By Cormac Lucey
The Standard and Poor’s 500 index of American stocks continues to hit all-time highs. The index of Irish shares — the ISEQ — is at post-crash highs, hitting the level first reached in 2006 towards the very end of the boom era.
Unemployment in Ireland has fallen to 6%, not far off the multi-decade low of 4% achieved more than a decade ago. Mario Draghi’s European Central Bank (ECB) has allowed the eurozone’s ailing banking sector to heal, and global industrial activity is at its strongest in 13 years. What could possibly go wrong?
There is a tendency for humans, when looking at financial markets and economic phenomena, to expect the recent past to carry on indefinitely into the future. So it was that in 2006 most people expected rapid house price appreciation to continue. By contrast, in 2011, it was hard to find many people expecting house prices to rise.
To anticipate successfully significant market changes one must consciously steer against consensus opinion. While some economic phenomena generally proceed in a linear fashion — underlying productivity growth, for example — others, such as asset prices and annual rates of economic growth, tend to be cyclical.
This suggests we should treat the current state of the global economy with caution. The long equity bull market, now in its ninth year, should signal an amber light. Reuters declared that Switzerland’s central bank owned more publicly traded shares in Facebook than Mark Zuckerberg. Last September, it was reported that the Japanese central bank owned more than 75% of the country’s exchange-traded funds, the main instruments through which individual investors own shares.
Deutsche Bank titled its long-term asset return study, published in September, The Next Financial Crisis. In addition to looking at asset return statistics, it considered the frequency of financial crises and shocks through history and speculated where the next crises may originate.
If the origins of recent economic recessions in America were the subject of a game of Cluedo, it would be easy to identify the culprit as the central bankers, with the interest rate rises, in the dining room. It’s little wonder that Deutsche Bank identified this as its No 1 candidate for the source of the next financial crisis.
For the past five decades, the most reliable indicator of recession has been an inverted yield curve. This describes the unusual situation where the annual interest rate on short-term borrowings, of a year or less, exceeds the long-term borrowing rate — say, for 10 years. The phenomenon generally occurs when central bankers are so concerned about choking off inflationary pressures that they raise the base rate of interest above the long-term rate of borrowing. On each of the past three occasions when this condition was observed in America — 1990, 2000 and 2006 — a recession followed within a year or two.
The yield curve today indicates that long-term rates still exceed short-term rates by about one percentage point, so there is no indication of a looming American recession. On the other hand, across the globe, central bankers are gradually tightening the monetary screws. In the US and UK that means increasing base rates. In the eurozone, it involves reducing the amount of quantitative easing (QE) and the prospect of base rate rises in 2019.
That doesn’t mean that an economic storm is imminent, but does indicate that global monetary conditions are shifting from sunny to cloudy.
The authors of the Deutsche Bank report looked at the key risks that might trigger the next recession. These included elevated valuations in many asset classes, the incredible size of central bank balance sheets, global debt levels, multi-century lows in interest rates, and the level of potentially game-changing populist political support around the globe. It warns that if there is an economic crisis relatively soon — within the next 2-3 years — it would be hard to look at those risks and say that we had no way of spotting them.
The risk that probably has the greatest chance of unleashing the next recession is an unexpected rise in inflation. That could force the hand of central bankers to raise interest rates faster than planned.
It can be argued that the first pebble set in motion, which eventually led to the popping of Ireland’s credit bubble a decade ago, was the ECB’s quarter-point increase in rates in November 2005. That was followed by eight further hikes.
These had the cumulative effect of making life ever more difficult for highly leveraged owners of expensive property assets, because the low rental yields on those assets lay well below the ever increasing interest rate that had to be paid on their associated borrowings. Buy-to-let landlords found their monthly interest bills exceeding their monthly rental incomes. Their position deteriorated markedly as the ECB kept raising rates.
While history never exactly repeats itself, it does rhyme. So will central bankers will take the plunge and raise interest rates several times in order to forestall inflationary pressures? Or merely dip their toes in the water and raise rates a few times as a nod towards returning monetary policy to normal?
It all depends on inflation that has remained remarkably low despite unprecedented levels of fiscal and monetary stimulus since 2008. The most recent data for core inflation in the eurozone put it at 0.9% in October, a fall from 1.1% the previous month. The latest projections from the ECB see the rate rising to 1.5% by 2019. But that projection has tended to be revised downwards in recent years.
A recent study from the International Centre for Monetary and Banking Studies, And Yet It Moves: Inflation and the Great Recession, considered the low level of inflation that the global economy has experienced over the past decade.
It concluded it was possible that it reflected the size of the economic shocks that had hit the world economy but that inflation — and inflation expectations — would eventually return to target. But, it warned, it was also possible underlying inflation had permanently shifted lower post-crisis. This is a danger as, when the next recession hits, policymakers “have less room to lower real interest rates and cushion the shock”.
Since 2008, Ireland has corrected the financial imbalances built up over the preceding years. Private sector debt is lower and public sector debt is falling relative to income. But over that period global financial imbalances, especially debt levels, have got bigger.
The problem for Ireland is that we are so exposed to trade, we would suffer significantly from any international recession even though we have been behaving ourselves.
Published in The Sunday Times (Ireland edition)
November 19th 2017