Economic sweet spot of 2016 before the reflation storm
China, Europe, and the US are picking up speed but the credit cycle is ageing, and treacherous waters lie just beyond the horizon
By Ambrose Evans-Pritchard
US car sales are booming on pent-up demand
Sunlit uplands beckon. Almost $2 trillion of annual stimulus from cheap oil has been accumulating for months, pent up and waiting to be spent. It will soon come flooding through in a burst, catching the world by surprise.
But beware: the more beguiling it is over coming months, the more traumatic it will be later as the reflation scare comes alive.
Since the rite of New Year predictions is to stick one's neck out, let me hazard hopefully that this treacherous moment can be deferred until 2017.
The positive oil shock will hit just as austerity ends in the US, and big-spending states and cities ice the cake with a fiscal boost worth 0.5pc of GDP. Americans broke records with the purchase 1.7m new cars and trucks in December, a foretaste of blistering sales to come. There is a ‘deficit’ of 20m cars left from the Long Slump yet to be plugged.
The eurozone is nearing the sweet spot, a fleeting nirvana of 2pc growth, conjured by the trifecta of a cheap euro, budgetary break-out, and the end of bank deleveraging.
Mario Draghi’s printing presses are firing on all cylinders. The 'broad' M3 money supply is growing at turbo-charged rates of 5pc in real terms. This is a 12-month leading indicator for the economy, so enjoy the ride, at least until the demonic Fiscal Compact returns at the dead of night to smother Europe once again.
In China, the dogs bark, the caravan moves on. There will be no devaluation of the yuan this year, because there is no urgent need for it. Premier Li Keqiang has vowed to keep the new exchange basket stable. Armed with a current account surplus of $600bn, $3.5 trillion of reserves, and capital controls, that is exactly what he will do.
The lingering hangover from the Great Chinese Recession of early 2015 has faded. The PMI services gauge has just jumped to a 15-month high of 54.4, and this is now the relevant index since the Communist Party is systematically winding down chunks of the steel, shipbuilding, and chemical industries.
China's money supply is also catching fire. Growth of 'real true M1' has spiked to 10pc, a giddy shot of caffeine not seen since the post-Lehman spree. Combined credit and local government bond issuance is surging at a rate of 14pc. The Communist Party cranked up fiscal spending by 18.9pc in November.
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Whether or not you think this recidivist stimulus is wise - given that the law of diminishing returns set in long ago for debt-driven growth - it will paper over a lot of cracks for the time being.
One thing that will not happen is a housing revival in the mid-sized T3 and T4 cities of the hinterland. It will be a long time before the latest reform of the medieval Hukou system unleashes enough rural migrants to fill the ghost towns. The stock of 4.5m unsold homes on the books of developers is frightening to behold.
The epic dollar rally has come and gone. The world's currency will drift down over coming months, and that will be a reprieve for the likes of Brazil, Turkey, South Africa, Indonesia, and Colombia.
Those at the wrong end of $9 trillion of off-shore debt in US dollars may breath easier: they will not escape. The MSCI index of emerging market stocks will return from the dead, clawing back most of the 28pc in losses since last April, but only to lurch into a greater storm.
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Dr Copper will recover. Inventories are down to 13-days supply in Chinese warehouses, and African supplies are dwindling. Forced liquidation of base metals by exchange trade funds - with a final killer twist from hedge funds - has distorted the market. Finance has decoupled from physical demand. The springs are coiled for a short-squeeze.
Oil may take longer as Saudi Arabia and Russia slug it out. The Saudis think they have deep enough pockets to outlast the Russians, and the Russians think they have the greater strategic depth to survive a long siege.
Both are courting fate. Russia's reserve fund will be depleted before the end of this year if oil stays anywhere near $40, and there is no other viable way to fund the Kremlin's budget deficit. Pressure on the Saudi riyal will keep building despite the latest austerity package, and capital flight will turn virulent.
Behind the bluster, both are looking for a way out. We will know if they reach a secret truce, and by implication take the first step toward 'super-OPEC'. Excess production will stop. Crude will be nursed back up to $60. So watch what they drill, not what they say.
It is not bad a outlook for the world, but economic recovery contains the seeds of its own demise at this late, stretched, phase of the cycle. Inflation lurks. Core CPI for services in the US is already creeping up to 3pc and the jobs market is tightening hard.
Base effects will lift the headline inflation in the US and Europe by mechanical effect as the commodity slump bottoms out, and it will not be long before we are all chattering about ‘secular stagflation’.
This is where the danger lies. $6 trillion of global government debt trades at interest rates below zero, and $17 trillion below 1pc. The bond market is priced for deflation as far as the eye can see, yet deflation is yesterday’s story.
Let us hope the lull before the storm is long enough to enjoy. The world is not prepared for the inevitable pivot when the Fed suddenly finds itself behind the curve and switches to rapid fire rate rises, sending 10-year US Treasuries screaming back towards 4pc, and lifting German Bunds with them. The global cost of borrowing will go up whether or not debt is in dollars.
Nobody knows where the pain threshold lies for a global system leveraged as never before.
Public and private debt ratios are hovering at all-time records of 265pc of GDP in the OECD club and 185pc in emerging markets, 35 percentage points higher than at the top of the pre-Lehman credit bubble.
But that is a bedtime horror story for 2017.
Happy New Year.
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