical recovery. They are betting heavily on the impossible trinity of falling inflation, double-digit gains in corporate earnings, and a Goldilocks economy of perfect pitch. But what macroeconomic force is supposed to drive this rebound?

China is still grappling with the fallout of its enormous property slump. Cities and local authorities that once depended on land sales for 42 per cent of their income have seen this revenue halve since that bubble burst in 2021. They are in the midst of a public debt crisis that dwarfs the eurozone travails of 2010-2015 in absolute numbers, if not in character.

Beijing is trickling out just enough stimulus to prevent a chain reaction – mobilising the “national team” to lift share prices on the carpet-bombed stock markets of Shanghai and Shenzhen – but not enough to lift the mood of cosmic gloom enveloping the country, or to reverse the onset of debt-deflation.

International analysts have cut their global growth forecast from 2.8 per cent last year to around 2 per cent this year, a level that used to be deemed a world recession by the World Bank. It is certainly near stall-speed.

At the same time, credit spreads on junk debt are compressed to levels seen during the wildest phases of pre-Lehman speculation. The BBB corporate debt index has dropped to a wafer-thin spread of 120 basis points. The fever has spread to risky “B”, a grade defined by Fitch as having a “material default risk and a limited margin of safety”. So much for claims that we are now in a world of scarce capital.

“Euphoria is the name of the game,” said Barnaby Martin, credit strategist at Bank of America. “What are the classic signs of a credit bubble? When discipline goes out of the window and markets buy deteriorating credits because of a feeling of ‘value’.”

It does not yet feel like the pervasive blow-off of 2007, when Icelandic banks were going mad and Greek bonds were trading like German bunds, as if the eurozone had a fiscal union. But we will know that moment is nigh if CCC-rated debt joins the party. At that point, run for the hills.

Equities are better behaved but AI values are absurd and we have seen all-time highs over recent days on Wall Street, Japan’s Nikkei, Europe’s Stoxx 600, the French CAC, the German DAX, and India’s nifty fifty, and it cannot all be attributed to the illusion of nominal money.

Investors are behaving as if the West is already in the early stages of a cyclical recovery.Credit: NYSE

The standard price/earnings multiple for the S&P 500 index is currently 22.95, versus 15.77 at the peak in May 2007. “The current AI bubble is bigger than the 1990s tech bubble,” said Torsten Slok from Apollo Global Management.

Bank of America’s Bull & Bear indicator is flashing warnings of excess exuberance at 6.6, but has not yet hit the contrarian sell-signal of 8.0. “It won’t take long,” said the bank’s equity guru, Michael Hartnett.

The US economy is still in good shape, enjoying the turbo-charged fiscal stimulus of the Trump tax cuts and the Biden New Deal, which have together pushed the federal deficit to 6.5 per cent of GDP. But even this has its limits. The Hutchins “fiscal impact measure” suggests that budget policy is now a net drag on growth.

Markets have pocketed a perfect soft-landing before it is actually achieved.

Most Americans have exhausted the excess savings accumulated during Covid lockdowns, and they have dipped deep into their rainy day reserves for good measure. The US savings rate has collapsed to 3.7 per cent of GDP and is now close to an historical extreme. Such episodes always end badly.

The first sugar rush from the Inflation Reduction Act is fading too as foreign investors discover what it actually means to face US bureaucracy and local content rules. A free market, it ain’t. The National Association of Manufacturers expects capex spending to fall to an eight-year low of 0.6 per cent this year.

The American exceptionalism of the last two years is fraying at the edges. Truck freight volumes dropped 4.7 per cent last month (y-on-y). Durable goods orders fell 6.1 per cent in January, or by 7.3 per cent excluding defence.

New home construction fell 14.8 per cent, doubtless exaggerated by bad weather but unlikely to roar back soon given the jump in the average 30-year mortgage rate to a new cycle peak of 7.16 per cent. None of this means that the US is necessarily clattering into recession but the post-Covid boom is assuredly over.

Markets have pocketed a perfect soft-landing before it is actually achieved. Banquo’s ghost at this feast is extremely tight money from central banks fixated on lagging indicators of wages and inflation, and trying to repair their reputations after letting inflation take off. They are therefore likely to make a policy mistake.

China’s stuttering economy is a concern for the rest of the world. Credit: Bloomberg

This is not to say the job of central bankers is easy. What are they to do in the face of rampant speculation from AI stocks to Bitcoin and Ethereum? Monetary tightening is like pulling a brick across a rough table with elastic; you tug and tug, and nothing happens; you tug again, it leaps into your face.

The Federal Reserve, the European Central Bank, and the Bank of England are all talking as if the world economy touched bottom several months ago. They are keeping interest rates very high as an insurance policy against a resurgence of inflation, just in case this really is the 1970s again.

But even standing still has consequences. Real rates are rising passively – and fast – as inflation drops.

Paul Donovan from UBS says real rates in Germany have risen by 160 basis points since the last policy change. This is an odd prescription for a country facing the worst property slump in 60 years and also trying to contain liquidity woes at Deutsche Pfandbriefbank before it sets off a systemic German banking crisis.

The ECB’s policies seem so far out of kilter with the needs of a depressed economy that it may end up pushing Europe back into incipient deflation. All three central banks may be underestimating the delayed effects of monetary tightening – past and current – and risk pushing the world economy into a stubbornly long downturn.

As for the credit bubble, it could end two ways: if the doves are right, a weak economy will set off a wave of corporate defaults; if the hawks are right, a strong economy will lead to monetary torture and also a wave of defaults. Pick your poison.

Read more:

Stephen Bartholomeusz: US inflation shock rattles markets and central bankers

Stephen Bartholomeusz: The signal that has the world on edge

Telegraph, London

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