Macro

The Slowdown Abroad: Implications for the U.S. and the Ongoing Risk of Bubbles

December 16th, 2015 | By Nick Sargen

Impact of the Slowdown Abroad

The backdrop for this topic is the worries investors had about a slowdown in China and Emerging Market Economies (EMEs) that resulted in the first stock market correction in four years in the third quarter. While risk assets have rallied since then, investors are uncertain about the outlook considering how sluggish profit growth has been amid weakness abroad, plunging commodity prices, and a strong dollar.

I will begin by observing that historically the U.S. economy has had greater influence on overseas economies than vice versa: The catch phrase "When the U.S. sneezes the rest-of-world catches a cold" is well known. The prime exceptions have been oil price spikes, which have been accompanied by recessions.

Regarding the current situation, the U.S. economy is holding up fairly well to the slowdown abroad. This is evinced by the improving jobs picture, solid growth in the services sector, and the likelihood the Federal Reserve will begin to tighten monetary policy at the upcoming FOMC meeting. What makes our economy so resilient to developments abroad is that it is highly diversified and not heavily reliant on exports as a growth engine. Thus, while China is the world's second largest economy (and fastest growing), U.S. exports to China are only 1% of our GDP.

But that is not the full story. While China's economy may not be critical for the U.S., it is key for commodity-producing countries and Asian economies that export to it. The sell-off in equities reflected concerns about China and EMEs, which collectively account for more than 40% of the global economy. While lack of transparency makes it difficult to assess the true growth rate of China's economy, several EMEs including Brazil, Russia, and Venezuela are in recession, and some of the fastest growing economies in Asia have slowed significantly.

For U.S. exporters, multinationals, and energy producers this is a headwind, especially when the dollar has appreciated substantially. My bottom line, therefore, is that the slowdown abroad is important for segments of the U.S. economy and financial markets, but it should not derail the U.S. expansion.


Restoring International Financial Stability

Since the 2008-09 financial crisis, policymakers around the world have been fixated on actions that can be taken to lessen the risk of another financial crisis. While the goal is laudatory, the approach that is being taken entails re-regulating domestic financial systems.

On this score, I am in favor of increasing capital requirements of banks and other financial institutions, as excessive leverage contributed to the severity of the crisis. However, I am skeptical that regulation per se is the answer to the problem. First, throughout my career regulators have repeatedly failed to identify risks in the financial system until it was too late. Second, legislation such as Dodd-Frank is so complex that it is impossible to know what the consequences will be. My fear is that it will result in regulatory overkill of institutions that had nothing to do with the crisis. Third, history is not on the side of increased regulation – witness the numerous asset bubbles and financial crises in the past 25 years, beginning with Japan, Southeast Asia, the tech bubble, the global financial crisis, the euro-zone crisis, and now potentially the credit bubble in China and EMEs.

From my perspective, we need to ask why bubbles have become more prevalent in an environment where inflation has been low. I share the view of the Bank for International Settlements (BIS) that central banks have become too fixated on keeping inflation under control, but they have not paid adequate attention to the role that rapid expansion of credit has played in contributing to bubbles. The Fed's stance of waiting for a bubble to burst and then flooding the market with liquidity seemed to work during the tech bubble, but it failed during the housing bubble, when financial institutions had significant exposure to assets that plummeted in value. And while I credit the Fed for acting decisively to avert a repeat of the 1930s, the question remains whether the massive injection of reserves in recent years will sow the seeds of future bubbles.

In the end, I am skeptical that policymakers can eliminate bubbles and crises. My conclusion, therefore, is that investors need to be more vigilant about what causes bubbles and how to react, so they can survive them and ultimately capitalize on situations when assets become over-sold.