Why Financial Markets’ New Exuberance Is Irrational

Owing to a recent easing of both Sino-American tensions and
monetary policies, many investors seem to be betting on another era of
expansion for the global economy. But they would do well to remember that the
fundamental risks to growth remain, and are actually getting worse.

NEW YORK – This past May and August, escalations in the trade
and technology conflict between the United States and China rattled stock
markets and pushed bond yields to historic lows. But that was then: since then,
financial markets have once again become giddy. US and other equities are
trending toward new highs, and there is even talk of a potential
“melt-up” in equity values. The financial-market buzz has seized on the
possibility of a “reflation trade,” in the hope that the recent global slowdown
will be followed in 2020 by accelerating growth and firmer inflation (which
helps profits and risky assets).

The sudden shift from risk-off to risk-on reflects four positive
developments. First, the US and China are likely to reach a “phase-one” deal
that would at least temporarily halt any further escalation of their trade and
technology war. Second, despite the uncertainty surrounding the United Kingdom’s
election on December 12, Prime Minister Boris Johnson has at least managed to
secure a tentative “soft Brexit” deal with the EU, and the chances of the UK
crashing out of the bloc have been substantially reduced.

Third, the US has demonstrated restraint in the face of Iranian
provocations in the Middle East, with President Donald Trump realizing that
surgical strikes against that country could result in a full-scale war and
severe oil-price spike. And, lastly, the US Federal Reserve, the European Central
Bank, and other major central banks have gotten ahead of geopolitical headwinds
by easing monetary policies. With central banks once again coming to the
rescue, even minor “green shoots” – such as the stabilization of the US
manufacturing sector and the resilience of services and consumption growth –
have been taken as a harbinger of renewed global expansion.

Yet there is much to suggest that not all is well with the
global economy. For starters, recent data from China, Germany, and Japan
suggest that the slowdown is still ongoing, even if its pace has become less
severe.

Second, while the US and China may agree to a truce, the ongoing
decoupling of the world’s two largest economies will almost certainly
accelerate again after the US election next November. In the medium to long
term, the best one can hope for is that the looming cold war will not turn hot.

Third, while China has shown restraint in confronting the
popular uprising in Hong Kong, the situation in the city is worsening, making a
forceful crackdown likely in 2020. Among other things, a militarized Chinese
response could derail any trade deal with the US and shock financial markets,
as well as push Taiwan in the direction of forces supporting independence – a
red line for Beijing.

Fourth, although a “hard Brexit” may be off the table, the eurozone
is experiencing a deepening malaise that is not related to the UK’s impending
departure. Germany and other countries with fiscal space continue to resist
demands for stimulus. Worse, the ECB’s new president, Christine Lagarde, will most likely be unable
to provide much more in the way of monetary-policy stimulus, given that
one-third of the ECB Governing Council already opposes the current round of
easing.

Beyond challenges stemming from an aging population, weakening
Chinese demand, and the costs of meeting new emissions standards, Europe also
remains vulnerable to Trump’s oft-repeated threat to impose import tariffs on
German and other European cars. And key European economies – not least Germany,
Spain, France, and Italy – are experiencing political ructions that could
translate into economic trouble.

Fifth, with crippling US-led sanctions now fueling street riots,
the Iranian regime will see no other choice but to continue fomenting
instability in the wider region, in order to raise the costs of America’s
current approach. The Middle East is already in turmoil. Massive protests have erupted in Iraq and Lebanon, a country that is
effectively bankrupt and at risk of a currency, sovereign-debt, and banking
crisis. In the current political vacuum there, the Iranian-backed Hezbollah
could decide to attack Israel. Turkey’s incursion into Syria has introduced
many new risks, including to the supply of oil from Iraqi Kurdistan. Yemen’s
civil war has no end in sight. And Israel is currently without a government.
The region is a powder keg; an explosion could trigger an oil shock and a
renewed risk-off episode.

Sixth, central banks are reaching the limits of what they can do
to backstop the economy, and fiscal policy remains constrained by politics and
high debts. To be sure, policymakers could turn to even more unconventional
policies – namely, monetized fiscal deficits – whenever another
downturn occurs, but they will not do so until the next crisis is already
severe.

Seventh, the populist backlash against globalization, trade,
migration, and technology is worsening in many places. In a race to the bottom,
more countries may pursue policies to restrict the movement of goods, capital,
labor, technology, and data. While recent mass protests in Bolivia, Chile,
Ecuador, Egypt, France, Spain, Hong Kong, Indonesia, Iraq, Iran, and Lebanon
reflect a variety of causes, all are experiencing economic malaise and rising
political resentment over inequality and other issues.

Eighth, the US under Trump may become the biggest source of
uncertainty. Trump’s “America First” trade foreign policies risk destroying the
international order that the US and its allies created after WWII. Some in
Europe – like French President Emmanuel Macron – worry that NATO is now
comatose, while the US is provoking rather than supporting its Asian allies,
such as Japan and South Korea. At home, the impeachment process will lead to
even more bipartisan gridlock and warfare, and some Democrats running for the
party nomination have policy platforms that are making financial markets
nervous.

Finally, medium-term trends may cause still more economic damage
and disruption: demographic aging in advanced economies and emerging markets
will inevitably reduce potential growth, and restrictions on migration will
make the problem worse. Climate change is already causing costly economic
damage as extreme weather events become more frequent, virulent, and
destructive. And while technological innovation may expand the size of the
economic pie in the long run, artificial intelligence and automation will first
disrupt jobs, firms, and entire industries, exacerbating already high levels of
inequality. Whenever the next severe downturn occurs, high and rising private
and public debts will prove unsustainable, triggering a wave of disorderly
defaults and bankruptcies.

The disconnect between financial markets and the real economy is
becoming more pronounced. Investors are happily focusing on the attenuation of
some short-term tail risks, and on central banks’ return to monetary-policy
easing. But the fundamental risks to the global economy remain. In fact, from a
medium-term perspective, they are actually getting worse.
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Author: NourielRoubini.com

Nouriel Roubini is a professor of economics at New York University’s Stern School of Business. He is also CEO of Roubini Macro Associates, LLC, a global macroeconomic consultancy firm in New York, as well as Co-Founder of Rosa & Roubini Associates based out of London. At a 2006 address to the International Monetary Fund, Roubini warned of the impending recession due to the credit and housing market bubble. His predictions of these upside-down balance sheets became a reality in 2008, with the bubble bursting and reverberating around the world into a global financial crisis – a recession we’re only recently rebounding from after a decade climb. Dr. Roubini has extensive policy experience as well as broad academic credentials. He was Co-Founder and Chairman of Roubini Global Economics from 2005 to 2016 – a firm whose website was named one of the best economics web resources by BusinessWeek, Forbes, the Wall Street Journal and the Economist. From 1998 to 2000, he served as the senior economist for international affairs on the White House Council of Economic Advisors and then the senior advisor to the undersecretary for international affairs at the U.S. Treasury Department, helping to resolve the Asian and global financial crises, among other issues. The International Monetary Fund, the World Bank and numerous other prominent public and private institutions have drawn upon his consulting expertise. He has published numerous theoretical, empirical and policy papers on international macroeconomic issues and co-authored the books “Political Cycles: Theory and Evidence” (MIT Press, 1997) and “Bailouts or Bail-ins? Responding to Financial Crises in Emerging Markets” (Institute for International Economics, 2004) and “Crisis Economics: A Crash Course in the Future of Finance” (Penguin Press, 2010). Dr. Roubini’s views on global economic issues are widely cited by the media, and he is a frequent commentator on various business news programs. He has been the subject of extended profiles in the New York Times Magazine and other leading current-affairs publications. The Financial Times has also provided extensive coverage of Dr. Roubini’s perspectives. Dr. Roubini received an undergraduate degree at Bocconi University in Milan, Italy, and a doctorate in economics at Harvard University. Prior to joining Stern, he was on the faculty of Yale University’s department of economics.