Join our community of smart investors

The world economy in 2020

Economists are less worried about recession than they were a few weeks ago – but most expect near-stagnation to continue
December 19, 2019

Economists are approaching 2020 in less fearful mood than a few weeks ago. “The risks of recession are receding” says Neil Shearing at Capital Economics.

One reason to believe this is that the best recession predictor we have is no longer sending so strong a recessionary signal. This is the US yield curve. Back in May, ten-year Treasury yields fell below the fed funds rate. Such an inverted yield curve has often led to recession in the past. Thanks to the Fed’s recent cuts, however, the curve is now upward-sloping again. Because of this, the New York Federal Reserve now estimates that the chance of a recession next year is only around one-in-four, compared to almost 40 per cent a few weeks ago.

This is not the only reason for optimism. China’s purchasing managers’ index recently rose to its highest level since January 2017, thanks to rising output and export orders. Berenberg’s Mickey Levy points out that this indicator has recently been highly correlated with global manufacturing growth.

In the euro zone, growth in the M1 measure of the money stock – which comprises money that can be quickly spent – has accelerated to 8.4 per cent. Adjusted for inflation, this is the fastest growth rate since late 2016. This matters, as this has traditionally been a good predictor of upturns in output growth: pick-ups in monetary growth in 1999, 2003, 2009 and in 2015 all led to faster output growth within a few months. If this relationship continues to hold, it points to industrial growth picking up next year.

And in the UK, the Conservatives’ clear majority paves the way for a fiscal expansion, likely to be announced in the Budget early next year.

All this is good news for equity investors for a simple reason. There has for years been a strong link between annual growth in US industrial production and annual returns on the All-share index, with each percentage point increase in US output growth associated, on average, with 2.1 percentage points higher annual returns since 1996. This isn’t simply because increased economic activity raises corporate profits. It’s because economic growth encourages people to take on more risk, which drives share prices up.

Although economists now attach a smaller probability to recession than they did a few weeks ago, few are optimistic about the central scenario. “A strong upturn doesn’t seem to be in the offing” says ING’s Mark Cliffe.

Lead indicators are telling us this. Narrow money growth in the euro zone and China are pointing only to weak growth, as is China’s purchasing managers’ survey.

Other signs tell us the same thing

One is that American consumers are not spending much. In fact, the ratio of retail sales to the S&P 500 is now close to its lowest level since records began in 1947. Main Street is a lot more downbeat than Wall Street. This matters, because consumer spending is partly forward-looking: we spend less if we anticipate bad times. Previous lows for this ratio - in the early 1970s, late 1990s and 2007, for example, led to recessions.

Consumers are not the only Americans who are downbeat. So too are boardrooms. Official figures show that non-residential capital spending has fallen in the last six months. This too can predict weak growth: one reason why companies don’t invest is that they don’t anticipate much demand.

Weak capital spending is not, however, merely a short-term cyclical issue. It has been a problem in in both the UK and US for years – which is a big reason why bond yields have continued to trend downwards. There are countless reasons for this. One, in the US, is that the profit rate has been trending downwards for half a century which means that capital spending no longer pays off as well as it used to.

Another is that the tech crash and recession of 2009 have had a scarring effect: managers have learned the hard way that over-expansion can be very dangerous because the economy is riskier than we thought in the 90s. This has drawn attention to a fact uncovered in different ways by Yale University’s William Nordhaus and Stanford’s Charles Lee – that investing and innovation have often not paid off as much as overconfident bosses expected.

A third – stressed by the MPC’s Jonathan Haskel and Nesta’s Stian Westlake in their book Capitalism without Capital – is that businesses with lots of intangible assets such as potential ideas simply lack the collateral with which to raise finance.

There’s also the problem, first noted by Northwestern University’s Robert Gordon, that great innovations – the sort that transform economies - have become scarcer. Good ideas, says Stanford University’s Charles Jones, “are getting harder to find.”

Nor is there much hope that clarity about Brexit will lead to an upturn in UK capital spending. Economists agree that Brexit uncertainty has held back investment. But, says Investec’s Philip Shaw, “some Brexit uncertainty will persist throughout 2020.” He doubts whether the UK can secure a trade deal with the EU by the end of next year, which leaves the Prime Minister with the options of either prolonging the transition period or leaving the EU on WTO terms – with the tariff and non-tariff barriers that entails – in 2020. Uncertainty about this could well hold back capital spending and hiring. “Growth remains weak and the prospect of the fiscal stimulus is still unlikely to boost growth above 1% for 2020” says Sajiv Vaid at Fidelity International.

The lack of great growth in investment has led to what former US Treasury Secretary Larry Summers has called secular stagnation – permanently weak growth and low interest rates. One reason for this is that lower capital spending itself reduces aggregate demand and hence interest rates. But just as importantly, it lowers productivity growth and hence reduces future trend growth. That makes assets that protect us from weak growth – as bonds do – more attractive.

One big fact tells us that financial markets expect secular stagnation to continue. It’s that they expect interest rates to stay low. Futures markets are pricing in negative short-term rates in the euro zone until late 2024. And even in the US, bond markets are pricing in a slight fall in 12-month yields over the next 12 months, from 1.57 to 1.5 per cent.

Economists are increasingly worried, however, that ultra-low rates might feed on themselves by exacerbating weak growth.

One reason for this is that negative interest rates are a tax. If banks lose money by depositing with the European Central Bank (ECB), they are less able to lend. Although this problem is mitigated by the ECB’s targeted longer-term refinancing operations, which in effect subsidise bank lending, another problem remains – that negative real rates on our savings can encourage us to save more to preserve our wealth.

A second reason is that low interest rates are a signal. They tell boardrooms that central banks are worried about the state of the economy. That’s a sign to them to be wary of expanding.

A third factor has been pointed out recently by economists at the Bank of France. They say that low interest rates keep inefficient firms in business. That reduces aggregate productivity by simple maths. But it also does so by increasing the competition faced by efficient companies, which deters them from expanding.

All this means we might now be stuck in a positive feedback loop, whereby low interest rates reduce investment and productivity, which in turn keep interest rates low.

What might break us out of this loop?

One thing would be looser fiscal policy. If increased public spending boosts aggregate demand, central banks will be able to raise rates.

Prospects, here, however, are mixed. Economists fear that Congressional gridlock will prevent any new fiscal stimulus in the US. In Germany – which is running a huge budget surplus – social democrats are pushing for big rises in infrastructure spending, but it is unclear that they’ll win an electoral mandate for these. That leaves the UK as the best hope for an expansion – though this is unlikely to be sufficient to raise global bond yields much.

2020, therefore, might well see more of the same: weak growth and low bond yields.