The post this morning on the evolving strategy of Germany’s SPD was actually yesterday’s post. I didn’t get a chance to write it because I went to bed super early. So I am going to write a short piece for today’s post focussing on Japan, Europe and the US.
The Fed’s backpedalling
I think you know my mantra on the Fed by now. But let me boil it down as simply as I can because, in my role as editor at Real Vision, I am seeing a steady flow of market people talking about the Fed in ways I disagree with. And the sense I get is that people who work in the market tend toward a self-referential framing when thinking about policy. And they see the Fed and other central banks acting or not acting based upon the state of asset markets, rather than on employment and inflation.
I see it very differently. This is an episode, not unlike what we saw in 2016, when the Fed was poised to raise rates aggressively. But, it was forced to pause by incoming data. Back then, the Fed raised rates in December 2015 and came to see that initial hike as somewhat of a mistake. Analogously, the same could be said about the December 2018 rate hike. In the first instance, the Fed pause coincided with a mid-cycle slowdown. And I would argue the Fed’s pause aided this slowdown in not becoming a recession. Analogously, the Fed’s pause right now could help prevent recession yet again. We’ll just have to wait and see.
The key here is that the Fed has backpedaled because the global economy is slowing. Financial conditions tightened in response to that slowing and the Fed eased. The result is that financial conditions have eased as well. In fact, market indicators have turned bullish after flashing red late last year. Yet, the global economy continues to decelerate.
The IMF’s view
For example, the chief economist at the IMF is now warning that the economic outlook has darkened. Here’s the FT on her recent comments:
The IMF’s new chief economist has backed the Federal Reserve’s decision to shelve interest rate increases, citing “weakening momentum” and “considerable and rising” risks to the global outlook.
Gita Gopinath, who took over as the IMF’s top economist at the beginning of the year, flagged up a darkening picture in the euro area and China, as she warned there may have been a contraction in world trade in December.
But Ms Gopinath said the Fed’s “pivot” towards putting “tightening on hold” would have a positive impact on the US, the world’s largest economy, which is already being helped by the remaining influence of a fiscal stimulus package.
“The fact that the Fed has put a pause on raising rates is going to provide a lot of support to the economy,” Ms Gopinath said in an interview with the Financial Times. “We endorse the Fed view of having a data-driven approach.”
The Fed last month ditched its guidance signalling further increases in short-term interest rates as it responded to “cross-currents”, including decelerating growth in China and Europe and elevated uncertainty around trade policies. Other institutions including the central banks of India, Australia and the UK have also turned more dovish.
So, everyone sees the outlook worsening globally. And so, little wonder the Fed is not the only central bank that is easing its policy stance. This has little to do with asset markets and much more to do with preventing recession.
The Japanese problem
In that context, what’s happening in Japan bears watching. Now, I’ve been talking a lot about the slowdown in Germany. That’s part of why I think the SPD has been forced to pivot. But things are turning south almost everywhere, including Japan, where third-quarter profits fell at the fastest rate since the 2011 earthquake and tsunami rocked Fukushima. Here’s the FT again:
“We think we hit a bottom during the October to December quarter. But the biggest problem is that we just cannot foresee the timing of a recovery,” said Yoshiharu Inaba, chief executive of industrial robot maker Fanuc, which lowered its guidance following a 42 per cent fall in quarterly operating profit.
According to SMBC Nikko Securities, 1,014 of companies in the benchmark Topix index reported third-quarter operating profit that was 2.6 per cent lower than the same quarter last year. That was the biggest percentage fall since the 2011-2012 fiscal year when the March 11 earthquake and tsunami disrupted supply chains worldwide, according to SMBC.
On a net profit basis, the decline was 26 per cent, mostly because the US tax windfall that Japanese companies had the previous year fell away…
“We witnessed an extraordinary change” in Chinese demand for electric motors in November and December, said Shigenobu Nagamori, chief executive of Apple supplier Nidec. “In the 46 years of my management, I have never seen such a drastic fall in monthly orders,” said Mr Nagamori after the group slashed its full-year net profit forecast by 24 per cent.
Notice the connection to China. I think this is the first cyclical global economic slowdown that’s essentially being led by China. And it’s not just emerging markets that are being pressured, but advanced economies too. You see it in German figures. And you can see it here in Japanese figures as well. The UK has Brexit to worry about. So that’s less about China. But the economy has also slowed sharply, with capital investment falling.
My view
I don’t think this has to end badly. A lot of the negative fallout can be mitigated by policy, both monetary policy and trade. The Fed has already paused, signalling an easing of policy along with the Bank of England and a number of minor central banks. The Reserve Bank of India is actually cutting rates.
The ECB is the most prominent holdout. But I expect movement here too. On Friday, I mentioned speculation in markets that the ECB would reverse its decision to halt QE, and even restart QE by March. I was sceptical. But now, at a minimum, we have Dutch central bank governor Klaus Knot publicly saying the ECB should reverse its decision to halt QE. Here’s the FT quoting him:
“At this moment a wait-and-see attitude is probably the optimal attitude,” Mr Knot said in an interview in Amsterdam. “We are now going through a couple of quarters where growth has fallen below potential, which means the build-up of inflationary pressures will also incur some slight delays.”
Notice that Knot was saying just last year that the ECB should not only be stopping QE but also raising rates soon. With the eurozone the weakest link in the advanced economies, this shift is practically mandated. If the ECB didn’t shift, the euro would rise and strangle the remaining bits of Euroland’s export-led recovery. A recession is just one policy error away for the eurozone.
So, for now, it looks like we have a major shift in macro policy. Everyone is a dove now. I don’t foresee any rate hikes from the biggest central banks during the first half of this year now. Let’s see where that gets us, because if these economies slow further, expect policy easing to become more aggressive still.