There is no “business as usual” scenario possible for the 2015-2017 Budget period. Over the past 15 years (since the “dotcom bubble” burst in 2000), policymakers have provided increasing amounts of stimulus to support the economy. Now, finally, we are in the endgame, as the Great Unwinding takes place.
This presents us all with major challenges:
- Most executives and investors under the age of 40 have spent their working lives in the post-‘dotcom bubble’ world. They have learnt to expect that central banks will intervene more or less continuously to support the economy. They have no experience of a world where markets are left to balance supply and demand
- Equally, those over 40 are recognising there is no going back to the Boomer-led SuperCycle that dominated their working lives before the ‘dotcom bubble’. There is instead an increasing acceptance that a move into a New Normal is underway. China recently announced its economic policy will “adapt to the New Normal state“
This means, however, our past previous experience may well not be a good guide to the future.
3 SCENARIOS FOR THE 2015 – 2017 PERIOD
What does this mean for Budgets?
Firstly, it means we likely have a very hard road ahead. China and the US are both now ending their vast stimulus programmes – but not before China’s debt increased by $11tn, and US debt increased by $10tn. Globally, around $35tn has been spent in the major economies just since 2009.
Two developments on Friday highlight the risks we face:
- One is that policymakers may panic and rush to expand stimulus programmes again. Friday saw this happen in Japan, with the Governor of the Bank of Japan deciding to ‘double down’ on the failing Abenomics policy, warning “We are at a critical moment. There is a risk that victory over deflation may be delayed.”
- A second is that price wars become common. Energy markets face major supply gluts, leading Iraq’s oil minister to tell Parliament “There is a price war within OPEC. The market’s fundamentals have changed, with an extra 3 million barrels/day of crude entering the market at a time when growth in China and India has slowed.”
The result is that the world faces 3 quite distinct outlooks for the 2015 – 2017 period:
All’s well that ends well. Of course, we must all hope that policymakers have been right all along. In this case, we will still face a bumpy ride for the next few years. But over time, confidence will grow as it becomes clear that strong economic growth is being restored.
Global hard landing. The opposite is argued by those who believe stimulus programmes have put the global economy at risk. They fear a global ‘hard landing’ is the likely outcome, as stimulus is withdrawn and underlying problems are exposed to view
My own view is that whilst both of these outcomes are certainly possible, neither are very likely. Demographics must drive demand, and today’s globally ageing populations cannot recreate the Boomer-led SuperCycle of economic growth. Equally, policymakers would have to be completely incompetent to allow a global ‘hard landing’ to occur.
The most likely Scenario focuses on the Great Unwinding of policymaker stimulus now underway. This is taking us into the final stages of the Cycle of Deflation, which has been building since the ‘dot-com bubble’ burst in 2000.
THE CYCLE OF DEFLATION
The key feature of this Scenario is that the world is now becoming demand-constrained. In the past, advantaged-cost supply was key to success. “If you build it, they will come” was the motto.
But today, it is becoming widely recognised that we have a supply glut in most key areas – certainly in energy and commodity markets, and also further down most value chains. As the chart shows, we are thus now moving from the stage of Competitive Devaluation into Protectionism, as all the new capacity comes online:
- Competitive devaluation. This began with China in 2001, as part of its export-oriented development model. The US followed in 2009 with QE – again with the aim of promoting exports. Japan has tried the same policy since 2012, and more recently the Eurozone has followed. All, of course, are responding to a lack of domestic demand
- Protectionism. Globalisation is already becoming a memory. Sadly, the World Trade Organisation has recently failed even to streamline customs procedures. Instead, countries are moving towards bilateral agreements. This makes it much easier for them to protect jobs by imposing tariffs
- Plant closings. Only a small number of plants have closed to date. But Protectionism means that any plant which depends on exports is at risk, as low-cost will no longer be key to success
- Debt default. Cash is king in a deflationary environment. Default risks are already rising, with Blackrock (the world’s largest asset manager) warning secondary markets are “broken”. Companies therefore need to pay down debt as fast as possible, and watch working capital like a hawk
It is impossible to overestimate the shock that the Great Unwinding is already creating. The critical issue is that Deflation is now becoming inevitable as the oil price falls back to historical levels. This has two key effects:
- Debt becomes very expensive, as its cost is rising in real terms. So instead of borrowing, people focus on repaying debt as a top priority
- Purchases are postponed because prices will be cheaper tomorrow. So demand slows even further, as people see no rush to buy
Of course, deflation wouldn’t be a major issue today if markets had been allowed to operate normally after 2000. Most Western countries had moved into budget surplus, and were not burdened with today’s debt levels.
But we are where we are.