Strong Economy, Scary Risks
A bevy of black swans lines up to threaten a surprisingly strong economic outlook.
Going strong, feeling good
We’ve started 2024 with a lot of optimism, and for good reasons. U.S. growth remains resilient, with the latest data confirming strong consumer confidence — the strongest since December 2021 according to the Conference Board — and a robust labor market, with job openings above expectations and January’s job creation almost twice market forecasts, sustaining strong wage growth (4.5%). The U.S. economy expanded 2.5% in 2023, with a marked acceleration in productivity in the second half of the year; and the Atlanta Fed is tracking Q1 GDP at over 4%. Boomtown.
Europe is on a weaker footing, but the recently released buoyant performance of Spain in the last quarter of 2023 (+0.6% month-on-month) held the euro area afloat and gives some reason for optimism — supported by January’s strong jump in Spain’s and Italy’s manufacturing PMI. The IMF has just upgraded its growth forecasts and expects the global economy to expand just over 3% this year, on par with the average of the last ten years.
The Fed is gearing to cut interest rates. Fed Chairman Powell this week poured half a glass of cold water on markets’ enthusiasm, saying that rate cuts are unlikely to start in March. But the reason the Fed wants to wait is not that it’s still that worried about inflation, but rather that with growth so strong it can afford to be patient and make sure disinflation gets well entrenched. The Fed wants to cut, and later this year it will cut. Buoyed by this propitious combination of resilient growth and forthcoming monetary easing, financial markets maintain a strong momentum; fueled by optimism, rising asset prices in turn contribute to it, in a positive feel-good feedback loop.
And yet. Even before we consider the risks, it’s not hard to cast this positive baseline outlook into less flattering light: underlying inflation appears stubborn and could still get entrenched significantly above 2%, which would limit the scope for monetary easing; U.S. growth is boosted by unsustainable government spending, while corporates are taking a more prudent stance; and public debts have already grown to dangerous proportions. In other words, the positive economic outlook is to some extent predicated on the Modern Monetary Theory-ish view that we can count on loose fiscal policy and easy money forever. And we can’t.
A bevy of black swans
More worrying still are the risks. The most serious identifiable dangers come from geopolitics, where some very real fat tail risks have emerged: the fact that the U.S. has become increasingly divided, dysfunctional and inward-looking has emboldened a set of more aggressive players. Human nature, sadly, is what it is.
The Middle East stands out as the most visible problem, with the Israel-Hamas war at constant risk of igniting a broader conflict, various brands of Iran-sponsored terrorists taking potshots at American troops, Yemen’s Houthis disrupting the Suez Canal, and the Iran - Saudi Arabia rivalry festering in the background. The risk of regional instability flaring up in an even more destabilizing way is significant.
China might be considering whether to make a move on Taiwan this year or next. Taiwan’s recent election outcome has antagonized Beijing, and the probability that the current U.S. Administration — or the next one, on current trends — would be willing to risk a hot war in response appears limited. True, a takeover of Taiwan by force would carry important risks, including that of damage to the coveted semiconductor factories; but a sober risk assessment might not be enough to deter China, which insists reunification remains its fundamental goal.
Russia’s experience suggests that China should not be too concerned by the international reaction. Economic sanctions have had only limited effect — most trade has simply been diverted through third countries. Russia has paid a high price for miscalculating its attack on Ukraine — but as the conflict drags on, U.S. and EU support for Ukraine looks more likely to waver, increasing the chances of a settlement that would include important concessions to Moscow. What would be the next step? Sweden and the Baltics have grown more concerned that Russia’s attention might turn in their direction. Vladimir Putin might be wondering whether the West would really be ready to go to war over the Baltics. The temptation is obvious: if Russia attacks a EU NATO country and NATO fails to respond, NATO is effectively over and the EU fatally weakened. For someone with Putin’s historical grievances, this might be the best revenge.
This is quite a collection of very real tail risks. And remember, it only takes one.
Geopolitical instability breeds economic trouble. Shipping through the Suez Canal (30% of global containership trade) has already been disrupted; with traffic though the Panama Canal at risk because of low water levels, this highlights the vulnerability of the Malacca Strait, a chokepoint that handles one-quarter of global trade. The Fed is counting on further normalization of supply chains, but its hopes might easily be dashed — and there is a lot more work to be done to rethink global supply chains, as Luca Silipo at GEODIS has been arguing. And supply chain disruptions are just one of several important economic shocks that could be triggered by geopolitical events, as I’ve flagged in a previous post.
We have become tunnel-vision drama queens: we whip ourselves into a helpless frenzy on selected issues, and ignore the most salient real problems.
Drama queens
I am not a natural pessimist. In the years following the Global Financial Crisis I was harshly critical of the apocalyptic bias in media and market analyses, permanently predicting another crisis just around the corner and assessing the economic environment with an unshakable doom and gloom unsupported by the data. But now we seem to have swung to the opposite extreme.
We have become tunnel-vision drama queens: we whip ourselves into a helpless frenzy on selected issues, and ignore the most salient real problems. On climate change, we keep screaming that extinction is imminent, then jump onto the next cheap flight to take selfies in Venice. In the U.S. we keep screaming that democracy is in danger, but we can’t be bothered to read anything more than a tweet on the issues that matter. These perfunctory lamentations hide the fact that we are not really worried, we just love the drama. Whatever happened to the obsession with black swans and the VUCA world (volatility, uncertainty, complexity and ambiguity)?
Recent experience should have taught us that extreme risks do eventually materialize and when they do we tend to react in highly suboptimal ways — our response to the Covid pandemic was so disastrously misguided that we are still too ashamed to discuss it. Let us by all means stay optimistic, but let’s not be blind. We need to acknowledge the salient near-term tail risks and discuss how to mitigate them. Corporations need to go beyond the usual defensive response focused on cutting costs and curtailing investment — they need a more systemic approach to make their operations more robust; governments need to exercise stronger and more prudent leadership; and all of us need to spend more time thinking through the big issues that matter — at the very least, let’s ask ChatGPT for an executive briefing…
I have just come across this article by the excellent Stanford economic historian Niall Ferguson, who provides a well articulated discussion of the greatest geopolitical tail risk: that of sliding recklessly into WW III. Includes interesting parallels to the run up to WW II, and like my latest post also makes the point that we are underestimating some very clear and present dangers.
https://www.dailymail.co.uk/news/article-13039073/NIALL-FERGUSON-Bidens-fear-Putin-appeasement-World-War-III-likely.html