Structural Change Watch List

Sowing the Seeds of a Financial Crisis

Read the August Economic Currents in PDF 

Special International Edition: Part II The following represents the second of a two-part series on the global economy. The first covered the outlook for global growth, which is slowing. The second integrates what I learned with my peers, representing every region of the world with our own analysis of the structural or secular changes many of our economies are grappling with. If we don’t change course, we could find ourselves back where we started, in the throes of another financial crisis.

Deceleration Real GDP growth is expected to slow to a 1.7% pace in the third and fourth quarters, after rising an average 2.5% in the first half. Our forecast shows consumer spending moderating after a snapback in the second quarter. Lower prices at the gas pump and mortgage refinancing will blunt the erosion in purchasing power associated with higher tariffs. Employment growth has moderated significantly in recent months. Business investment will remain weak in response to weak growth abroad and uncertainty surrounding trade policy. The trade deficit will widen as export growth slips below import growth, the opposite of what the White House hoped. Inventories should continue to drain; the vehicle industry shut several plants permanently in July.

Government spending will hold up better than we previously thought. The bipartisan agreement on discretionary spending removes a fiscal cliff from the forecast.

Fed Eases Cautiously. Weak growth abroad and concerns about the direction of trade wars suggest that the Federal Reserve will cut rates two more times before year-end. Fed officials are trying to keep preemptive cuts to a quarter point each and save larger cuts for when the economy falters. They have little choice but to react to disruptions in trade and the broader economy created by poor trade policies.
Economists focus on two distinct forms of change:

  1. Cyclical changes, which play out quickly, over as little as a few months’ time
  2. Structural or secular changes that take much longer to form and work their way through the economy

Structural changes are inherently more powerful because they can impact the contour and length of any given cycle. They are also easier to identify as they are already happening. The aging of the population across much of the developed world and China is one of the most profound shifts currently under way. Aging demographics affect how fast our economies grow, to whom we elect.

The remainder of this report provides a top ten list of structural changes and the ways they could potentially interact. Older electorates with “atavistic” tendencies - a longing for a return to the past - are voting in autocratic leaders who are ushering in a new era of nationalism, harder borders and a backlash to anything foreign (immigrants and trade). The result is a cascade of policies that tend to curb growth, or worse. Countries led by autocrats tend to trigger negative economic outcomes.

Top 10 List 1. Much of the developed world and China are aging. Increased longevity, the retiring of the baby boom generation and a drop in fertility rates are crimping the size of the working age (15-65 years old) population. This is already taking a toll on growth via constraints on the labor force and a slowdown in productivity. Older workers tend to be less productive than their younger colleagues, especially given the rapid pace of technological change; these problems are expected to compound. One recent study suggests that aging alone could halve the pace at which the U.S. economy can grow over the next decade.

Japan provides a cautionary tale as one of the first major economies to age. That triggered the rise of what my Japanese friends politely term the “Silver Democracy,” or an older electorate determined to preserve its benefits regardless of the burden placed on the young. In response, younger workers became more pessimistic about the future and saved more and spent less when the economy needed the opposite. The result exacerbated the vicious cycle of deflation and stagnation in Japan.

The Pew Research Center suggests a similar phenomenon is occurring elsewhere in the world, including the U.S. Millennials were hardest hit by the global financial crisis and are now more pessimistic about their future than older generations. The recent surge in debt and deficits will only worsen those concerns. Add to that, millennials suffered the largest blow to earnings and wealth in the wake of the crisis. Young people are not likely to play the role they once did in fueling growth. Millennials have already delayed marriage, child bearing and home ownership, which is taking a toll on our potential to grow.

China represents an extreme. Everything from the onechild policy to improved earnings for women has taken a toll on fertility rates. The working age population has hit a cliff and is now plummeting. This leaves China with one of two options to keep growing: Open the doors to a large influx of immigrants, which is a nonstarter, or invest aggressively in new technologies to boost the productivity of the Chinese who are still working. China has chosen the latter, making massive investments in R&D, technological infastructure and engineers. It is also stealing intellectual property in order to innovate, which is raising other issues.

2. Curbs to immigration will intensify. The backlash to immigrants is coming from a minority of the electorate. Views on immigration have actually improved in recent years in countries with the most immigrants, including the U.S., France, Germany and the UK. The result stems from who votes. Older voters in rural areas have a much higher participation rate. They dominate U.S. primary elections, which determine who runs in larger elections. The result is a stronger backlash to immigration than the polls suggest and active curbs on new immigration, legal and illegal.

Delays have increased for H1B visa applicants and their spouses who qualify to work; this is acting as a deterrent to legal immigrants filling key positions. Often they are positions for which we cannot find qualified, domesticborn applicants. The government has yet to rule on spouses of highly skilled, H1B visa holders, which is a hurdle to double-income, highly educated immigration.

Upcoming elections could trigger a shift in the enforcement of immigration policy but unless major immigration reform is accomplished, the shortfall in workers will persist. Deportations of illegal immigrants and fear of a backlash are deterring a whole spectrum of workers from entering countries. Net migration from Mexico has actually been negative during much of the current economic expansion in the U.S.

This is in addition to efforts to curb immigration across Europe. Hungary and Poland are especially hostile to immigrants and refugees, despite a surge in retirements and increasingly tight labor market conditions.

Japan is an exception as it has attempted to open its doors a crack to new immigrants but largely failed. The country still allows systemic discrimination of immigrants in hiring and housing policies, which is acting as a deterrent to the very population it needs to attract.

3. Protectionism is on the rise. Protectionism was already picking up prior to the 2016 presidential election in the U.S. Brexit was passed as a referendum nearly six months prior to our elections. The pushback to trade and the shift from multilateral to bilateral agreements by the U.S. accelerated the process. Tariffs are the default mechanism for enforcing bilateral agreements; they up the ante for retaliation by affected trading partners.

“Japan provides a cautionary tale as one of the first major economies to age…The result exacerbated the vicious cycle of deflation and stagnation in Japan.” The trade war shows no sign of abating. The president surprised his own advisers by tweeting yet another round of tariffs to go into effect on China starting September 1. A few days later, he had Treasury declare China a currency manipulator. That move was more symbolic than consequential for China, but it seems to have had the desired effect. China reversed the small downward drift it had allowed in its currency the day after the U.S. declared it a currency manipulator.

The question is, what is next? Efforts to penalize China for intellectual property theft have bipartisan support. The Senate Minority Leader Chuck Schumer was quick to support the president’s move to declare China a currency manipulator. Presidential candidate Senator Elizabeth Warren supports even more aggressive curbs on trade.

Vietnam, South Korea and Thailand have been hit with higher tariffs as the administration penalize firms that attempt to circumvent tariffs; they diverted shipments to countries with lower tariffs. The administration is expanding its net by threatening additional tariffs on vehicles and parts coming in from Europe and Japan. Vietnam and France are also on the list.

Protectionism has proven contagious. Japan is now following the lead of the U.S. and penalizing South Korea with curbs on materials critical for their tech sector. The stated reason is national security, but the real reason is diplomatic. Japan wants South Korea to back off its demand that Japan atone for atrocities inflicted on Koreans during WW-II.

4. Supply chain disruptions will compound. Many large-scale producers have begun to relocate from China to Vietnam and Mexico, instead of returning to the U.S. This is triggering a chain reaction across suppliers; they move with the producers. The results are costly and compound over time. The worst of the first round of tariffs are expected to squeeze profit margins in 2020.

People often forget the disruptions to vehicle production in the wake of the tsunami that hit Japan in the spring of 2011. Damages to one key components maker shuttered plants around the world. The ripple effects took weeks to show up, but months to rectify.

5. Currency wars are a consequence of weaker growth. Treasury put nine countries on a watchlist for currency manipulation in May. China was declared a currency manipulator on August 6, one day after it allowed its currency to fall below a key support level for markets. A day later, the central banks of three different countries - India, Thailand and New Zealand - surprised markets by cutting rates more than expected. They are attempting to counter weak economic growth. This has upped the ante for rate cuts by central banks in Europe and Japan where short-term rates are already negative.

In response, the U.S. dollar is appreciating as foreign currencies plummet, while fears of a more broad-based currency war are mounting. The president sent out a flurry of tweets goading the Federal Reserve to act more aggressively to offset the upward movement in the dollar.

That said, China has more to lose than gain by engaging in a full-blown currency war. Much of its debt is denominated in dollars. That debt would become much harder to service, while access to credit could dry up. It’s hard to find collateral for a depreciating asset. Capital flight is another risk. The Chinese government has already put substantial curbs on nationals seeking to transfer their wealth out of the country via investments in real estate abroad and cryptocurrencies. A rapid depreciation in the yuan would accelerate those outflows.

The Federal Open Market Committee (FOMC) will cut short-term U.S. rates further to counter the weakness we are seeing abroad. The Fed is trying to keep its powder dry by moving in one-quarter-point increments until our own economy falters. Then, they believe one-half-percent moves or greater will be needed to right the ship.

The Federal Reserve would like to avoid being seen as aiding and abetting a currency war. The dollar is a reserve currency, which gives us more latitude than other countries when it comes to funding debts and deficits.

Overt attempts to devalue the dollar would undermine that status, which is already being questioned. Investors flew to the perceived safety of the German bund market instead of Treasuries when the president threatened a 5% acrossthe-board tariff on Mexico.

6. Fragilities in financial markets are forming. The unintended consequences of low rates for longer - inflated asset prices, an excessive rise in debt in both the public and private sectors and weakening bank balance sheets in Europe and Japan - have created fault lines in the financial system. An escalation of trade tensions between the U.S. and China could trigger another quake. The U.S. alone experienced the worst tightening of financial conditions since December in early August as tensions between the U.S and China flared. (See Chart 1.)

The spread on junk bond yields experienced the worst one day increase since the Brexit vote. (See Chart 2.) That is especially worrisome given the surge in junk bond issuances in recent years. Nearly one third of the recordbreaking, nine trillion dollars in corporate debt outstanding is rated BB or lower. The next largest tranche is just above the threshold for investment grade, which means it has a high risk of being downgraded as the economy slows.

This is all at the same time that investors are worried about the validity of the ratings. A recent Wall Street Journal survey found that six of the largest bond rating agencies have eased their standards for bond issuances since 2012. Those who rated bonds as less risky than their competitors gained market share, at least temporarily.

Structural Change Watch List

Structural Change Watch List

In response, defaults could surge and losses could mount rapidly. The ripple effects would be felt throughout credit markets. Pension funds have been aggressive in their purchases of junk and emerging market debt in recent years as they reached for yield in a low-yield environment.

7. Debt and deficits will soar. Aging populations supported by aging electorates are voting for politicians who care little about debt and deficits. Spending on entitlements - pensions and health care - are rising, while major investment in R&D, infrastructure and education is lagging. The exception is China, which is taking on debt to fuel current consumption and investment in large-scale research projects and education. The result is soaring debt and deficits.

The fiscal situation in the U.S. is unusually dire. Deficits as a share of GDP are expected to hit 5.1% in fiscal year 2019, the highest we have ever seen, well into an expansion. The debt-to-GDP ratio could easily top the high of WW-II in the decade to come unless something is done to change our current trajectory. (See Chart 3.)

A shift in the electorate toward younger voters could usher in a new era of investment and longer term fiscal discipline. Few (if any) politicians believe they can win an election by supporting austerity measures. The focus is on eliminating student debt, which is a servicing problem.

Millennial voters rank access to healthcare, climate change and mass shootings as their top priorities. The first two will be costly and require additional funding.

The result is an older electorate willing to leave its debt problems for the young and a younger generation that still believes in Santa Claus. We have real problems that government needs to address and can afford, not just a sound bite that can win elections.

8. Climate change is accelerating. Damages associated with extreme weather events have increased in recent years. Floods, drought and an increase in the number and severity of natural disasters are wreaking havoc on everything from agriculture to manufacturing.

Moreover, disruptions associated with extreme weather are expected to get worse in the years to come. We simply haven’t done enough to reverse warming trends by weaning ourselves from fossil fuels. Insurance companies are already feeling the pain as they are forced to rethink how and what they can cover. The parts of Houston not covered by flood insurance remain in tatters two years after the devastation caused by Hurricane Harvey.

The results will further drain government coffers and accelerate the emphasis on cleaner forms of energy. The U.S. is now a laggard and may have to play catch-up. The transition from fossil fuels to cleaner energy will be particularly costly for existing fossil fuel producers. The blow to asset prices is expected to be so severe that the European Central Bank (ECB) is now requiring banks to stress-test their portfolios against climate change.

9. Diversity will intensify. Demographics are shifting toward a more diverse population, regardless of how many doors we close to immigration. Millennials in the U.S., who dominate the labor force, are a particularly diverse group. Over 30% of the population are considered “new minorities:” Hispanic, Asian and multiracial Americans.

Older workers will need to be retained instead of retired, while firms more effectively exploit technology to bridge the skills gap. This has the potential to narrow the divide between generations, but only if firms really understand how to leverage diversity. A critical mass of different perspectives is needed to move the needle on the quality of the decisions we make.

Structural Change Watch List

10. China is decelerating. China has the second largest economy in the world, with tentacles in nearly every other economy. Weakness there is felt almost everywhere. China’s Belt and Road initiative provides an example, as many countries are now struggling to service the debt they took on to develop their infrastructure with China.

Most of the problems that China faces are structural in nature. The country is aging, over-indebted, still subsidizing inefficient companies with ties to the government and lhas lent aggresively to emerging countries. This is all hindering its efforts to stimulate its own economy. It is hard to get over-indebted individuals and firms to take on more debt when they can’t afford to service what they have. The trade war is adding insult to injury.

The only way China currently sees out of its mess is to innovate. It is investing in R&D, people and infrastructure to move up the value chain. It has also engaged in intellectual property theft, which has raised the ire of its trading partners.

Many somewhat naively assume that China will win the technology war. After all, patents have surged since the Chinese started focusing more aggressively on growing their tech sector. The heavy hand of government, an aversion to critical thought and privacy concerns are all gremlins in the engine. China could easily be isolated from innovation elsewhere in the world, which will limit their own ability to innovate.

Bottom Line The global economy is slowing and becoming more fragile. These fragilities stem from a sequence of shifts, from aging to a related desire to turn back the clocks. This means we could repeat the mistakes of the past. A financial crisis cannot be ruled out, but could be averted.

Much of the burden of stabilizing financial markets is on the shoulders of the Fed. Its tools to counter a crisis are more limited than they were the last time around.

A better solution would be a 180 degree change in our trade policies. We need to join forces with our allies to leverage the power of peer pressure to bring China in line with the rest of the world. That means harnessing multilateral instead of bilateral trade agreements. The Trans-Pacific Partnership, which was abandoned by the administration, was designed to do this. Multilateral negotiations at this late stage in our political cycle are a heavy lift, given upcoming 2020 elections.

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