Nicholas Rilley, Butterfield
In an age of on-demand media, flashing stock market tickers and minute-by-minute market commentary, it is easy to forget that real shifts in underlying economies happen at a comparatively much slower pace. Business cycle analysis is a common way to think about investment and based on general market commentary we seem to have been in the latter stages of the current cycle for a number of years now.
Broadly speaking, financial and labour market indicators suggest that we are very late cycle, but real economic indicators are much more varied. In addition to this shorter cycle analysis, there are important overarching longer-term structural shifts that often present evolving challenges for both market participants and policymakers.
The three most important changes have been: a shift away from manufacturing towards services in developed markets, globalisation and financialisation. Over the last three decades, economic cycles have been longer, flatter and shallower than they had been previously and the changing structure of the US economy helps to explain why. The shift from goods and manufacturing to services was a key driver of the ‘great moderation’ thesis, which ended abruptly with the financial crisis. However, even including the impact of this period, the volatility of both growth and inflation has fallen substantially.
Manufacturing has been declining as a share of the economy since the late 1960s and goods-producing industries are generally less volatile than services-oriented businesses. However, other factors such as better inventory management, partly driven by technology, and global supply chains have allowed the manufacturing sector to operate in a much more efficient manner.
A good example of this was that the downturn in the US energy sector in 2014/2015 did not cause an economywide recession. What we saw was a classic capital expenditure-led boom-bust cycle that ended abruptly when oil prices fell. These imbalances and capital misallocations tend to cause slowdowns or recessions, however the strength of other sectors such as healthcare and software, increased the overall resiliency of the economy.
Since 2016, the evolution of globalisation has been covered extensively, with the tension between the US and China a key focal point. It is difficult to overstate the extent to which globalisation has allowed businesses to arbitrage the costs of labour and capital globally. The two most prominent beneficiaries of globalisation have been multinational corporations and the emerging market middle classes, particularly in China.
Financialisation has been the process by which financial institutions and markets have increased in size and influence. The rise of shadow banking peaked in the US in 2008, but since then much of the credit creation globally has taken place in China. Credit creation outside of the traditional banking sector was a major contributor to the US housing crisis. Our understanding since then has evolved, with much written about how loans create deposits, rather than the other way around and the importance of the eurodollar system.
Of the three structural shifts, the one most at risk is globalisation. In absolute terms there are no winners from deglobalisation and from an investment perspective the risk to profit margins is very real. However, deglobalisation is probably too strong, as supply chains will ultimately adapt to the changing environment, although this will take time and cost money.
Globalisation has challenged the conventional economic thinking with regards to the relationship between employment, wages and inflation. Benefits have accrued to capital owners and the flexibility afforded to business has put downward pressure on inflation. Output gaps need to be considered in a global context and are also harder to measure in a service driven economy. Jerome Powell has even gone as far as saying that too-low inflation is ‘one of the major challenges of our time’.
Financialisation is probably the most challenging, because it is less of a mechanical process and the challenge is one of reflexivity. For example, central banks respond to changes in financial conditions, but financial conditions are influenced by central bank policy, particularly various forms of forward guidance.
Last year provided a good example of how essential it is to understand these shifts. As China tightened credit conditions, we saw manufacturing-oriented countries outside of the US with exposure to China suffer. With US interest rates on the rise, this put upward pressure on the US dollar and tightened financial conditions in the US. Weaker financial markets were an important factor in disappointing first quarter consumption, which ultimately caused the Fed to pivot significantly more dovish.
Sources: Bernstein Research, TS Lombard
Disclaimer: The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.