The International Monetary Fund (IMF) took a decidedly bearish tone during its annual meeting in Bali earlier this month – in fact, I would say it was the grimmest gathering of the IMF that I’ve ever seen. I had the opportunity to attend the talks in Indonesia, and I came home with five key takeaways. Below, I summarize those takeaways and share the viewpoint from Invesco’s Office of the Global Market Strategist.
1) U.S. – China tensions are likely to persist or even escalate until there is a significant economic policy shift or serious economic damage on one side or the other. That said, there may be hope for a near-term reprieve given the U.S. mid-term election in November, the potential for the U.S. and Chinese presidents to discuss the issue at the November summit of the G20, and potential policy changes that might crystallize on Dec. 18, 2018. That date marks the 40th anniversary of Deng Xiaoping’s reforms in China, and there’s speculation that President Xi Jinping might mark the occasion with a series of new reform announcements.
Our viewpoint: We don’t expect President Donald Trump to retreat from his trade stance after the mid-terms, and if China does announce any far-reaching reform commitments, we would expect a “don’t-trust-but-verify” approach.
What makes this issue so difficult? The U.S. is demanding nothing less than a fundamental shift in the structure of the Chinese state – the West believes that Xi is seeking a return to state control after his predecessors moved away from that direction. But even if Xi pledges to reform, we believe that distrust on both sides would shorten any relief rally in the stock market. We believe volatility will remain elevated, and that we could see ongoing divergence among global economies.
2) U.S. Federal Reserve (Fed) policy normalization seems very likely to go ahead unless there is a significant weakening in U.S. economic data or a shock in financial conditions that slows U.S. growth, labor markets and inflation. The Fed has paused twice in normalizing monetary policy over the last half a decade, and believes that U.S. growth and inflation are now strong enough that it needs to take policy at least to neutral.
Our viewpoint: We believe that economic “spill-backs” could stay the Fed’s hand or prompt it to reverse the course of normalization, but a shock to financial conditions would not necessarily deter the Fed – unless it were severe. We also believe that there is a consensus at the Fed that there has been enough time for other economies, particularly emerging market economies, to adjust to the long-flagged shift in U.S. monetary policy. This interpretation was corroborated in Bali by former and current high-level Fed officials and several other major central bank governors and finance ministers.
We also note that every major, modern Fed tightening cycle has been followed by a major global financial collapse, including the Latin American and Eastern European debt crises of the 1980s; the EM currency/banking/public debt crises of the 1990s and early 2000s; and most recently the global financial crisis and the eurozone sovereign debt crisis. The open question is which regions or asset classes could suffer most if that history repeats itself this time? The clearest candidates are the countries that are expecting to be beneficiaries of China’s Belt and Road Initiative (which encompasses plans for $900 billion in spending on infrastructure and investment projects in a long list of countries). The unspoken fear is that it could be China itself. Most other emerging markets are highly exposed, and it’s possible that the U.S. could continue to suffer from events such as the October equity sell-off.
3) Growth, though still reasonably resilient, is under pressure and desynchronized, with some regions showing positive growth, but others not faring as well. The pressure is likely to continue, as reflected in the IMF’s moderate downgrades to its growth forecasts, with the risks tilted towards further down grades in growth forecasts. The U.S. is growing reasonably strongly, the eurozone and Japan are on a decent track, but the U.K., China, India and Indonesia are all slowing. There are significant risks to the rest of emerging markets, with few growing at all. The rest of the world is unlikely to move the needle much, let alone cushion any significant shock to growth or financial conditions.
Our viewpoint: Cyclical global growth and inflation may be decent, but are not robust, resilient or represented widely enough across the globe to offset the trade, financial and geopolitical risks to potential growth in most economies. Hence, we do not believe they can support risky assets if tensions mount further. We agree with the IMF that more countries are likely to fall towards slower growth than faster growth, given rising global bond yields, a stronger US dollar and a higher cost of funding.
4) Political dominance continues to trump monetary dominance. The key political areas to focus on are the conflict between Italy and the eurozone; the Brexit situation between U.K. and the European Union; strains in Turkey, Brazil and Russia; and of course the potential for U.S.-China trade tensions to spill over into Russia, India, Indonesia and the countries participating in the Belt and Road Initiative, as well as the wider world economy and global financial markets.
Our viewpoint: We expect geopolitics, domestic politics, fiscal policy and structural policies to become much more important in both developed market and emerging market economies.
5) The weaponization of trade, finance and the U.S. dollar via sanctions. There is growing worldwide concern about the increasingly rapid and widening spread of U.S. dollar sanctions, as well as threats to limit access to dollar markets or impose direct sanctions. This fear is shared by U.S. allies, adversaries and rivals alike, as well as those who have not decided on which side they stand. The EU, China and Indonesia have expressed concern about the U.S. weaponizing the dollar, the financial system and trade. Russia has already been sanctioned, Saudi Arabia has been threatened, Turkey has caved, and India is under pressure to stop buying oil from Iran.
Our viewpoint: The rest of emerging markets and the frontier markets could suffer collateral damage from the U.S.-China trade tension. Japan and the EU are likely to acquiesce because of the need for security and access to the critical U.S. market. However, the EU is making a lot of noise on this front, and is maneuvering the IMF away from the U.S. dollar through the choice of a new chief economist, Gita Gopinath, whose work has focused on the risks of a USD-dominated trade system. And yet, the euro is not a viable alternative as long as there are risks of eurozone exits, which would reduce the viable pool of euro reserve assets. The EU would need an alternative capital market as large, liquid and deep as the USD and an alternative export market. China may use this as a lure to the EU.
Southeast Asia may try to play off the U.S., Japan, Korea and China as sources of foreign direct investment. A big question is India, which is why China spent considerable effort trying to draw India into the Belt and Road Initiative, though it wasn’t able to do so in a meaningful way. We believe India is very unlikely to choose China for geopolitical reasons, but will have a domestic political challenge in openly choosing the U.S.
We’re keeping an eye on rising refinancing risk in frontier markets. Most host countries for the Belt and Road Initiative (BRI) are effectively caught in the middle between China and the U.S., but so far their debts are largely in U.S. dollars. Many BRI host countries are frontier markets that have issued a lot of US dollar debt, with lumpy maturities in the coming years, and may face a severe rise in refinancing risks as well as difficulty in financing their commitments to the Belt and Road Initiative.
Pakistan is perhaps the most important case to monitor among frontier markets and BRI host countries, for it is facing severe financing challenges, has just entered its 13th IMF program and sits at a crucial nexus among the U.S., China and India. Pakistan has had a long and fruitful but tense relationship with the U.S. and China, having facilitated the original U.S.-China rapprochement. Pakistan is also major ally of China and the largest recipient of BRI-type funding through the China-Pakistan Economic Corridor.
There is strong concern in the West, the IMF, India and other emerging market countries that global resources via the IMF and private creditors might be used to support Pakistan to the benefit of China but at the expense of other emerging and frontier markets. India is in a perennial standoff with Pakistan – with which it has fought several wars and has disputed territory, as it does with China – yet India would not benefit from a serious economic or financial crisis in Pakistan, which might lead to greater instability and terrorism.
We expect this constellation of interests to result in heavier conditions and demands for IMF lending than in the past, which might represent a new direction in IMF programs involving a larger role for geopolitical factors, given U.S.-China tensions, and given the fact that many major emerging or frontier markets are, like Pakistan, repeat IMF borrowers.