Global bond house Pimco has warned that China has the potential to disrupt the global economy in three ways – through a severe downturn, a move into high end technology and through its ambition to establish a global sphere of influence.
The firm’s baseline case is for a global recession though it says that in the absence of major private sector economic imbalances and hawkish central banks, it will likely be shallow.
The firm’s global market outlook identifies five major disruptors for the global economy in coming years including China.
The others are populism, demographics particularly in Europe, technology and financial market vulnerability.
We excerpt some of the firm’s thoughts below.
China’s three ways of disrupting the global economy
“China has the potential to disrupt the global economy and markets in at least three different ways. First, while our baseline view is for a controlled gradual slowdown of China’s economic growth over the secular horizon, the path may turn out to be bumpier than expected, especially if the trade war with the U.S. escalates further. In the case of a sharper slowdown, the massive buildup of internal debt over the past decade would be more difficult to digest and could aggravate a downturn. In such an adverse scenario, the Chinese authorities might resort to aggressive currency depreciation, which would send a deflationary shockwave through the global economy.
“Second, even in a relatively benign Chinese growth scenario, China’s targeted efforts to move up the ladder to higher-value-added manufacturing with the help of leading-edge technologies will likely disrupt established producers in Europe, Japan, the U.S., and Southeast Asia.
“Third, China’s growing economic power and its ambition to establish a global sphere of influence (e.g., via the Belt and Road Initiative) could disrupt the established geopolitical order dominated by the U.S. and, irrespective of the outcome of the current trade conflict, is likely to lead to continuing economic and political tensions between the U.S. and China in the coming years.”
Populism will continue to disrupt politics
“While our discussions didn’t result in a clear consensus on whether populism has already peaked or will gain even more influence around the world in coming years, we agreed that populist movements, parties, and candidates will likely continue to disrupt national and international politics and policymaking over the next three to five years.
“To be sure, the populist challenge from both sides of the political spectrum for the established parties and governments could result in either positive or negative economic and financial market outcomes. Economic growth and asset prices would be supported if populist governments or traditional governments under pressure from a populist opposition tackle overly zealous regulations, reduce the tax burden, and/or address excessive inequality.
“Other aspects and variants of populism tend to be more detrimental to growth and asset prices, especially when they are aimed at slowing or reversing globalization by increasing impediments to immigration, cross-border trade in goods and services, and capital flows. In many cases, populism thus rhymes with protectionism, which is a clear and present danger for a global economic system built on complex international supply chains and myriad financial linkages.”
“Another implication of the rise of populism and the fact that it comes in many different forms is that economic policies and outcomes are likely to become more divergent across countries. Over the secular horizon, we expect more varied and in some cases more extreme policy approaches, which could increase the importance of the country factor for asset price determination and also produce larger exchange rate variability.”
Demographics may see Europe face ‘Japanification’ but be less able to cope
“Slower population growth and increasing longevity in the major economies are important contributors to lacklustre economic growth, low inflation, and the global saving glut that depresses equilibrium, or neutral, interest rates. This is likely to continue to force the major central banks to keep policy rates low or even negative and to engage in asset purchases during or even outside recessions whenever the lower bound for interest rates becomes binding.
“Low interest rates and flat yield curves for longer pose challenges for the financial sector, which is an important transmission channel for monetary policy. Second, low rates for longer have contributed to rising corporate leverage and pushed many investors into riskier assets in search for yield, which increases the vulnerability of private sector balance sheets in the event of major asset market corrections (more on this later). Third, with central banks having limited tools in a low-rate environment and government borrowing costs low, both the calls for and the temptation to engage in more active and expansionary fiscal policy are increasing. This is a two-edged sword: On the one hand, expansionary fiscal policy is welcome if demand and/or inflation are undesirably low and also when there is a heightened demand for perceived safe assets. On the other hand, fiscal discipline might be lost, which could make public sector balance sheets vulnerable to future interest rate, growth, or confidence shocks.”
“Of the major advanced economies, the eurozone looks most likely to be disrupted by “Japanification” – defined as a demographically challenged macro environment of low growth, near-zero inflation, and very low interest rates. In short, Japanification may have worked for Japan but could turn out to be very disruptive for a eurozone lacking social, fiscal, and political cohesion.
Technology could mean a lot of corporate losers
“With new technologies becoming better, cheaper, and thus more accessible to a wider range of companies, their benefits for productivity growth are becoming increasingly visible: Over the past year, U.S. non-farm business sector output per hour worked – i.e., labour productivity – picked up from its dismal pace in the previous five years, and investment in research and development (R&D), software, and tech hardware accelerated. While it is early days, these may be the first signs that technology has been trickling down from the few large productivity leaders in each industry to the many laggards.
The other, ominous side of the coin of technology is that it disrupts existing business models in the corporate sector and, while it produces winners, it will create many losers as well. It holds the potential for emerging market economies and companies to “leapfrog” competitors in the advanced economies with the help of new technologies.
Moreover, potential jumps in productivity growth, which are not our base case but a distinct possibility, could lead to temporary or longer-lasting technological unemployment, which in turn could feed back into political discontent and further support for populist parties and candidates.
Financial market vulnerability
“In the past 50 years there have been seven U.S. recessions, as defined by the semi-official arbiter, the National Bureau of Economic Research. The five prior to 2000 were driven by overheating and Fed tightening, including the impact of oil price shocks. The two recessions in 2001 and 2008 were primarily driven by the unwinding of financial market imbalances. We must be very attentive to the risk that instead of reacting to the news, it is financial markets that make the news.
“Looking over the next three to five years, the Fed’s pivot and the likelihood that it will end its tightening cycle at close to the New Neutral rate, rather than tightening policy to an outright restrictive stance that would elevate recession risk, has the potential to lead to greater excess in valuations, particularly in credit and similar to the period in the mid-2000s before the onset of the global financial crisis.”
Dealing with climate-related disruptions
“Climate-related shocks may become not only more frequent but also more persistent and severe, increasing the probability of fat tail catastrophic events. Weather-related shocks look set to become more frequent with global warming and have the potential to wreak havoc with economic activity and inflation, and thus could make it more difficult for investors and central banks to separate the noise from the signal. Climate-related shocks may become not only more frequent but also more persistent and severe, increasing the probability of fat tail catastrophic events.
“Moreover, investors will have to factor in additional government responses to climate and other environmental risks in the form of regulation, carbon taxes, and public investment. These will create many winners and losers in the corporate sector, which in turn will require active management of credit and default risks.”