Synchronicity
August 2, 2019
Synchronicity is an important topic in the physical sciences and in psychology. Pop singer Sting thought it was so fascinating that he wrote two songs about it in an album of the same name. 1When global economies move together, economists refer to it as synchronization. The interconnectedness of communication, supply chains, and (sort of) trade has changed the relationships between economies and made synchronization a popular topic. It is especially important to market participants right now, because one of the biggest concerns is the ongoing moderation in global growth. Each individual country seems more worried about slowdowns in other countries then they are about their own economies. 2It may be that global economies are only synchronized in passing the blame for their problems.
Most economists would probably argue that synchronization should be most pronounced on the broadest set of data such as GDP, but that each economy should have its own areas of cyclical strengths and weaknesses based on domestic conditions. Oddly, the opposite seems to be the case now. In this peculiar episode, the details of the economic data in developed markets seem as coordinated as the headline growth. Sure, there are some EM outliers as there always are, but they stand out as anomalies.3
Labor markets are solid around the world. The U.S., Japan, Germany, and China all have unemployment rates that are at or near historic lows. 4Many years ago, some economists created what they called the “misery index,” which added unemployment and inflation. 5Now that could be renamed the joy index. Inflation is low almost everywhere. In the U.S. and Western Europe, we are used to that now, but in some other countries it is shocking how much it has fallen. India, Brazil, and much of Eastern Europe have battled double-digit annual price increases, but now seem to have achieved price stability. As a result, interest rates around the world have fallen dramatically.
With inflation low, people employed and credit affordable, it’s intuitive that retail sales would be good around the world. Consumers are spending so economies are growing. Unfortunately, the global economy is not all chocolate and sunshine. Investment has been weak. Purchasing Managers’ Indexes have fallen sharply. Industrial production has been disappointing. As has been reported on the top headlines of almost every news source, global trade has been disrupted. And except for a few Fortnite players’ winnings, 6wages have not risen as quickly as people would like.
This mish mash of concurrent data across the world is difficult to assemble. How can firms be cutting back on production but still hiring people? Also, if consumers are spending, wouldn’t companies need to produce more to meet that demand? One possibility is that that data is not reliable. For example, one large country’s consumers may not be spending as much as the public releases indicate, and that is hurting trade and production around the world. But even if that is true, there are a few bigger trends worth noting.
The first is that there appears to be some overcapacity in global manufacturing. Even though demand has been decent, it does not match what can be produced. This helps explain why inflation and interest rates are low. It is very difficult to get prices up when there is excess supply. In the old days, oversupply in goods would lead to recessions as firms retrenched. In recent decades, we’ve seen several contractions in global production which have not led to material slowdowns in growth. For example, in 2015, low oil prices hurt investment in that very large sector and manufacturing numbers fell but no global recession followed. Now we are seeing it again, though this time it is less concentrated.
The reason for the resiliency in global growth is that developed economies have become far more service oriented. In addition, mechanization has increased output per person in the manufacturing sector. 7This makes individual economies far less sensitive to the ups and downs of the inventory cycle in manufacturing. After all there is much less inventory in service products. If interest rates go down because of overcapacity in manufacturing, easy credit can benefit other sectors. This can translate into more jobs, but perhaps not significant increases in wages.
While the service economy can protect against inventory cycle contagion, it does not inoculate the world from recessions. Some economists would argue that while it makes them less frequent, they are in fact worse when they do occur. The causes, however, are different. Instead of being driven by excess inventory, as they were prior to World War II, the more recent ones seem to be more related to excesses in credit. We’ve seen that retrenchments can lead to financial crisis, which can cause a full-blown recession both in a single country and, in the worst-case scenario, much of the world.
We are currently seeing a cyclical manufacturing and trade slowdown. Policymakers are reacting by easing credit or signaling that they will do so in the future. There doesn’t seem to be any indication that it will lead to any broader issues, in that sense it is similar to the 2015 episode. However, we would caution against becoming too complacent about that view. It is important to look for signs of credit problems around the world. Credit spreads are generally tight, but they should be monitored. 8There are a few pockets of softness in the U.S., but 9 1 nothing alarming. In China, two medium-sized banks have failed this year. 9Investors should be on alert for any signs of deterioration there. Investors should also look for signs of weakness in employment and consumption, which would indicate that lower rates are no longer helping service sector growth. And the trade war could reemerge as a real threat to global growth. However, absent any surprises, there is little reason to believe that the synchronized global manufacturing slowdown will lead to a synchronized global recession.
What We Are Watching
Australia Central Bank Meeting (Tuesday) Faced with a weakening economy, persistently low inflation, and rising unemployment, the Reserve Bank of Australia (RBA) was one of the first developed market central banks to cut rates this year. Policymakers at the RBA highlighted the uncertainty generated by trade disputes and consequent downside risks to global growth. Australia’s strong trade linkages with China as well as other Asian economies integrated into the Chinese supply chain may make the country particularly vulnerable to a worsening of current tensions. In this context, the RBA has lowered its policy rate by 0.5% this year and introduced a conditional easing bias, vowing to “adjust monetary policy if needed to support sustainable growth.” Market-implied odds for a rate cut this month are very low, however any new dovish tilt in the policy statement could boost expectations for further easing in 2019.
New Zealand Central Bank Meeting (Wednesday) As in Australia, the New Zealand central bank (the RBNZ) has shifted in a dovish direction this year. In May, the RBNZ cut rates to 1.5%, citing slower growth, downbeat business sentiment, and subdued inflation. At the subsequent meeting in June, the RBNZ statement emphasized that further easing was likely, declaring that “the outlook for the economy has softened” and “given the downside risks around the employment and inflation outlook, a lower [policy rate] may be needed.”1 0New Zealand fixed income markets now price a cut at the August meeting followed by at least one additional move in the next few quarters. Provided the RBNZ reduces rates at this week’s meeting as expected, attention will likely focus on the tone of the statement and the updated economic projections. In particular, market participants will be looking for confirmation that the central bank expects to continue easing. If statement language and staff forecasts are more equivocal, it could prompt a selloff in domestic fixed income and strength in the New Zealand dollar.
Canada Employment Data (Friday) Labor market data in Canada has generally been strong this year, strong job gains in the service sector have more than offset weak employment in manufacturing (a divergence seen in broader activity data as well). Last month’s labor market report showed some signs of deceleration from elevated levels, with a slight decline in the overall employment level. However, hourly wage gains for permanent employees grew much more rapidly than expected, a sign that a tight labor market may be generating inflationary pressure.1 1Despite easing action and rhetoric from other developed central banks, the Bank of Canada has maintained that the current stance of monetary policy is appropriate. Further upside surprises to employment or wages are likely to support the BoC’s current on-hold stance, potentially driving underperformance in Canadian fixed income and strength in the Canadian dollar.
[1 ] I am a big fan. The music he’s created, I don’t really listen to it, but the fact that he’s making it, I respect that. The songs are creatively titled “Synchronicity I” and “Synchronicity II.”
[2 ] The Fed, ECB and RBA have all expressed that concern as a potential reason for easing.
[3 ] Unfortunately, they stand out as downside outliers. Turkey and Argentina come to mind.
[4 ] Some European countries such as Spain and Italy still have very high rates, but they are showing improvement.
[5 ] The first Misery Index, a simple sum of a country’s unemployment rate and annual inflation rate, was created in the 1960s by Arthur Okun. Steve Hanke, a professor at John Hopkins University, has created a slightly modified version that is the sum of the unemployment rate, inflation and bank lending rates, minus the percentage change in real GDP per capita. Hanke’s latest modified Misery Index readings as of the end of 2018 can be found in: Forbes, “Hanke’s Annual Misery Index 2018: The World’s Saddest (And Happiest) Countries,” 3/28/19.
[6 ] Bloomberg: “Teen Wins $3 Million Prize in First Fortnite World Cup Tournament,” 7/28/19.
[7 ] There are some well documented side effects of this in the composition of employment and wages.
[8 ] Every move they make, investors will be watching them.
[9 ] On May 24, 2019, Baoshang Bank, was taken over by financial regulators in China and China’s government-imposed losses on some creditors. This was the first bank failure in China in more than 20 years. On July 28, 2019, three state-controlled financial institutions said they would take at least a 17.3% stake in the Bank of Jinzhou, which had run into trouble earlier in June.
[10 ] RBNZ: “Official Cash Rate unchanged at 1.5 percent,” 6/28/19.
[11 ] Statistics Canada data showed wage growth of 3.6% YoY, well above the 2.7% economists’ survey median forecast from Bloomberg.
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