by Terry O'Neill
Founder, Institute for the Study of Global Economics and Finance (ISEF)
Chairman Emeritus, The O'Neill Company
As we look at our global economic outlook for 2020 through the
lens of economics, I have repeatedly stated that we’re in the middle of a
global synchronized slowdown in addition to de-globalization, global
decoupling, Balkanization, fragmentation, nationalism and populism plus an over-dependency
upon monetary policy by all of the following central banks: The Federal Reserve,
European Central Bank, Bank of Japan, Bank of England and People’s Bank of
China along with absolutely no emphasis upon fiscal stimulus or infrastructure
development domestically and globally.
The annual global
growth over the past few years has been positive, yet slowing for the last two
years respectively: 3.8%, 3.4% and this year 3% (with COVID-19 possibly 2+%). Along
with the synchronized slowdown we are experiencing, there have been a variety
of global tail risks that we could refer to as “white swan” events. A "white swan" is a highly certain event with three principal characteristics: it is certain; it carries an impact that can easily be estimated; and, after the fact, we reason an explanation that recognizes the certainty of occurrence, but again, shifts the focus to errors in judgment or some other other human form of causation.
Three economic scenarios were the consideration going into this
year. First, an optimistic view with global growth at around 3.4%, inflation
being maintained and financial risk disappearing as economic expansion
continued. Second, a skeptical view of the world in the midst of a global
synchronized slowdown, with only some growth picking-up in emerging markets.
Third, a global recession where the US and China would be in a trade war; a
hard Brexit setting in and/or a war with Iran.
The “white swan” global tail risk event of the year has been
triggered by COVID-19. Some pundits say we have had these kinds of epidemics in
the past from SARS to MERS (SARS, at the peak, was approximately 8,000 cases
and 800 deaths. As of this writing, COVID-19 has experienced near 170,000 confirmed
cases and more than 6,600 deaths globally, not a good comparison). In China
alone, we have seen the Swine Flu, Bird Flu and now the Coronavirus. My first
comment is the markets will be more severely affected now because when SARS
surfaced, China had just joined the World Trade Organization and was only 4% of
the global GDP, contributing around 20% yearly to global growth. Today, China
is approximately 20% of the global economy and contributing around 50% yearly to
global growth.
Now, think about the economic “spillovers” in the surrounding
Asian world in addition to Europe and the United States that will take place
because China is a key player in the global supply chain. All over the world,
firms are shutting down because they cannot do business due to a lack of key
supplies coming out of China. Think about it this way: In the fourth quarter of
2018, you had almost a “bear stock market” (down 19.78%). Why? Because the
market wrongfully felt that, as the Federal Reserve was on their way to “rate
normalization”, they would end up normalizing too fast and would squelch
economic growth. The Fed rate was at 2.5% and I forecast at the time that the
terminal rate would be at around 3.2-3.5%. (Caveat: I always said the Fed would
go extremely slowly in the rate normalization processes so as not to hinder the
overall economic trajectory.) My hypothesis proved to be correct. And, when the
markets realized the Fed would normalize slowly, the markets quickly recovered.
Now, I will attempt to explain what is happening currently. This
time around certain pundits are saying, under the best scenario, we will see a
“V” shaped recovery. That means, as you would imagine, that the first quarter
of 2020 is down and then the global economy recovers and grows faster the
second quarter and then, subsequently, in the third and fourth quarters. Well
let’s go back to the China scenarios. First, again, the pundits are saying that
China’s growth in 2020 will be adjusted because of the COVID-19 pandemic to be
around 5.5%. I would strongly argue that, after one completes the calculus year
over year, China’s first quarter growth will be a minus 2% to a minus 4%. And
if you annualize that it turns out to be a negative year over year. As a result, my final conclusion on China is that
their year-end GDP growth will close out the year between 2.5 and 4.0% -- what academic
economists refer to as a hard landing. Therefore,
a “V”- shaped recovery will look more like a “U” shape or even a “hockey stick”
recovery which everyone became familiar with after the 2008 Great Recession. It
would not be too far fetched to conclude that we could experience what I would
refer to as a “rolling recession”. Today, Italy, Korea and Japan are in a
recession; Germany is on the brink of a recession, and, subsequently, the EU
and the United States could be close behind...we can’t count out that scenario.
The European Central Bank has minuscule policy bullets. Their current lending
rate is a negative .5% and I will forecast that soon they will go to negative
.6%. In addition, the Bank of Japan is negative and, last October, Prime
Minister Abe implemented a consumption tax that has dramatically hurt Japan’s
economy. (Reminder: a recession is simply two consecutive quarters of negative
GDP growth, a business cycle contraction is when there is a general decline in
economic activity.)
In conclusion, for the past 11 years, I have stated repeatedly
that the world has been over dependent on monetary policy, zero and negative
interest rates, asset purchases and Quantitative Easing (QE) scenarios QE1,
QE2, QE3, and, probably, now QE4. Let’s get ready for one additional scenario
that needs to take place before we slide into the next recession and that is a
big and bold fiscal stimulus. We must bring out the “heavy weapons” (helicopter
drops of money) and not the “small arms”. On March 4, the EU finance ministers
held a conference call to discuss the latest developments and COVID-19’s impact
on the economy. Instead of coordinating a decisive fiscal response to support
businesses and households, they merely agreed to stay ready to act, using the
small wiggle room allowed by existing fiscal rules. This is a missed
opportunity to create a common fiscal capacity to deal with adverse shocks via
automatic stabilizers.
In the US, approximately 70% of our GDP is attributable to
consumption. (In China, 70% of GDP was driven by infrastructure development and
they have been striving to migrate rapidly toward consumption which is vital to
the China and global economies.) With COVID-19
destroying demand and supply simultaneously, this has undermined global growth.
Also, it is important to note that with an over abundance of collateralized
loan obligations (CLOs), shadow banking, an over leveraged consumer, and with
the rating agencies about to down grade the CLOs of the fallen angels to
non-investment grade high-yield status (also know as junk bonds) estimated at
around 1 trillion dollars, the CLO’s and high yield bonds are at risk. Therefore, a recession would not necessarily
come from the stock market but from the credit markets as a credit crisis. (The 2008 recession dramatically affected the
banking sector and government bailouts were required, however, the sector is
healthy currently as a result of Macroprudential and Basel 3 regulatory
requirements.)
As a result, asset managers and pension funds (with specific
covenants once the down grades occur) will be forced to sell these assets which,
unless the liquidity is created in the system, will cause massive defaults. As
of this writing, the Fed has experienced two nonscheduled meetings and lowered
the Fed funds rate 0 to ¼% (which will have no economic effect on the current
crisis) and will facilitate 1.5 trillion dollars to provide order and liquidity
in certain markets. In addition, the government will possibly need to bail out
the airline industry (because it is tied to our national security), the cruise
ship industry and other hospitality sectors of the economy. And, let’s not forget the large troubles
currently occurring in the energy sector.
During the 2008
Great Recession, some uninformed comments were made that we were on our way to
possibly slipping close to the Great Depression of the 1930s. Nothing was
farther from the truth. Empirically, the Great Recession had a GDP contraction
of 4% and the Great Depression had a contraction of 40%. There was obviously no
comparison and, yet, times like these can be extremely trying. Equities will continue to adjust until market
participants believe that the virus has been successfully contained at the
global level.
These uncertain times shall pass, and, in no way do I desire to
give the impression of being panglossian, however, I know that, over the long
term, idiosyncratic shocks and externalities along with extremely volatile
moments can and do often occur over long economic cycles and that being
prudent, calm and having patience and understanding is truly warranted. Having
been privileged to lead a financial service enterprise for four decades and
being a continual student in the area of behavioral and macroeconomics, I have
learned that financial and economic success does not come automatically in life
with the possession of wisdom, but with how it is applied. Moment by moment, we
have choices and we must prioritize, so let the lessons be learned as we set
our affections on the giver not the gift and make an eternal significance.
As we all navigate through these current turbulent economic
waters, soon a day of calm and sunshine will return and, when it does, be
prepared for economic growth like you have never experienced before.
Historically the bronze, iron and industrial ages have taken 1,500 to 2,000
years of technological transition. However, over the next twenty to thirty
years, we will all enjoy wonderful technological advances that have been
unprecedented since the beginning of time. As an example, the vinyl record
industry in 1985 was approximately an eighteen billion dollar industry and, in
the year 1990, it was dead (other than as a collectible). Today, we produce a
multitude of songs as digital downloads at a fraction of the cost. When your
parents and grandparents grew up, a carburetor in the engine of their vehicle
cost approximately three hundred dollars (depending on your era), however,
today, a micro-chip costs a few cents and it doubles a vehicle’s fuel
efficiency.
On the near-term horizon, we should see the following markets
revolutionize the way we work and live. Our industries of the future are: Ed-tech,
Energy-tech, Biotech, Information-tech, Manufacturer tech, Financial tech,
Defense tech, Humanoid robots, technological singularity and high-tech
artificial intelligence. We have not seen these at the macro-level. Some people
say it has been mismanaged and some say it takes time to see the results,
however, I say, “Get ready.” All hands on deck because we’re about to set sail
on an incredible economic journey.
In January of 1995, Mr. Smart invested 1m dollars in a diversified asset allocation mix of 80% equities and 20% fixed income and during the Great Recession of 2008 his account was DOWN -34.88%. Mr. Smart maintained his allocation and subsequently fully recovered and achieved over a twenty-five year period an average annual rate of return of 9.78%.
