What's driving complacency in global markets?

The world is beset with risks - political, geo-political, fiscal and monetary. But markets choose to look the other way, either being blissfully oblivious or wantonly negligent

Equity markets around the world continue to be on a tear. The MSCI Global Equity Index is close to its lifetime highs, up a staggering 30 per cent over the last year. But it is not just equities; all asset classes have thrived in recent months.

 

Yields may have backed up in recent weeks but United States rates are still pricing in lots of Federal Reserve cuts over the next year. And credit spreads remain very modest. So financial conditions in the US are very benign and have gotten progressively easier as reflected, for example, in the Chicago Fed’s Financial Conditions Index.

 

This buoyancy is not limited to advanced economies. Emerging Market (EM) equities are also up almost 25 per cent over the last year and many EM currencies have rallied against the dollar over the last three months.

 

But why should we be surprised? Isn’t the US firmly on its way to a soft landing? Or perhaps, no landing at all, given the sheer resilience of US growth? Hasn’t China finally pulled out all the stops to jumpstart growth? Isn’t the Fed in the midst of a large cutting cycle that will induce EM central banks to cut in tandem? In short, aren’t we in macroeconomic “Goldilocks” land?

 

Or, are we? A more sober assessment of the data suggests the enthusiasm of global markets sits uneasily with a more uncomfortable economic reality that is peppered with a litany of political, geopolitical, fiscal and monetary risks.

 

To be clear, US growth has been resilient beyond expectation. Defying all forecasts, gross domestic product (GDP) growth is remarkably on track to print close to 3 per cent again this year. Prima facie, this is good news for the economy and equity markets, but it risks making the last mile of disinflation harder.

 

Over the last two months, for example, US core consumer price index (CPI) prices have re-accelerated to 0.3 per cent month-on-month – an annualised inflation rate of over 3 per cent. Don’t be fooled by how sluggish year-on-year inflation evolves. Look at underlying monthly momentum.

 

In the first nine months of 2024, monthly core momentum in the US has averaged almost 0.3 per cent –   an annualised rate of 3.2 per cent. Much disinflation has been achieved, but we are not done yet. The last mile still awaits.  

 

Eye on the Fed

 

Stronger growth and a re-acceleration of core inflation in recent months is likely to make the Fed more cautious after its 50 bps cut. Since then, all the growth and inflation data have pointed towards policy rates being “higher-for-longer.”

 

The Fed is still likely to ease, but the pace could be slower and terminal rate higher than commonly presumed. Markets are pricing in US rates at below 3.5 per cent at the end of 2025. But, as the J P Morgan Global Economics team has shown, it only takes small but correlated shocks (slightly higher inflation, slightly lower unemployment, and a slightly higher neutral rate) for policy rates to be closer to 4.3 per cent at the end of 2025 under the Fed’s own Taylor Rule – much above what markets are pricing.

 

In turn, sustained “high-for-long” rates create growing risks of something eventually breaking down the line. Alternatively, higher rates may simply be reflecting a higher post-pandemic “neutral rate” in the US

 

Prima facie, this is not a bad thing, because it simply reflects stronger private sector fundamentals, but also a more expansive fiscal situation in the US (more of that below). But even so, this is not good news for emerging markets, many of whose rates are influenced by US rates.

 

The trilemma

 

Consider small open economies in Asia, for example. Unlike the US, many of these economies are much below the pre-pandemic path and have existing slack, which is why core inflation has come off so sharply in their economies over the last year. Indeed, given their cyclical positions, their current real rates are too high.

 

Ordinarily, they would have been cutting rates some quarters ago, but because their interest rate differentials with the US Fed are at historical lows they are constrained from cutting until the Fed moves.

 

Indonesia is a classic case in point. Domestic macro conditions are crying out for a cut. Yet, it cannot cut until Fed rates are lower, for fear of inviting currency pressures and imperiling financial stability. Indeed, if global financial conditions tighten further, Indonesia may be forced into a pro-cyclical hike.

 

Several Asian economies are therefore trapped in the classical “trilemma”. Higher neutral rates in the US will therefore spill and further weigh on already-uncertain growth prospects in many emerging markets.

 

Till debt do us apart

 

But concerns about rates are not limited to just the short end of the curve. Debt levels in the United States look increasingly untenable. Debt to GDP jumped to 114 per cent of GDP in 2023 and is on course to exceed 130 per cent of GDP by 2028.

 

If neutral rates are higher than presumed in the US, this further imperils debt sustainability. The US fiscal deficit – after adjusting for the student loan write-off – was incredibly still running above 8 per cent of GDP in 2023, according to Fitch. And given expansive fiscal promises by both candidates in the US election, there are no signs of any course correction.

 

The optimists will argue the US benefits from “exorbitant privilege” and can sustain higher levels of debt. But things are fine until they are not. With the Fed continuing with Quantitative Tightening, an ever-increasing fraction of fiscal issuance will have to be absorbed by the market.

 

Is the current term-premium – which is very benign by historical standards – enough compensation to hold ever-increasing issuance? Will the US eventually face a “Liz Truss” moment? Will the monotonic rise in debt increase the risks of fiscal dominance?  How much will a steepening US yield curve tighten monetary conditions around the world to the detriment of global growth? Market pricing appears blissfully oblivious to these risks.

 

And none of this takes into account the risks emanating from the upcoming US election.

 

Litany of risks

 

A second Trump presidency would significantly increase the odds of a trade-war with China alongside immigration curbs in the US. From an economics perspective, both of these constitute adverse “supply shocks” to the US economy.

 

The inconvenient truth is high levels of immigration into the US have boosted the supply side the last few years, simultaneously fueling growth and tempering wage and core inflation. If that is reversed, and coupled with tariffs on China, expect higher prices and inflation in the near term and increased odds of an eventual recession as sentiment, business confidence and capex take a hit – all of which was evident in the 2018 trade war. Adverse supply shocks have the exact opposite effects of a soft landing.

 

Equally unappreciated is the damage to China and Asia. Despite all the excitement about recent policy announcements, Chinese growth is still expected to be sub 5 per cent in both 2024 and 2025, according to the International Monetary Fund. Now overlay onto this the effects of large US tariffs on China, which are likely to be very deleterious.

 

In turn, the risk is China retaliates with reciprocal tariffs, a weaker currency (the CNY depreciated 13 per cent in the 2018 war) and restricting Western use of critical minerals.

 

A deepening and broadening trade war among the world’s two largest economies will not only hurt both but also impart collateral damage to the rest of the world. Asia, in particular, will be in the firing line. Some Asian economies benefited from trade-diversion in the 2018 trade war as China engaged in transshipment and simply shipped its exports to the US via third countries. This strategy is likely to attract punitive action this time around.

 

So, at least in the near term, the rest of Asia will not be a beneficiary of Chinese transshipment. Instead, they will likely be the recipients of Chinese excess capacity increasingly directed their way, which risks hurting domestic growth and manufacturing, and likely create pressure to increase tariffs on Chinese imports in these economies. The trade war will only proliferate. Furthermore, these economies risk suffering a competitive disadvantage to China in third markets, as was the case in 2018, if the Chinese currency depreciates sharply.

 

A policy put?

 

Given the litany of risks, why are markets so complacent? Is it because the evidence of the last 15 years suggests monetary and fiscal policy will jump right in to help at the first hint of trouble? But this is not 2019.

 

Public debt levels have surged post-pandemic and fiscal space has been exhausted around the world. Similarly, monetary policy cannot be unconstrained. If a Trump Presidency slaps on tariffs and curbs immigration, its immediate impact will be inflationary, making it harder for the Fed to respond even if sentiment sours and growth slows.

 

The world is beset with two wars, a US election whose outcome could upend the world order, a non-trivial risk of policy rates remaining “high-for-long”, an absence of any fiscal space around the world, and growing concerns about US debt dynamics. But you’d never know if you simply looked at buoyant asset prices.

 

Markets, of course, are entitled to look the other way and be blissfully oblivious or wantonly negligent. But ignoring risks does not mean they do not exist. It just means that if and when they fructify, the consequences are that much more pernicious.

 

Sajjid Z Chinoy is Head of Asia Economic Research at J P Morgan. All views are personal.