It would be “historically unprecedented” were markets not to rise further in line with the US business cycle, according to Invesco’s John Greenwood, who says the current expansion looks set to continue for a number of years.
July will see the US economy set a new record for its longest period of growth, breaking a 10-year record set between 1991 and 2001. While many analysts warn this means a recession is due, Greenwood, chief economist at Invesco, said the major bellwethers of a downturn are currently notable by their absence.
“Aside from the improved health of balance sheets in the US financial and household sectors, the most important fact is that inflation remains below 2 per cent, implying that the Fed has no reason to tighten monetary policy in such a way as to end the expansion any time soon,” he said.
“This in turn means that risk asset prices – equities, real estate or commodities – can rise further before the end of the current upswing.”
He added: “As long as the business cycle continues to expand, it would be historically unprecedented if the asset markets were to deviate very much from the underlying profile of the business cycle.”
Many analysts have warned it will be a rise in inflation – either as a result of large fiscal deficits and high government debt, or a tightening in labour markets – that will mark the beginning of the end of the business cycle.
However, Greenwood said these analysts appear to be ignoring the true origins of inflation, which have been largely absent in developed economies over the past decade.
“Excess money growth and/or excess leverage are the two main underlying triggers for recessions,” he added.
“Therefore, if money and credit growth remain moderate and inflation stays subdued, there will be no need for central banks to tighten in such a way as to threaten a recession.”
Equally, he said provided leverage does not build up excessively – as it did in 2003 to 2008 – there is no reason to expect a major financial accident similar to the bankruptcy of Lehman Brothers, which led to the freezing of credit markets in 2008 and the collapse of spending and GDP.
“The fact that large-scale government borrowing in the wake of the global financial crisis has replaced private sector borrowing in the US, the eurozone, Japan and the UK, allowing varying degrees of deleveraging in the private sector, has enabled persistently low money growth and therefore inflation,” the Invesco chief economist continued.
“Provided that money growth remains consistent with low inflation, it is perfectly feasible for an economy to grow at or close to its potential growth rates, with low unemployment, without inflation rising much.
“Higher inflation, rising interest rates and a collapse of asset values are not inevitable – at any rate within the next two or three years.”
As a result, Greenwood believes the US economy is currently closer to mid-cycle than end-cycle, adding that last year’s Fed rate-hikes – which, combined with the manufacturing slowdown in 2018, set alarm bells ringing for some investors – represented a normalisation rather than a tightening of policy, similar to the mid-course corrections in 1994 to 1995 or 2004 to 2005.
Performance of index 1994 to 1995 and 2004 to 2005
Source: FE Analytics
In both these cases, the business cycle expansion continued for several more years after the series of interest rate increases.
Greenwood also sees no reason to be alarmed about the recent yield-curve inversion in the US, which he believes is a symptom of shifts in supply and demand in the credit markets.
Source: MSCI
“An inverted yield curve will normally be followed by a recession only when it is a symptom of tightening monetary conditions,” he explained.
Greenwood forecasts 2.6 per cent real GDP growth in the US in 2019.
The Invesco economist is not as confident about the world’s other superpower, however. He warned that having accumulated large amounts of debt over the preceding seven to eight years, the Chinese state-owned corporate sector and parts of the financial sector have found growth constrained more recently.
“They cannot continue to borrow and invest at the same carefree pace as before, yet the People’s Bank of China and other authorities are wary of allowing the growth rate to fall too sharply because of the social unrest that may follow,” he explained.
“As a result, China’s macro-policy making over the past year or so has shifted from the previous clear directional thrust – either to expand or contract – to a seemingly contradictory set of strategies.
“These include a mixture of restraints on lending by the shadow banking system and macro-prudential controls on lending to the housing sector on the one hand, accompanied by the easing of interest rates and lowering of reserve requirement ratios on the other.”
In the short term, Greenwood expects this to lead to some further slowing of growth momentum and a significant downturn in reported inflation. He projects real GDP growth of 6.3 per cent in China in 2019.
His outlook for the eurozone is also subdued, at 1.4 per cent, as it feels the impact of the manufacturing downturn during 2018.
“The question now is whether this downturn will prove to be a temporary period of weakness, or whether it is symptomatic of a deeper, underlying shortage of aggregate demand,” he continued.
“Aggregate demand, or total spending on goods and services, has been depressed by low money growth. The problem remains that while eurozone banks have not fully repaired their balance sheets, they remain risk-averse, and lending is still anaemic. Without the boost from the European Central Bank’s QE [quantitative easing] asset purchases, it is highly likely that broad money supply will slow further, undermining the potential recovery.”
Turning to the UK, Greenwood said that Brexit-related hesitancy continues to hold down bank lending and investment. With consumer and business confidence also faltering, he forecasts real GDP growth of just 1.3 per cent.
Finally, on Japan, he said that real GDP growth – at 0.9 per cent for this year – will continue to be depressed by lenders’ risk aversion and borrowers’ reluctance to increase their indebtedness in an environment of very slow real or nominal growth.
He pointed out that rather than creating the required money growth itself by buying securities from non-banks and paying them with new deposits, the Bank of Japan has focused its asset purchase programme on the banks.
“As a result, it has had to rely on risk-averse banks to increase lending and hence broad money growth,” he said.
“If it had purchased Japanese government bonds from non-bank financial corporations and households, there would by now be a substantially higher level of deposits and money in the Japanese banking system, and the inflation rate would be 2 per cent or greater,” he finished.