Economics Group. The Global Economic Expansion: Mind the Risks. Special Commentary. January 02, 2018

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1 January 2, 218 Economics Group Special Commentary Jay H. Bryson, Global Economist (74) The Global Economic Expansion: Mind the Risks Executive Summary A global economic expansion has been in train for eight years, and we look for it to continue in 218 and 219. That said, there are risks associated with any forecast, and readers would be well advised to be mindful of some of the more prominent risks at present. In our view, some of the most notable risks include the levered nature of many economies at present, the potential for interest rates, both short-term and long-term, to rise more than many market participants expect, and elevated equity prices in some economies. Perhaps the biggest risk facing the global economy at present, but arguably the most difficult to quantify, falls under the broad rubric of geopolitical risk. The Global Economy Should Continue to Expand in 218, But Global GDP grew near its long-term average rate of 3.5 percent per annum between 212 and 216, and it appears that the global economy expanded at a similar rate last year. Looking into 218 and 219, we forecast that global GDP will continue to grow near this long-run average. 1 But are there any potential developments that could trip up the global expansion? In this report we focus on a few risks that, should they come to pass, have the potential to lead to a less benign economic outlook. We should stress again that our base-case view is for continued global economic expansion. But there are risks associated with any forecast, and we would like to alert readers to some of the notable risks of which, in our view, they should be mindful. The World is More Levered Today Than in 28 The global recession of 28-9 was caused by excessive debt that originated, at least in part, among American households. The household debt-to-income ratio in the United States has receded from a peak of nearly 125 percent in 27 to about 95 percent today. But leverage ratios have increased elsewhere. As shown in Figure 1, there has been a notable increase in leverage in the non-financial corporate (NFC) sector in developing economies in recent years. Much of this increase has occurred in China, but China is not the only developing economy in which the NFC sector has become more levered in recent years. 2 Overall household and government debt ratios in the developing world have also risen over the past decade, but not to the same extent as the NFC ratio. Turning to developed economies, the trends in leverage ratios have not been as noticeable as in developing countries, but overall leverage has increased in the former group of countries (Figure 2). Although the overall household and NFC ratios in developed economies are more or less unchanged on balance over the past decade, leverage in the public sector has increased over that period. In 28, the overall government debt-to-gdp ratio in developed economies stood below 7 percent. It exceeds percent today. There are risks associated with any forecast. Leverage ratios have increased in many economies. 1 For further details on our global economic outlook see Which Way Will the Global Economy Go in 218? (October 2, 217) and our 218 Annual Economic Outlook. All Wells Fargo reports referenced herein are available upon request. 2 See Should We Worry About Chinese SOEs? (September 14, 217) for analysis of NFC debt in China. This report is available on wellsfargo.com/economics and on Bloomberg WFRE.

2 January 2, 218 Figure 1 Figure 2 Debt-to-GDP Ratios in Developing Economies Debt-to-GDP Ratios in Developed Economies 12 Household: 37.9 Government: 47.8 Non-financial Corporations: Household: 75.4 Government: Non-financial Corporations: Source: Bank for International Settlements and Wells Fargo Securities As long as interest rates do not rise significantly, widespread debt-servicing difficulties do not seem very likely. Higher-thanexpected inflation could lead more a more aggressive pace of Fed tightening. Should we be worried about this general build-up in leverage? The answer is yes if debtors were having problems servicing their debts. But there does not appear to be widespread instances of debt-servicing difficulties, at least not at present. The low interest rate environment that currently exists in most countries makes it less onerous, everything else equal, for debtors to service their debts. Data from the Bank for International Settlements (BIS) show that debt service ratios for the private sector have either receded or remained largely unchanged in most economies relative to ten years ago. So as long as interest rates do not rise significantly, widespread debt-servicing difficulties in the foreseeable future do not seem very likely, everything else equal. But could interest rates shoot significantly higher in the next year or so? Could Inflation Really Shoot Higher? Let s start with the outlook for short-term interest rates, which are heavily influenced by the monetary policy stances of central banks. The Federal Reserve has increased its target range for the fed funds rate by 125 bps since December 214, and we look for the FOMC to hike rates three more times in 218. If the Fed were to tighten policy faster than market participants expect, then the U.S. yield curve could move meaningfully higher. What would lead the Fed accelerate its pace of monetary tightening? Most FOMC members expect that the personal consumption expenditures (PCE) deflator, the Fed s preferred measure of consumer price inflation, will rise 1.7 percent to 1.9 percent in 218, near the Fed s target of 2 percent. The PCE inflation rate ran below 2 percent for most of 217, and there is no compelling reason to expect it to shoot meaningfully higher anytime soon (Figure 3). That said, the unemployment rate stands at a 17-year low of 4.1 percent. If the recently legislated tax cuts give a further boost to economic growth in coming quarters, then the labor market could tighten even further. Wage acceleration could then lead to higher-than-expected inflation, which could induce the Fed to tighten even faster. Not only would higher short-term interest rates lead to higher debt-servicing costs for some debtors, but they could lead to significant deceleration in the U.S. economy. Our forecast for continued solid GDP growth in the United States could be at risk if the Fed were to tighten faster than we currently expect. In our view, the Fed is the only major central bank that could realistically hike rates faster in 218 than most market participants currently expect. Whereas the unemployment rate in the United States has fallen to a multi-year low, there still appears to be significant slack remaining in the labor market in the Eurozone (Figure 4). Moreover, the underlying rate of inflation in the euro area remains well below the ECB s target of below, but close to, 2 percent over the medium term. The ECB has committed to keep its quantitative easing program in place through at least September 218 and, in our view, probably will not begin the process of hiking rates until 219. The probability that the Bank of Japan, which has been fighting deflationary forces for the past two decades, hikes rates in the foreseeable future seems to be remote. In sum, the Fed could 2

3 January 2, 218 conceivably tighten policy faster than most market participants currently expect, but it does not seem likely that other major central banks would follow the Fed s footsteps, at least not in 218. Figure 3 Figure 4 5% PCE Deflator vs. Core PCE Deflator Year-over-Year Percent Change 5% 13% Eurozone Unemployment Rate Seasonally Adjusted Eurozone Unemployment: 8.8% 13% 4% 4% 12% 12% 3% 3% 11% 11% 2% 2% 1% 1% 1% 1% % % 9% 9% -1% -1% PCE Deflator: 1.8% "Core" PCE Deflator: 1.5% -2% -2% % 7% % 7% Source: U.S. Department of Commerce, IHS Global Insight and Wells Fargo Securities Who Will Be the Buyer of Last Resort of Treasury Securities? Although the policy stances of central banks have significant influence over short-term interest rates, they have less effect on the long-end of yield curves. But long-term interest rates could be adversely affected by supply and demand dynamics in sovereign bond markets. In that regard, the widening budget deficit in the United States will lead to significantly higher issuance of Treasury securities in coming years. As we discussed in a recent report, we estimate that net issuance will jump from roughly $5 billion in calendar year (CY) 217 to nearly $1 trillion in CY 218 as well as in CY 219 (Figure 5). 3 We estimate that the majority of this new issuance will take the form of Treasury notes (maturities of 1 to 1 years) and Treasury bonds (maturities in excess of 1 years). Figure 5 $2, Net Treasury Issuance Composition Billions of Dollars, Calendar Years Net Interest-Bearing Issuance: $662.5B Net Treasury Bill Issuance: $285.4B $2, Figure 6 $3 $25 Foreign Purchases of U.S. Treasury Securities Bars = Billions of USD Line = 3-Month Moving Average $3 $25 Issuance of Treasury securities is set to increase meaningfully. $1,5 $1,5 $2 $2 $1, Forecast $1, $15 $ $15 $ $5 $5 $5 $5 $ $ $ $ -$5 -$5 -$ $5 -$ Foreign Purchases: $161.1B Foreign Purchases: $85.3B -$ $ -$15 Source: U.S. Department of the Treasury, U.S. Department of Commerce and Wells Fargo Securities But will buyers step up to absorb all this new issuance? For starters, net foreign purchases of Treasury securities have weakened noticeably over the past few years. Although foreign purchases have recovered somewhat in 217, it is not at all clear that they will return to their strong pace of a few years ago, let alone accelerate (Figure 6). As we discuss in our previously referenced report, the Fed will be reducing its holdings of Treasury securities in coming years, and it appears that demand for Treasury bills, notes and bonds among American banks may be softening. If other 3 See Who Will Buy All the New Treasury Securities? (November 27, 217). 3

4 January 2, 218 The United States is not the only country in the world that has enjoyed a booming stock market. domestic buyers do not step into the breach, then yields on Treasury securities would need to rise to bring quantity demanded back in line with quantity supplied. Yields on long-term U.S. Treasury securities have generally been stable over the past year or so, and we would expect that any rise in yields that should occur in 218 should be orderly, as long as the Fed remains more or less predictable. As we discussed above, however, inflation could potentially rise faster than most investors expect and bond yields could snap abruptly higher if long-term inflation expectations were to become unmoored. Financial markets in general clearly could encounter volatility if a disorderly rise in Treasury yields should occur, and financial market volatility could have deleterious effects on the economic outlook. Could Stock Markets Swoon? The stock market in the United States has had an impressive run over the past few years. Not only has the S&P 5 index nearly quadrupled during the current bull market that began in 29, but it currently stands about 7 percent above its previous peak in 27 (Figure 7). We are not equity strategists, so we will not opine on whether U.S. stocks are overvalued or if the entire market is in a bubble. But a significant decline in the American stock market, should one occur, clearly would have negative effects on the growth outlook for the United States. And the United States is not the only country in the world that has enjoyed a booming stock market. The German DAX index has outperformed the S&P 5 index in recent years, and the Canadian TSE Composite index (not shown) also stands at an all-time high. Figure S&P 5: DAX: 638. CAC: Topix: Stock Market Indicies Index, Jan 1995 = Source: Bloomberg LP and Wells Fargo Securities But this is not early 2 either when soaring equity prices were ubiquitous. For example, the French CAC index has not yet regained its 27 high let alone its all-time peak in 2, and most other stock market indices in Europe (outside Germany) remain below previous all-time highs. The Japanese Topix index has been more or less flat on balance for more than 2 years. The Chinese Shanghai Composite index (not shown) remains nearly 5 percent below its 27 peak. In sum, meaningful declines in share prices could occur in some countries, but not all countries appear to have the same degree of vulnerability. Geopolitical Risks Abound Perhaps the biggest risk facing the global economy in 218, but arguably the most difficult to quantify, falls under the broad rubric of geopolitical risk. Let s start with North Korea. The United States obviously is at loggerheads with the renegade Asian nation. But how will disagreement over North Korea s nuclear weapons program be resolved? Will open conflict break out? Will nuclear weapons be used? What sort of economic and financial fallout would armed conflict with North Korea entail? But North Korea is only one of many examples of potential geopolitical risk in 218. Will Saudi Arabia and Iran go to war in coming months? Will the decision to eventually move the U.S. 4

5 January 2, 218 embassy from Tel Aviv to Jerusalem lead to generalized tensions in the region? Will Russia feel embolden to threaten one of the Baltic States, which all are NATO members, as it did to Ukraine (not a NATO member) a few years ago? Will territorial disputes in the South China Sea lead to conflict between China and some of its neighbors? Will any terrorist attacks occur in western countries that are so disruptive as to significantly affect the global economic outlook? There probably are more potential geopolitical risks that we could mention, but the point should be fairly obvious by now. That is, there are a number of credible geopolitical risks that, should they come to pass, could have detrimental effects for the global economic outlook. However, we do not know what probability to assign to these potential geopolitical risks, nor do we have a good way to quantify the effects that they could have on global growth. We strongly suspect that nobody else does either. Conclusion There has been a global expansion under way since 21, and our base-case forecast looks for global GDP to grow near its long-run average rate of 3.5 percent per annum in the coming two years. But, there are risks that are associated with any forecast, and readers would be well advised to be mindful of some of the more prominent risks. In our view, geopolitical events probably represent the biggest downside risk to the global economic outlook. Although there are numerous geopolitical risks that exist at the moment, it is difficult to assign a probability to their realization or to quantify their potential economic effects. Overall financial leverage has risen in many economies over the past decade, but debt-servicing difficulties likely will not become onerous, at least in the near term, unless interest rates move significantly higher. In that regard, the Fed could conceivably tighten policy faster than many market participants expect, but other major central banks probably will not follow suit, at least not in 218. There is potential for a disorderly move in the U.S. government bond market as Treasury issuance ramps up, and elevated stock prices in some countries are noteworthy. In sum, we expect the global economic expansion to remain intact for the foreseeable future. But to paraphrase the unofficial slogan of the London subway system, decision makers should mind the risks. 5

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