2018 likely to be serious year of reckoning for global economy

2018 is likely see the world embroiled in slower economic growth, yet higher inflation and interest rates, aka stagflation.

A decade of reckless money printing and loan growth, which fuelled unsustainably high debt in all major economies, will finally meet its antidote: higher inflation.

It will add to the burden of debt servicing, begetting more debt, and culminating in devaluations of all currencies, particularly the US dollar against hard resources.

Devaluation of the US dollar will result in a monumental change. The 10 per cent decline of the dollar index this year is primary a consequence of runaway US budget deficits, which invariably permeates into the current account deficit, and then worsens net external position.

Shrinking receipts and rising welfare expenses will erode the budget deficit beyond 3.5 per cent of gross domestic product. Tax cuts have never boosted growth and payback themselves.

The US dollar will resume devaluing against metals, ores, energy, and other currencies. That the dollar index futures open interest, steered by money managers, is crashing speaks volumes.

US economic growth, meanwhile, will decelerate, dogged by fragile productivity growth of 1 per cent, and shrinking unit labour costs. There are also signs of an imminent slowdown in economic growth in the form of slowing activity measures or weak productivity growth in China, the UK and Japan.

Germany, the last stronghold, is unlikely to last and its slowdown will hit China, Hong Kong, and the rest of world. Exports and thus profits will slow.

Despite shadow banking bad debt concerns, exacerbated by slowing earnings and rising interest rates a moderate trade surplus, an ample real interest rates differential between the renminbi and US dollar will cushion the renminbi, so it may trade within 6.2 and 6.9 against the dollar, with a bias towards strengthening.

US equities will correct on prohibitive valuations, imminent slowdown of earnings growth, and grossly insufficient risk premiums against treasury bonds.

Money managers have stampeded out of Russell 2000 index futures. The last time such disturbing, capitulation happened was in 2008, just before the market collapsed.

Resources prices may correct because of slowing economic growth, however it will probably be consolidation, not a devastating bear market.

For several years there’s been sharp cuts in capital expenditure for mining and refining leading to stagnant reserves, deterioration of ore grades, and marginal inventory levels.

A drop in resource prices of 15 per cent will rekindle interest among developing nations, which now dominate the world economy in boosting infrastructure projects, particularly along the New Silk Road or renewable energy-related developments.

Few acknowledge any resource price correction will be reciprocated by sharp cuts in mining and refining capital expenditure.

These will snowball into slower mining output, depleted inventories, congesting refining or smelting utilisation, at a time of reviving world demand led by the developing world. This feedback mechanism underpinned a splendid resource recovery since late 2015, and it will continue.

But do not overlook the impact of reduced capital expenditure on future supplies. World crude oil reserves have been stagnant for six years, while demand has risen, depressing reserve life.

US petroleum inventory life has fallen meaningfully below the 100-day threshold. A surge in US shale oil output will soon taper: a contracting shale-rig fleet says it all.

Global new refinery capacity will be mostly offset by scrapping of old facilities, resulting in less than 1 million barrels per day of net new capacity, while world demand growth is likely to far exceed that. Tightening refinery utilisation effectively restrains supply.

Notwithstanding overstretched money manager net longs in NYMEX crude oil futures – which suggest price consolidation soon – recent new historic highs of open interest pre-empted any bear divergence, which precedes bear markets.

Next year, crude oil prices may trade in a higher range of US$50 to US$70 a barrel or even higher, subject to US dollar devaluation. Ditto for gas.

Hong Kong will again be doomed by the mismatch of US interest rates and our own local inflation, courtesy of the outdated linked exchange rate regime.

US dollar Libor is likely to rise for years on higher inflation, and the Hong Kong dollar Hibor must follow, while ironically Hong Kong’s inflation rate is decelerating on slowing rent growth – a consequence of slowing exports.

Real Hibor – defined as nominal Hibor minus inflation rate – is rising. Few appreciate how much bearing real Hibor has on Hong Kong equities and properties. The prospects of resource shortages and currency devaluations suggest a long-term rally of Libor, and thus Hibor.

However, this is happening at the worst possible time, since slowing exports are dragging down rent growth, and thus inflation. So real Hibor is likely to rise for years, ending a decade of ridiculously low real Hibor.

Currently, real Hibor has reached negative 0.25 per cent, approaching the critical zero per cent threshold. Historically, during periods of rising positive real Hibor, equities were confined within ranges, while properties tanked.

This almost happened in 2016, when real Hibor briefly exceeded zero per cent, triggering minor corrections of equities and properties, only to be alleviated once more by lucky Chinese hot money.

2018 will see Hong Kong entangled in positive real Hibor again. The Hang Seng Index may trade within 25,000 to 31,000 – a nadir may occur in the second quarter.

Henry Chan is head of research at Caitong International Securities.