The present moment reflects a significant change in the structure of the global economy, comparable to the scale of change we saw in 1973, when the Opec oil embargo enabled oil producers to seize control over the pricing of their own natural resource.
But this time, almost in reverse.
Historically there is a significant amount of volatility as markets adjust to the new reality, so for that reason, I think, at least at the beginning of the year, it makes sense to maintain a relatively cautious outlook, with respect to this potential volatility.
The knock-on impact on global growth (GDP growth) is clear when explained in the context that global growth is, in its most basic form, composed of four components.
The first one is consumption, the second is investment, the third is exports versus imports – or net exports – and finally government spending.
Given the withdrawal of investment in oil, consumer spending has become an even more critical part of growth. This is particularly true in the United States.
Aside from the volatility element and the impact on the global economy, the reduction in the price of oil reflects a shift in economic power from the producers of oil to the consumers.
As such you would expect to see a significant boost to countries which are major energy consumers (and without much production) such as Europe, Japan, and India.
The issue, though, is with timing. We have had the decline in oil, we’ve had the cutback in investments, but we haven’t, as yet, had a commensurate increase on the spending side.
Another concern, arguably more headline grabbing, is the sharp decline in demand from China: extremely important given China’s economy is about the same size as the United States.
Historically the economy of China has been largely supported by investment spending and exports. Roughly 50 percent, of recent Chinese GDP growth was derived from investment spending.
This source of growth proved difficult to sustain, however, because the investment spending was financed by, and informed by, government policy that encouraged the banking sector to lend to certain sectors of the economy, in order to boost those sectors of the economy, regardless of the default risk.
Ultimately, the development of the debt created a drag, which the Chinese government clearly has been aware of as it made it a policy goal to shift to consumption.
However, the stock market correction that occurred this summer really significantly weakened the likelihood of success of that strategy.
Ultimately this is a meaningful fiscal hit to the consumer sector of the economy, because 80 percent of the investors in the market are the same individuals spending and consuming.
The manufacturing side of the Chinese economy – an old driver of exports – is also weakening substantially, in part owing to softness in demand from developed markets. And so the government, I think, is hoping that consumption will recover.
I believe it’s unlikely to do that. Government data on this has been opaque so I feel that the signals point to more surprises of weakness in demand from China and the market volatility associated with weak demand from that.
So I think, basically, we could see a similar period of economic weakness that we saw in 1973-74, which was essentially demand-driven.
It might not necessarily be a recession, in a global sense, but just very weak growth, which would have a commensurate impact on equity prices.
This kind of scenario is not readily amenable to monetary policy, because monetary policy controls interest rates, so if interest rates are the cause of a decline in the market, as in like ‘94 or ‘80, it can be reversed by loosening monetary policy very easily.
If a financial crisis is the cause, then a combination of monetary policy, reforms and so on are needed, like in 2008.
But a purely demand-driven decline – you need some fiscal stimulus to turn it around, and aside from the oil, there doesn’t seem to be any fiscal stimulus out there.
Indeed the US economy is struggling with this issue of controlling the government deficit.
In Europe, the same thing. Austerity is still driving most of the markets in Europe as they have a fiscal pact that actually has legal teeth to penalize countries for spending too much.
China could instruct major fiscal stimulus if they wanted to, however, it would mark a return to policies which are not sustainable in the long term.
Emerging markets arguably have priced in a lot of the deflationary impact. They’ve gone down a lot and the currencies have gone down a lot. And so it may be that the opportunities for turnaround in the market are more on the emerging side then on the developed side.
But it’s probably premature to go into emerging market equities until we get some kind of resolution on whether the developed markets are going to stabilize or go down further.
So, for that reason we’re seeing, basically this demand-weak recessionary impulse, or deflationary impulse, working its way through the system at the same time as the deflationary of oil is working its way through the system.
Looking into next year we’re likely to see volatility at the beginning of the year, I think, a fair amount of volatility from all of these deflationary impulses.
Further into the year I believe there’s reason for optimism for fiscal stimulus. In terms of getting back into the market it might well be the case that emerging markets will be the place to go because of valuation considerations.
Andrew Harmstone is portfolio manager of the Global Balanced Risk Control strategy at Morgan Stanley Investment Management
