Do not expect the Fed to stop global growth unravelling
Dozens of central bankers from across the globe have arrived in Jackson Hole to discuss the “Challenges for Monetary Policy”. The headline for this year’s symposium hints at the waning power of policymakers to prevent recessions. Investors still have a lot of faith that the US Federal Reserve can put an end to the unravelling of global growth — but such confidence is misplaced.
The latest market turmoil is a symptom of the gradual unwinding of globalisation and the inability of the Fed to stem the bleeding. To move from a position of raising rates in late-2018 to cutting them 25 basis points months later is a dramatic reversal. Yet it has not been enough to ease investors’ fears about a recession.
Thirty years of globalisation have allowed manufacturing to flow to the lowest-cost areas of production, such as Mexico and south-east Asia. The prices of consumer goods fell, and the middle class in emerging markets expanded as they invested in domestic production and infrastructure. This shift has been incredibly good for consumers and, as a result, global growth.
But now the wheels are spinning in reverse for the world’s manufacturing economies. As multinational companies scramble to mitigate the effects of trade tariffs by reorganising supply chains and onshoring production, EMs need to find a new source of demand. If they fail to adapt, global growth will grind to a halt.
This fragmentation in trade has spooked investors as it has serious implications for global growth. Germany is already teetering on the brink of recession and other manufacturing economies, including Italy, Vietnam and Romania, are struggling. Key parts of the Treasury yield curves have inverted, another ominous sign of tough times ahead for the US economy.
The Fed has become more instrumental in shaping global monetary policy since the 2008 financial crisis. When it was raising interest rates between 2016 and 2018, it was, in effect, tightening global fiscal policy. And with the US dollar the de facto fiat globally for multinational companies borrowing money, every move by Fed chairman Jay Powell now ripples across the world’s money markets.
Lowering interest rates relieves some of the immediate pressure on EMs by reducing the rates on dollar-denominated debt. This sugar rush buys EMs time to develop new sources of demand for the manufacturing industries. But the strategy is fraught with risk, and if it fails we can expect major headwinds for global growth.
As the trade war has escalated, the Fed has shown itself to be more open and flexible to adjusting rates quickly to prevent a recession. Under career academics such as Alan Greenspan and Ben Bernanke, the Fed was less communicative and flexible, meaning it required more time to make decisions. When the yield curve inverted in 2008, long-term rates shifted lower swiftly, but Mr Greenspan, awaiting concrete economic data, failed to adjust the short end of the curve. In effect, he was too slow to stop the carnage.
The modern-day Fed is more open to using real-time market data to inform its decision-making. But with borrowing rates already low by historical standards, there are diminishing returns to further cuts, which are expected to fall 60bp this year according to market forecasts.
As there is not much ammunition available, the Fed’s best play is to trim rates in 25bp increments; acting more decisively with a 50bp cut or more would provide more shock and awe for investors, but risk drawing down the only real tool at its disposal.
Mr Powell must also be mindful of the cause of the current slowdown. A quick resolution on trade would swiftly revive market demand. As Donald Trump’s administration shifts into election mode, that seems more likely as a boost to stocks from a resolution would benefit the president in the polls. And if that happens, the Fed will have to raise rates again to avoid adding too much stimulus to the economy.
But in the meantime there is a risk that as business sentiment falters, manufacturing economies stumble, and consumers start to feel tariffs at the tills, the anti-globalisation sentiment will stall global growth. As quick as the Fed may be to act to remedy this with rate cuts, it has little dry powder in its arsenal to prevent this from spiralling into a full-blown recession.
Investors should not put faith in the idea that Fed can stop the unravelling of global growth, regardless of the statements coming out of Jackson Hole on Friday.
Peter Cramer is a senior portfolio manager at SLC Management