As Good As It Gets

World GDP is growing, but not terribly fast, and many clouds dim the horizon. Without productivity improvements, global growth may be stalled.

If you think that the world economy is doing only so-so and growth is lackluster, think again. World economic growth strengthened in 2017 to 3.7% and the International Monetary Fund (IMF) expects it to cruise at this rate—or slightly higher—this year and next.

The US is in its ninth consecutive year of expansion. Europe may have disappointed a bit in the first part of 2018 but could recover later this year. China is slowing down, but in a gradual fashion, and after a period of extraordinary growth. Emerging countries, aside from a few basket cases such as Argentina, Turkey and Venezuela, are doing well.

The only problem with the current state of affairs is that it may not last long.

“A lot of [the IMF projected] growth has to do with faster US growth, and the faster US growth is due to the fiscal stimulus that we learned was going to happen as late as October a year ago,” says Chris Rupkey, chief financial economist for MUFG Union Bank in New York. “This is finally as good as it gets for the world’s economic growth.”

Some economists fear that a plateau has been reached. A progressive slowdown is in the cards, as the impact of the tax cuts approved by the US government last December is going to peter out as the year ends. A long list of possible risks loom over the future, ranging from rising populism across Europe, Mexico and the US and the explosion of a full-blown trade war to record high levels of sovereign debt alongside paltry productivity growth and aging populations.

“We’re growing around the world,” says John Cochrane, senior fellow with the Hoover Institution at Stanford University. “It’s just that there are dark clouds on the horizon.” Cochrane fears a possible sovereign-debt crisis.

At least for the next year, though, most agree that the global economy will remain on a positive trend. There is “very, very little prospect of a significant economic downturn in the next 12 months,” says Paul Donovan, global chief economist at UBS Wealth Management. “I would almost guarantee no downturn—almost, I would stress.” Donovan notes that despite US employment statistics showing a tight labor market, the economy remains cool. “Whilst this economic recovery has been very long—the second-longest economic expansion since 1945,” he says, “it has also been the weakest economic expansion since 1945.”

A big and important unknown is global trade, which is often a key factor contributing to economic growth. The imposition of trade tariffs by US President Donald Trump since the start of 2018—and the various countermeasures taken by other nations—have been an alarm bell that this engine of growth could be halted, even reversed.

So far, announcements of anti-trade measures have prompted big headlines and concerns around the world, but they have not yet significantly dented the size of global trade. “The direct effect of what has been announced or even threatened so far is not huge. It is 0.7% of the total world’s trade,” says Andrew Kenningham, who runs the global economics service of Capital Economics in London. “It is a big deal if you are an importer in the US or if you are involved in the soybean market; but if you look at it from a macroeconomic perspective, the amount of trade affected is not big enough yet.”

And the tariffs announced so far are not expected to affect it in the short term. “Last year the world trade grew by about 6%. We expect that to drop this year to 4.9% and next year to around 4%. It’s a moderate decline, but not a dramatic one,” says Adam Slater, lead economist at Oxford Economics. “The risk is that we get a series of further escalations.”

A potential full-blown trade war would be particularly serious for European countries such as Germany or Italy, where exports represent a much larger proportion of the GDP than in the US, says Marcel Fratzscher, president of economic research institute DIW Berlin and a professor of macroeconomics and finance at Humboldt University in Berlin. However, he sees much more room for expansion in Europe than in the US.

“The United States is now in year number nine of its expansion. Europe and the euro area’s economies are in only their fifth or fourth year of economic expansion and recovery,” he says. “Compared to the United States, Europe is lagging behind and thus has a lot more potential for catching up and growing in the coming years.” Fratzscher expects the continent to cextend its modest expansion. “I expect that the recovery is going to continue and that we have three good years ahead of us,” he says, “if nothing goes wrong—and it is a big ‘if’.”

Yet after years of globalization, and world GDP growing with trade and immigration, many populations are expressing political discontent. In Italy, the populist Five Star Movement became the leading party. Mexico elected left-leaning Andrés Manuel López Obrador as president. In some countries, such as the US and Turkey, growing nationalism is empowered by increasingly imperial presidencies. Recep Tayyip Erdoan and Donald Trump, among others, have taken up calls to close borders and halt immigration. Although the impact has been muted so far, in the long run these trends may hamper global economic expansion.

“There is not much doubt that globalization has helped the world’s economic growth,” says Kenningham. “Reverting globalization would adversely affect global growth.” Kenningham points to Turkey and Argentina as economies that are suffering due to bad governance. “If you look outside Venezuela, which is in a terrible situation, there is Ukraine all permanently in a crisis,” he adds. “But Turkey and Argentina were very specific cases; it’s primarily mismanagement of economies that has made them vulnerable.”

These are isolated cases, not expected to create a cascade of problems elsewhere. They are a reminder for developed and larger economies of how nationalism can be detrimental to growth when acted out in economic policies. The change in US trade policies, on the other hand, can have a much broader impact than immediate price hikes for imported washing machines.

“A world economy where the postwar international order falls apart and the US abdicates its leadership seems to me like a more volatile place where bad stuff can happen more often,” says Cochrane.

Canary in the Coal Mine

Financial markets seem oblivious to these risks. Investors have been much reassured by the steadfastness of the US Federal Reserve and the European Central Bank (ECB). The former started to wind down its expansionary monetary policy in the last few years, with seven rate increases between December 2015 and June 2018. At least one, maybe two, more rate hikes are expected by December. The ECB is expected to start its own tightening cycle in a few months.

“This is an area of considerable uncertainty,” says Oxford’s Slater. “With all the argument in policy circles about how big an impact the tapering or ending of the quantitative easing will have, there’s no clear conclusion. There is a risk that it might be more restrictive than we think, with a big negative impact on the global economy.”

The winding down of the so-called quantitative easing, with the shrinking of the Fed’s balance sheet, so far does not seem to have created any problem. But some economists are worried by the flattening and possible inversion of the yield curve—the difference between short and long-term yields on Treasury bonds.

Usually, the longer the maturity, the higher the yield, to compensate for risk and possible inflation. But if short-term rates became equal to or higher than long-term yield, the market signals a possible recession. According to Christopher Waller, executive vice president at the Federal Reserve of St. Louis, the yield curve inverted ahead of the last seven recessions; and on average, the decline in economic activity happened 15 months after the yield curve inverted. “We are getting very close to having an inverted yield curve, and it’s the canary in the coal mine,” he says. “It’s a signal of danger.” The Federal Reserve of St. Louis has been calling for a more cautious approach, with a flat policy rate over 2018.

Still, Waller believes the US economy is on track for solid growth that could reach 2.6%, possibly even 3%, this year.

Another big question mark comes from the productivity puzzle. Some expect productivity to recover the high levels of growth seen before the financial crisis; others don’t. That dilemma of how to boost productivity—and who solves it—will determine whether the world’s economic growth remains limited in the medium or long term, or spikes again. The Federal Reserve of St. Louis, for example, says that there are different productivity regimes and that the economy could switch back to a higher productivity mood.

“Most forecasts generally assume that productivity growth—which has been fairly poor in the last few years—will pick up over the next five to 10 years,” says Slater. “If it does not, that could usher us in a world of low growth for some time.” Sluggish productivity of recent years has mystified analysts, according to Slater. “There are various competing theories, but none of them is really conclusive.”

According to the Bureau of Labor Statistics, productivity in the US nonfarm business sector rose by an average of 1.2% in the 10 years since the start of the great recession (from 2007 to 2017). This is less than half the 2.6% yearly increase shown between 2000 and 2007. If productivity growth does not come back, higher economic growth does not seem possible.

Did you say that the world economy is doing only so-so? Well, it seems you might be right after all.