Victory of Donald Trump in last year’s presidential election led to a boom in the markets. The promises of the new regime to overhaul regulation, invest in infrastructure and cut taxes were expected to give a boost to the 8-year-old economic upturn. The problem is that the debt-financed global expansion has already lasted for a long time (eight years) and its foundations are weakening rapidly.
There are three reasons why an economic downturn is likely to be just around the corner. First, credit creation in the US economy has stalled. Second, for the last year or so China has been supporting global growth and it is running out of road. Thirdly, the internal problems of Europe limit its ability to boost global growth. All this leads to a conclusion that we are heading to a global recession.
Leveraged American consumers and corporations
We found in our business cycle forecast in December that, although the US economy still had the room to grow, the relentless increase in total financial assets and (thus) leverage among firms and consumers was troubling. Because the industrial production of the US peaked in November 2014, we concluded that the US consumers are the key. If their confidence remains high or grows, there may even be an upturn in business investment, but if this confidence wanes, a recession comes in a short time. For example, a serious correction or fall in the stock market could collapse the consumer confidence and trigger a recession.
Although the consumer confidence remains high, something snapped in the US economy in December. Figure 1 presents the monthly growth of industrial and commercial loan stock in the US. It turned negative first in August last year, then in December and again in February.
The contraction in the industrial and commercial credit is a serious warning signal in a mature business cycle, like the current one in the US. Emerging signals for stagnation can be seen in many other credit categories, such as real estate, automobile and credit card loans.
These developments do not tell a tale of a boosting economy, but a stalling one. Because interest rates have been rising and because the debt burden of US companies is very high, it is unlikely that any tax cuts, infrastructure spending or regulatory changes are able to turn this trend.
China is running out of the road
It is not well known that China had a minuscule recession in 2015 caused by squeeze in lending and fiscal shocks. To counter this, Beijing issued a massive debt-driven stimulation program which reignited the global growth. Both the recession and the stimulation, which started at the beginning of 2016, are visible in the composite leading indicators (CLI) shown in Figure 2. CLIs track the near future prospects of an economy through changes in the orders and inventories of businesses, different financial market indicators and business confidence surveys. Figure 2 shows a downturn in the summer of 2015 and then a sharp upturn in the summer 2016 in the CLI in China and later in other regions.
Another thing not fully internalized is that, since 2008, China has relied heavily on debt creation to stimulate its economy. This has increased the debt levels to dangerous levels in China. Figure 3 shows that the share of credit-to-GDP is at a markedly high level in China, especially compared with those levels at which the other countries faced their financial crises.
The Figure 3 shows that the share of credit-to-GDP is at a very high level in China, especially when compared with the level when other countries have faced financial crises. With the speed of credit creation more than twice that that of growth of GDP, it is evident that China cannot continue with this trajectory for very long.
Economic revival of the Eurozone is far from self-sufficient
The economy of the Eurozone has shown some long awaited signs of recovery lately. However, the recovery is keenly dependent on state of the world economy and on China.
China has become the main trading partner of both the EU and Germany. Exports of goods and services also amount to over 27 percent of GDP of the euro area. This is a much larger share than that of China (21.9 percent) and the US (12.5 percent).
This means that the Eurozone cannot sustain its positive momentum, if the economies of China and the US tank. Europe is also battling with severe internal issues, including Brexit, the influx of migrants, and the still on-going debt crisis now turning acute in Greece. Thus, there is no way Europe to take the economic or political lead in the world economy.
Global recession is on the cards
From a purely mathematical perspective, we are closing in a global recession. The mature business cycle of the US and the rising debt in China hamper the prospects of the global expansion.
Whether recession is dead ahead or somewhat further down the road depends crucially on the policy that China takes. Recent actions indicate that the authorities in China have taken their foot of the gas. If this interpretation is correct, global recession is just a few months ahead. If China decides to continue with the massive stimulus and risk even greater financial instability, global economy may hum along for few quarters.
The US stock market bears another risk. If it crashes, the consumer confidence and the economy is likely to follow. Everywhere, the current asset valuations are now sustained through the artificial liquidity provided by the central banks (QE and very low interest rates), indicating that any crash may go global exceptionally fast. A panic in one of the major asset markets could thus cause a rapid deterioration of the global economy.
The world economy needs to prepare for the worst. Especially, as the upcoming recession may turn out to be very different than anything we have seen in a long time.