Italian bond yields, the Chinese yuan, emerging markets and the prospect of trade war have dominated the financial news cycle for the past month. The one constant in the world outlook, in the consensus view, is the strong US economy. Second quarter US GDP growth is forecast at 2.87% by the New York Federal Reserve’s “Nowcast” model and at a blistering 4.5% by the Atlanta Federal Reserve’s “GDPNow” model, based on economic reports to date.
That idea also has filtered into the US administration. Donald Trump’s economic adviser Larry Kudlow said June 28, “I believe China is operating from a greater position of weakness than folks think, and we are operating from a greater position of economic strength.” That is dangerous thinking; wars start when one side overestimates its strength and underestimates the strength of a prospective adversary.
The best place to look for trouble is where no-one expects it. The US consumer is the biggest source of demand in the world economy, and real personal spending came in unchanged in May, against a consensus forecast for a 0.2% monthly gain (equivalent to a 2.4% annual rate of increase). There’s a simple explanation for the disappointing consumer report, and that is the rising oil price. Consumer budgets are so stretched that a few cents more per gallon at the pump translates into reduced spending on other items.
The stock market shows a similar inverse relationship between consumer staples stocks and energy stocks during 2018 to date.
Consumer confidence has soared on the strength of the Trump tax cuts, to the point that US households are spending virtually all of their income. Personal savings have fallen to barely 2% of disposable income, a level not seen since just before the Global Financial Crisis of 2008.
But in 2007 US consumers had a decade of 10% annual gains in home prices behind them, and borrowed freely against home equity for spending. They don’t have that kind of home equity buffer today.
Meanwhile, real US hourly wages haven’t budged for a year, despite a very low unemployment rate.
As the impact of the tax cuts wears off and high energy prices persist, US GDP growth could fall well below the first quarter’s 2% annual rate.
China, by contrast, shows steady growth. The most comprehensive big data analytics point to a strong June. Union Bank of Switzerland analyst Ajit Agrawal, who manages the bank’s Evidence Lab, wrote earlier this week:
“Our preliminary big data analysis for China’s economic activities suggests June growth remains strong, with improvements over May in industrial production, property sales, and property investment. We spot some softness in consumption, but not by much. Auto sales growth looks soft but driven by fewer business days over last year. Given the strength of our monthly signals this quarter, we expect Q2 economic growth to be higher than Q1, and above consensus expectations. This analysis from UBS Evidence Lab Macro team uses high-frequency data gathered bottom-up from different segments of the economy.”
China has eased monetary policy, which requires some depreciation of the RMB against the US dollar. The usual suspects are now warning of capital outflows from China on the scale of 2015 and a sharp weakening of RMB. Those forecasts are based on a misunderstanding: as the Bank for International Settlements explained in its First Quarter 2016 report, the “outflows” of 2015-2016 came about when Chinese nonfinancial corporations paid down foreign debt and substituted domestic debt. The perpetually rising RMB had made it advantageous for Chinese firms to borrow in dollars and pay them back with stronger RMB, and that game came to an end in August 2015.
China’s central bank lost about US$1 trillion of reserves and Chinese corporations reduced their foreign debt by roughly the same amount. The reorganization of China’s balance sheet produced some temporary shocks. By contrast, the price of Chinese risk is very low today. Implied volatility on 3-month options on the RMB-US dollar exchange rate jumped to 10% in early 2016; today it trades around 5%, in the middle of its one-year trading range. And the cost of insurance against Chinese sovereign default over the next five years is a fraction of what it was in 2015, and around the lowest on record.