The global economic recovery has hit some resistance

Spatterings of weak data should have policymakers worried

Shoppers in Tokyo: Japanese consumer spending and wage growth has been weaker than expected © AFP

Not everything in the world has been going badly, at least until now. There may have been rising tension over geopolitics and trade, but the global economy has continued to achieve broad-based growth in the past couple of years. More recently, however, there have been a few spatterings of rain out of an apparently clear sky.

A series of downbeat business surveys in the eurozone, plus an unexpected third successive monthly fall in industrial production in February, have cast some doubt on the robustness of the European recovery. Employment in the US has been weaker than expected, as has Japanese consumer spending and wage growth, meaning Japan is likely to remain below its 2 per cent inflation target for some time to come.

Activity in the Chinese economy, meanwhile, also appears to be soft. Overall, the global economy is performing below expectations: Citigroup’s economic surprise indicator, which measures actual data relative to predictions, has turned sharply down. More policy-induced risk, especially from such an erratic source as US President Donald Trump, is precisely what the world does not need.

Even more worrying is the fact that many of these events predated the threat of significant international economic disruption from a trade war started by the US, which has had some impact on financial markets but has not yet had time to affect many data for the real economy.

Of course, it would be premature to call the top of the global recovery in growth terms, let alone the level of gross domestic product. This is particularly true in the US. Even the relative doves on the US central bank’s Federal Open Market Committee have agreed that the economy is set for more expansion, not least because of the big tax cuts passed last year by Congress and Mr Trump. The Fed is clearly planning more rate rises this year.

But the scattering of bad news should remind policymakers that the world economy remains in uncharted territory. Wage and price inflation have manifestly failed to respond as normal to years of sustained growth. Expectations that economies are at or close to sustainable capacity and that prices are just about to take off have repeatedly been confounded. Even in the US, wage growth remains weak.

Perhaps the most dangerous idea in modern policymaking is that of normalisation: the belief that the world economy went through a time-limited period of extraordinary weakness following the global financial crisis, but that it will necessarily return to the status quo.

The reality is that the growth in sustainable output may have slowed indefinitely since before the crisis across many of the advanced economies. And even so, given that the monetary policy pedal is still pressed close to the floor in some economies, particularly Japan, it is far from clear that policymakers can sustainably maintain domestic demand expansion sufficiently to fill the output gap.

In fact, if the past were a good guide to the future, the world should be bracing for a downturn, given how long the recovery has continued. If that does happen, there is not a great deal of monetary ammunition left to combat it. Most of the big central banks, if not fiscal authorities, have got their stance broadly right since the recovery began from the financial crisis, erring on the side of monetary laxity. That approach has served the global economy well. The recent signs of weakness across multiple large economies confirm it should not be abandoned now.

Higher Rates Hide a World of Easy Money

The direction and pace of travel for yields probably matters just as much as the level

Ten-year government bond yields adjusted for headline consumer-price inflation

Source: FactSet
Note: monthly data

America first. The 10-year U.S. Treasury yield has returned to 3% for the first time since early 2014 and markets are clearly sensitive to higher rates. But the bigger picture is that investors are still living in a world with very low rates.

That can be seen in several ways. The first is obvious: yields in other advanced economies are still nowhere near where they were in 2014, with central banks like the European Central Bank way behind the Federal Reserve in tightening policy. Germany’s 10-year yield is 0.64%, down from close to 2% at the start of 2014; Japanese yields are stuck close to zero thanks to the central bank’s yield-curve control.

Change in 10-year government bond yield, year-to-date

Source: FactSet
Note: Japan's yield is unchanged this year

The more important way to look at yields is through adjusting for inflation. On that front, the U.S. is again out in front: the 10-year real yield, based on prices for Treasury inflation-protected securities, is around 0.8%. It has risen this year by about 0.3 of a percentage point, but by historical standards is still low. Real yields in Germany, the U.K. and Japan are negative. Indeed, in Europe and Japan, there are still swaths of bonds with negative nominal yields. That means financial conditions are still loose, providing support for the economy.
ECB President Mario Draghi and Fed Chairman Jerome Powell at the spring meetings of the IMF and World Bank in Washington, D.C. on Friday. Photo: Andrew Harrer/Bloomberg News 

Yet another way to look at it is via the rule of thumb that says longer-term bond yields should roughly equal the rate of nominal growth in the economy. But that rule has broken down in recent years. Last year, nominal growth in both the U.S. and Germany was 4.1%, according to FactSet; bond yields are well below that level. Central-bank policy, regulatory pressures and demographics are all factors in keeping bond yields low.

The problem for markets is that the direction and pace of travel for yields probably matters just as much as the level. That suggests higher yields are still likely to cause jitters for investors.

And markets just have to live with it: given how low yields are, the process of repricing global rates has some way to go

The Far Reaches of US Soft Power

By George Friedman and Xander Snyder

The Russian ruble, Turkish lira, and Iranian rial are all falling in value.

What do they have in common? The United States is in some way involved in their decline. It’s a sign of US power: Even as its military becomes more limited and it threatens to pull back from the Middle East and other parts of the world, the US can still put pressure on the economies of countries that are working against US interests and impact global conflicts without resorting to military force.
Sanctions Pressure in Russia
For Russia, recently imposed sanctions and the threat of new sanctions are proving to be a drain on its economy and the ruble. Earlier this month, the US announced a new round of sanctions that target Russian oligarchs and their businesses. Rusal, a metals conglomerate and one of the world’s largest aluminum producers, was hit particularly hard, with its shares declining by nearly 35% in two days. But Rusal wasn’t the only company with ties to the Russian government to experience a rapid sell-off: Sberbank and VTB, two major Russian banks, saw their share prices decline by nearly 20% and 10%, respectively, after the sanctions were announced. Some financial analysts have estimated that up to $16 billion in wealth owned by Russian oligarchs was wiped out in just a couple of hours.

Source: Geopolitical Futures (Click to enlarge)

Through the use of so-called secondary sanctions, which target both US and non-US companies that do business with sanctioned Russian companies and individuals, the US is restricting Russia’s access to dollars. This limits Russian companies’ ability to conduct transactions globally in dollars and their access to foreign investment. For example, Rusal has been forced to ask its customers to fulfill contracts in euros rather than dollars. The declining ruble also makes foreign machinery and equipment—which are among Russia’s top imports and which Russia needs to modernize its economy—costlier.

By imposing sanctions, the US wants to make Russia’s domestic problems strong enough to force Moscow to turn its focus inward and limit its foreign adventures. And more sanctions might be on the way. A bill introduced in Congress last week would restrict investment in Russia’s sovereign debt, putting further pressure on the ruble. Washington is thus signaling that it is by no means out of ammunition.

Treasury Secretary Steven Mnuchin said the sanctions introduced this month are a response to Russia’s occupation of Crimea and its ongoing support of the Assad regime in Syria. The recent poisoning of a former Russian spy in the United Kingdom also undoubtedly played a role. But the sanctions shouldn’t be seen solely as a reaction to these events. The US is trying to send Russia a broader message: If Moscow keeps asserting itself in places like Ukraine, Syria, and Georgia, it will face consequences. In a way, it’s a proactive move intended to keep the Russians in check and prevent further Russian incursions elsewhere.
Uncertainty in Iran
Another adversary that the US faces in Syria is Iran. While the US was busy cobbling together a weak coalition of moderate rebels to fight Bashar al-Assad and the Islamic State, Iran was solidifying its position there. The US now needs a way to limit Iran’s expansion and encouraging the devaluation of the rial—by, say, threatening to scrap the Iran nuclear deal—is one way to do it. The uncertainty surrounding the deal makes it more difficult for foreign companies to conduct business in Iran, limiting its foreign investment potential. The US doesn’t need to actually abandon the deal to make an impact—it just needs to threaten to do so.

Source: Geopolitical Futures (Click to enlarge)

That the rial has so sharply declined as a result of this uncertainty is a sign that Iran’s economy remains vulnerable and its security tenuous, regardless of its rising clout in Syria and Iraq. Like Russia, Iran is now forced to turn its attention to domestic issues rather than its efforts at external expansion. For example, the government last week introduced its own exchange rate of 42,000 rials to the dollar—far better than the market rate, which currently hoovers around 60,000 rials to the dollar—to try to stem the currency’s decline.

The large-scale protests in January and the more localized ones in Khuzestan and Isfahan provinces last week indicate that there is consistent and widespread dissatisfaction with the regime. In Isfahan, farmers are again protesting the government’s poor handling of water shortages during a severe, nationwide drought, which has made it difficult if not impossible for farmers to make a living. As a result, fewer crops are being grown domestically, increasing Iran’s need to import food. But with a weaker rial, food imports become more expensive.

One of the catalysts of the January protests was a spike in the price of food staples.
Following those protests, Iran—under growing budgetary pressure as it allocates ever more funds to fighting wars—was forced to walk back planned subsidy cuts to appease the public. This forced Iran’s supreme leader, Ayatollah Ali Khamenei, to dip into Iran’s reserve fund to ensure funding for the military wouldn’t be slashed. But a weaker rial will certainly make the Iranians think twice about their military funding and could impact Iran’s ability to continue waging war at the scale that it has in the past couple of years.
Debt-Fueled Growth in Turkey
In contrast to Russia and Iran, Turkey isn’t a direct target of the United States.
Nevertheless, Turkey faces serious risks due to US monetary policy. In response to a tight US labor market and consistent economic growth, the Federal Reserve has been raising interest rates since 2015 and will almost certainly continue to do so throughout 2018. This encourages capital inflow to the US as investors seek higher returns. It also creates higher demand for the dollar, increasing the dollar’s value relative to other currencies, including the lira.

Source: Geopolitical Futures (Click to enlarge)

A weaker lira is a problem because, although Turkey’s economy has seen high levels of growth, it has been supported with external debt (that is, debt denominated in foreign currencies). Accompanying this debt-fueled growth have been rising rates of inflation, which devalue the lira. A weaker lira makes it harder for Turkish businesses to pay back foreign debt. In March, ratings agency Moody’s downgraded Turkey’s sovereign debt, citing a combination of factors including inflation, a weak lira, and the risk of external financing being tabled.

Higher US interest rates, therefore, are a threat to Turkey’s growing economy and thus its ability to expand its reach to places where it might challenge US interests. A weak economy that must dedicate more and more funds to servicing debt will find it progressively more difficult to support the costs of war.

To be clear, the US isn’t intentionally weakening the Turkish economy through its own monetary policy. Rather, the US economy is so large and pervasive that it has far-reaching consequences for countries around the world. That said, the US and Turkey have been at odds over the situation in northern Syria and Washington wouldn’t mind indirectly curtailing Turkey’s ability to expand its operations against Kurdish forces there.

The decline of US power has become a trope in discussions of global affairs. But its ability to contribute to the domestic problems of its adversaries—and an ally with which it is increasingly at odds—is a sign that the US can still exercise substantial soft power, even as its military is overcommitted and limited in its ability to deploy force to new theaters.

Is This as Good as it Gets for the Big Banks?

Huge lenders like Bank of America are turning in solid results, but their ability to do so in a less positive economic environment remains unproven

By Aaron Back

A Higher Bar
Price to book value over the last two years:

Source: FactSet

The laggards of American banking are at last producing unambiguously good results. The challenge for the banks now is to prove they can deliver healthy profits in less than ideal conditions.

Bank of America BAC -0.94%▲ said Monday its first quarter net income rose 30% from a year earlier to a record $6.9 billion. More importantly, its quarterly return on equity hit 10.8%, above the key psychological threshold of 10%. This comes on the heels of Citigroup reporting a decent 9.7% return on equity on Friday.

This was Bank of America’s best quarterly return since 2011, and Citigroup’s best since 2010, according to S&P Capital IQ. At Bank of America, pretax earnings were up 15% from a year earlier. 
The banks are benefiting from multiple tailwinds. Tax reform and years of economic expansion boosted growth, while higher interest rates, more active stock and bond trading and generally low loan defaults are all helping.
The banks deserve credit for steadily reducing expenses, winding down legacy portfolios leftover from the financial crisis and maintaining discipline on lending. At Bank of America the efficiency ratio, which measures operating expenses as a percentage of revenue, improved to 60% in the first quarter from 63% a year earlier. At Citigroup, it held steady from a year earlier at 58%.

The solid performance stands out compared with Wells Fargo , the industry’s new laggard, which has seen costs jump as it struggles to overcome a series of sales controversies. Investments in compliance are weighing on the bottom line, with the bank’s efficiency ratio rising to 65% in the first quarter from 62% a year earlier. The bank has little choice but to make these investments if it hopes to escape the Federal Reserve’s onerous limits on its asset growth.

Arguing that Bank of America can keep producing good results, Chief Financial Officer Paul Donofrio said the strong first quarter “is not an anomaly,” as it comes after several quarters of continuous improvement. The real question for investors is whether banks are at peak earnings and whether results will decline in a less perfect economic environment.

Bank of America’s shares now trade at 1.25 times book value, compared with just 0.6 times two years ago. That effectively prices in today’s higher returns. To keep rising from here, banks need to keep on improving.