Real Economy Threatened by Market Feedback
By Roubini EconoTeam
Moves in financial markets since the beginning of the year appear consistent with a meaningful global slowdown, if not a recession. This tightening in financial conditions—in part, driven by concerns about growth in China, emerging markets and the U.S.—is undermining countries’ economic performance and growth outlooks as well as commodity fundamentals, all of which, in turn, justifies even lower prices for risky assets.
The impact of tighter financial conditions is perhaps most evident in the deceleration of U.S. GDP growth to just 1.3% annualized in H2 2015. This slowdown is mainly attributable to the spike in the U.S. dollar, the contraction in the energy sector, and a rising cost of capital associated with declining equity prices and rising credit spreads in the HY space.
As financial conditions have tightened, the risk of a U.S. recession has risen, despite good labor-market performance, robust real wage growth and expansions in non-commodity-related sectors.
Already facing myriad headwinds (including the ongoing migrant crisis), Europe must now contend with mounting financial-stability concerns. An impaired banking system would be less able to transmit the European Central Bank’s stimulus to the wider economy, possibly undoing the Bank’s efforts to revive this channel.
Further, the recent equity selloff has reactivated the sovereign-bank “doom loop,” which the banking union was intended to break. If the bank selloff continues, it will eventually impact economic activity in the region.
Financial-market volatility and policy miscues have triggered fears of a hard landing in China, encouraging capital flight and stoking concerns that a sharp currency depreciation lies ahead. Although macro data do not reflect much damage (particularly with respect to domestic demand), growth momentum has weakened since Q3 2015.
“Abenomics” (Prime Minister Shinzo Abe’s policy program) continues to struggle to gain traction, and the recent strengthening of the Japanese yen has brought tighter financial conditions. The Bank of Japan’s recent adoption of negative rates has heightened the market’s concerns about the country’s banks—potentially the center of another debilitating feedback loop.
In aggregate, emerging-market growth remains sluggish, with commodity producers struggling and only a few countries accelerating above their 2015 pace of GDP growth. Emerging- and frontier– market economies are already suffering capital outflows, reserve drawdowns and diminishing access to dollar funding.
The tightening of financial conditions has played out in two ways—via reduced demand from developed market’s (especially the U.S.) and via reduced access to the U.S. dollar and local credit, which hits domestic demand. Dollar debt has sold off sharply, but much of this debt is concentrated among state-owned companies rather than private-sector institutions.
Oil and Commodities
The oil-price rout has led to a fall in U.S. and global equities and a widening of credit spreads. Mounting losses have made energy firms credit risks and generated acute fiscal pressure for certain oil-dependent sovereigns; systemic credit events could occur under very adverse scenarios. Falling commodity prices have also stoked deflationary pressures, undermining policy makers’ battle to overcome such forces.
Given these headwinds, the (mild) expansion that followed the mid-2015 slowdown is now at risk. Economic growth and risky asset prices may now be entering into a destructive feedback loop that can only be countered by policy makers.