Argentina, Italy, Oil, Economic Slowdown - How Bad Is It, Doctor?

All at once, several dark clouds suddenly came looming on the horizon of the world economy. In the first trimester of 2018, growth decelerated in most of the large economies of the OECD. The price of a barrel of crude oil reached 75$; Argentina demanded an emergency loan to the IMF to stem the fall of its currency; finally, in Italy, a populist coalition with little concern for the Euro’s fiscal rules may rule the country, which, alternatively, may have to go for another snap election. Is it a mere return to reality after a phase of euphoria, or the sign of an imminent economic drawback? For France and its reform-oriented government, the question is key, and, as we will see, the second option must not be discarded. 

Let us first check the facts. Global trade of manufactured goods, the trends of which reflect the dynamics of Chinese and American imports, got back on track since Summer 2016. Its pace of growth went from a sluggish 2% to a sound 5%, which remains below the pre-crisis trend (6 to 7%), but which is sufficient to pull the global economy out of the crisis. However, data related to global trade are coming late and are subject to revision. For instance, March data have just been published. They were bad (-1.2% over the month), but, to add insult to injury, February data were revised down to -0.7%. Therefore, it is useful to cross check ‘hard’ data with other indicators. The safest thing to do is to listen to the world champions in exports, i.e. the Germans manufacturers. Precisely, they rang the alarm last February, in the monthly German IFO survey, by significantly lowering their predictions for the next six months, probably in anticipation of the tensions fostered by the American trade policy. At the same time, the French INSEE survey-based reversal indicator had gone from sunny to troubled. A month later, the US surprise index, which compares current conditions to the ones anticipated by companies in the US ISM survey, nosed down. In April, a similar index from an INSEE survey in France followed the same path. There’s no denying that the global economy recently took a turn for the worse. 

"The conjunction of an economic slowdown and of an increase of the price of oil is worrying, because it poses a dilemma for the American Federal Reserve (Fed), the decisions of which are crucial to the world economy"

Simultaneously, the price of oil has not ceased to increase, going from 30$ per barrel at the start of 2016 to over 75$ in May. This rise cannot be the fruit of strengthening global demand since, on the contrary, the global economy seems to be running out of steam. We must thus turn to supply and risk premiums for an answer. The limitation agreement on production signed between OPEC and Russia clearly contributed to strengthening the market, as exemplified by the market reaction to rumors of a looser agreement, even though the American production of shale oil, which is highly elastic to spot prices, limits the consequences of this oligopolistic rationing. Finally, the rise of tensions between Iran and the US - Saudi Arabia - Israel coalition increases the value of the crude oil available on the market today, in comparison with future deliveries. This is raising the risk premium, as testified by the negative slope of the future price curve: the price of the barrel in a year is 5$ lower than it is today. 

The conjunction of an economic slowdown and of an increase of the price of oil is worrying, because it poses a dilemma for the American Federal Reserve (Fed), the decisions of which are crucial to the world economy. US inflation has already nearly reached the Fed’s goal (*), and seems to be well-engaged on the upward slope observed since the end of 2015, shown by the underlying trend estimated by the Fed of New York (3.2% in March). Without a serious wake-up call from the stock market, the Fed will keep on increasing its policy rate, most probably by 0.75% by the end of the year, which would lead the fed funds rate to 2.5%. Beyond that, it’s another story, and the markets are not expecting it to surpass 3%, as demonstrated by the stabilization of the 10 years risk-adjusted interest rate, also calculated by the Fed of New York (**). 

The Fed’s monetary tightening, no matter how modest, renders investors more circumspect when it comes to risky markets such as Argentina. The peso collapsed by 33% in the last year and by 12% in the last few weeks, despite the reaction of the central bank, which raised its prime rate to the unbearable level of 40%. This drastic fall is not due to economic mismanagement on the part of the Macri government, unlike during Ms Fernandez’s era, but rather to the US monetary cycle and to the country’s excessive external debt. The next increases planned by the Fed could well destabilize other emerging countries, and Turkey in particular, among those that took advantage of the Fed’s generosity to take loans with an advantageous rate. 

“The conjunction of a transatlantic cyclical slowdown, a weakening of several emerging markets and the return of the political risk in the Eurozone need to be taken seriously.”

"The conjunction of a transatlantic cyclical slowdown, of the weakening of several emerging markets, and of the return of the political risk in the Eurozone, must be taken seriously"

This brings us back to Italy, to emphasize a crucial difference between the country and developing countries dependent on the Fed’s policy. Indeed, the Italian government is heavily indebted to its own citizens, yet, the country has little external debt, less than France, other things being equal. Italian interest rates depend on the ECB and not on the Fed. Nonetheless, despite the protection that the ECB’s policy of government bonds purchase provides to Italy, the political risk is clearly back. Although not yet running the country, a coalition cabinet between the Five Star Movement and the League may decide to free itself from the rules of the Eurozone, as it was clearly indicated in the first draft of the agreement between the two parties. As long as the ECB is in the markets, ready to buy more Italian bonds if necessary, the financial risk is actually limited. Yet the hope to deepen the reform of the Eurozone governance could become the collateral victim of a Eurosceptic and populist cabinet settling in the Chigi Palace.

At this stage, economic data themselves aren’t able to decide whether this is a temporary slowdown or a deeper cyclical reversal. There are still many encouraging factors: the American tax reform, fostering investment, will extend the economic cycle in the United States; the monetary and budget policies remain conducive to economic growth in the Eurozone, and, last but not least, China does not seem to be slowing down so far. Yet the conjunction of a transatlantic cyclical slowdown, of the weakening of several emerging markets, and of the return of the political risk in the Eurozone, must be taken seriously. The phase of euphoria following Emmanuel Macron’s election - no causal link whatsoever, but German firms had never been so optimistic than in the second semester of 2017 - was succeeded by a return to reality. Given the current moderate growth, rising inflation and political and economic risks, we must consider the possibility of a far less promising reality settling in in the coming years. 

In France, if growth continued at the average pace of these four last quarters, i.e. 0.5%, - the slowdown recorded in the first quarter was partly idiosyncratic - it would barely reach 2% over the whole year. Fortunately, the 2018 budget was built on a conservative growth hypothesis of 1.7%. There is therefore no reason to worry prematurely about the budget execution. However, it would be a big mistake to rely on hypothetical growth dividends to fund the coming reforms. 

(*) Measured thanks to the price of personal consumption expenditure index, excluding energy and food. This indicator is more reliable than the price index and, for this reason, was adopted by the Fed. It reached 1.9% in March, the Fed’s ‘price stability’ goal being 2%. 
(**) Model developed by Tobias Adrian, Richard Crump and Emanuel Moench (“ACM”). Daily data collected since 1961 are available on the Federal Reserve Bank of New York’s website: Treasury Term Premia.