World Economic Update

World Economic Update

Don Pollard

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Economics

United States

Argentina

Emerging Markets

Oil and Petroleum Products

Monetary Policy

Federal Reserve

from World Economic Update

The World Economic Update highlights the quarter’s most important and emerging trends. Discussions cover changes in the global marketplace with special emphasis on current economic events and their implications for U.S. policy. This series is presented by the Maurice R. Greenberg Center for Geoeconomic Studies.

MALLABY: Welcome to today’s Council on Foreign Relations World Economic Update. I’m Sebastian Mallaby. I’m a senior fellow here at the Council. And I’ll be presiding over the discussion. I’m here with—immediately on my left, your right—with Rebecca Patterson, the managing director and chief investment officer at Bessemer Trust Company. Next is Jens Nordvig, founder and chief executive officer of Exante Data. And Ellen Zentner, managing director and chief U.S. economist at Morgan Stanley.

So world economy. We’re obviously meeting at a time when the baseline numbers for the last four quarters and also the projections for the next four quarters are essentially great—3.8 percent growth in 2017 and an expectation that that is broadly going to be maintained. But the world is an interesting place. And one can poke a few—you know, raise a few questions about this very benign baseline projection.

One kind of concern is simply that the whole system is still riding on a lot of policy stimulus, very accommodative monetary policy in Europe and Japan, a fiscal boost in the U.S. Chinese growth has been underpinned by a rising debt to GDP, which has only recently been addressed by the government. So that leads people—I was noticing your colleague, Ellen, Chetan Ahya of Morgan Stanley wrote a piece on Sunday where he said: So the big two concerns would be if some of that policy stimulus was taken away and you either had a reduction of financial stability in the U.S. or credit contraction in China. But we can obviously add to that—we’re going to get to this all in a second—but oil price because of Iran, Argentina suddenly starts to wobble, the new on the Italian potential populist coalition, trade conflict. There’s plenty to discuss.

So we’ll start with oil and I’ll start with Rebecca. And I guess just wanted to you to talk about two things on oil, Rebecca. One is that the discussion on Iran sanctions is the near-term cause of an uptick in oil prices. But then underlying that, there appears to be some change in Saudi Arabia’s outlook. Perhaps you could take both of those.

PATTERSON: Sure. Happy to. And good morning. And thank you for having me on the panel.

So with oil prices, you know, I think there’s been a constructive story in place for a while now in terms of—you already mentioned, Sebastian—global growth, global demand being relatively robust. That’s certainly been an underpinning. Supply has been relatively under control. OPEC appears not to be cheating too much for the moment and the U.S. supply, while rig count in the United States on the Baker Hughes data, is going up again, it’s not nearly where it was before 2015 and ’16 when oil prices fell. And you are seeing some logistical challenges in terms of getting the oil that is being pumped where it needs to go. And so supply and demand for the moment seems relatively in balance.

I think as we’ve entered this year and more people are focused on inflation and the risk of inflation rising, people have started looking at oil again as a bit of a hedge against rising inflation. So there were a number of reasons to be thinking about oil again. I think with Iran and geopolitics in general, it is perceived as a bit of a geopolitical risk hedge. Looking ahead, you know, it’s very hard to predict oil. I learned that a long time ago when I had to predict commodities for a living. And I take solace in the fact that the IMF and the Federal Reserve use futures prices for their forecasts, because they don’t think even with armies of economists that they can do better. So that tells you a lot.

But for what it’s worth, I think the fact that the U.S. is now such a large producer of oil—really, the world’s marginal producer—that if prices were to continue to rise you probably would continue to see more U.S. production, which eventually should put a lid.

MALLABY: So, in other words, the fact that Mohammad Bin Salman in Saudi Arabia may for a fiscal—because he’s got a dicey and risky political reform program, he may want the revenues. He may want a higher price. But you’re saying he can’t get it because the U.S. has become a new swing producer.

PATTERSON: Well, he’s getting it, but he can’t control it by himself anymore. The U.S. has a greater and greater role in terms of what the actual outcome is. So Saudi has given up some of that control, I think, relatively speaking. But to your point, MBS, he needs oil prices high. This is key to his success. To modernize and reform the Kingdom of Saudi Arabia, he needs the fiscal revenues for social stability programs and other initiatives. The biggest risk to Saudi Arabia is that if you have a sustained period of low oil prices and they have fiscal headwinds, they could have social unrest. So he’s extremely focused on that.

MALLABY: Ellen, you’ve put out a note recently of the effect on higher oil prices and gas prices on U.S. consumer demand. Can you talk a bit about that, and how you see the U.S. outlook being impacted, if at all?

ZENTNER: Yeah. So I think that one exercise that we do when we look at the effect of higher gas prices on the U.S. economy—of course, we focus on the consumer being 70 percent of the economy. And the rise acts like a tax hike on households. And so if you were to flatline gas prices from today through the end of the year, just say they stay right where they are today, and annualize that, it’s roughly about a $38 billion tax. And so that’s about one-third of the benefit from lower withholding from the Tax Cut and Jobs Act of 2017. So it’s not enough to overcome the positive fiscal lift from recent stimulative policies, but it does negate about one-third of that. And so, of course, the risk then to the U.S. consumer outlook is that gas prices continue to rise from here, is that we continue to eat into that higher disposable income we’ve gotten this year from the tax policy.

But of course, who knows where gas prices go? (Laughs.) And so they could easily go down as well. So I think it’s just an exercise to put a placeholder in there so that you can kind of think about how that might mute the consumer outlook, which then mutes how much growth really you can get in the U.S. economy. I think the other aspect of this that we have to follow closely is how do policymakers in the U.S.—monetary policymakers respond? If you average about $108 a barrel in the fourth quarter of this year, then you’re going to have CPI at 3 percent. And the issue that policymakers will face is that we are late cycle, tighter economy, at or near full employment with inflation already rising. And so you would have oil prices now rising all year that would start to bleed over into core as well. And so in that case, it starts to get awfully hard for the Fed to be patient, and continue to be patient, and resist the urge to raise rates more quickly.

MALLABY: So, in other words, for a short time the Fed would look through it and just simply tighten a bit less to offset the reduction in demand, but as that change in headline inflation feeds into core it becomes a real dilemma?

ZENTNER: Yeah, I think it’s—and it works the same way for tariffs, right? You’re supposed to look through these impacts as transitory. But when you’re so late in a cycle, with inflationary pressures already rising, the impulse might be to push against that first before—because you get the rise in prices first, before you get the dent to private final domestic demand. And so that is something that Bill Dudley, president of the New York Fed, had discussed in a recent conversation. And so I just think that’s the risk for policymakers on the backside of rising oil late cycle, or tariffs late cycle, is that you might not be able to resist the urge to go more quickly.

MALLABY: Jens, so going from the impact of the oil outlook on the U.S. economy, how do you see it on emerging markets? Because we were chatting before and you made a good point about how the historical pattern may not hold next time.

NORDVIG: Yes. So if we go back, like, 10 years ago, we had this massive spike in oil prices, up to 160. And at that point in time, there was essentially like a one-to-one correlation between what oil prices were doing and what the dollar was doing—i.e., the dollar was going down. It was tanking at the time. And how it’s very different, right, because we got the U.S. oil production online. And that correlation is really changing, right? So we’ve seen in the last three, four weeks we’ve had a significant rise in oil prices and the dollar has done really well. So it’s a quite new constellation.

And I think for emerging markets it creates a kind of accelerator effect. Like, so I think of a country like India that typically ranks among sort of the very big oil importers. So, they get hit by the oil price, and that puts the currency under pressure. If the dollar is then globally also rising and therefore having sort of a tendency for emerging market currency to depreciate, those two effects reinforce each other. And I think that’s exactly what you’re seeing right now. So it’s one element in this sort of EM fragility that you’re seeing right now.

MALLABY: So that’s a good segue for Argentina. You know, obviously if the Iran news and the oil price is one, you know, example of how the world may not be as secure as we thought, Argentina’s extraordinary, right? You’ve got this leader who was the darling of the markets a year ago. Issues a 100-year bond. He has that much confidence in the—you know, markets have that much confidence in him. And now all of a sudden, three rate hikes, 40 percent interest rates, going to the IMF. I mean, what went wrong?

NORDVIG: Well, so I think—I don’t want to jump in—

MALLABY: You lead. You lead.

NORDVIG: OK. So, like, I think a lot of it has to do with the global environment. There’s really been a pretty extraordinary shift in sentiment around emerging markets globally. Like, January one of the things we do in my company is we track capital flows with extreme detail. (Laughter.) And in January, we really had extraordinary EM inflows. It looked like close to a record month for EM inflows. And then everything changed. So February, March, April, and the early signals from May have been very, very weak. So it’s almost like we had that narrative, OK, global growth is going to be strong. EM is going to do well.

And then suddenly we had a little bit of a hiccup in the equity market and we’re starting to think, OK, maybe global growth is not quite as strong. And also, maybe it actually matters that we don’t have serial interest rates everywhere else in the world, like. So it’s creating these vulnerabilities, and I think that has been the catalyst. I think it’s not that there’s some sea change in Argentina’s policy that has said, OK, it’s moved from being the darling to now being, like, a disaster. But I think it’s something in the global environment that really exposed some vulnerabilities that were there in the first place.

PATTERSON: Maybe I can just build on that. I totally agree with everything you said. If we have higher yields in the U.S., there’s less need to look for high yield outside the U.S. Stronger dollar, obviously the corollary is a weaker in this case Argentine peso. So those two global headwinds. But then poor—I actually feel bad for Macri, because he came in, you know, really inheriting a(n) economy in disaster. He had to fix their statistics, which had been manipulated by the previous government. He had to do some very difficult reforms, a lot of fiscal austerity which was unpopular.

And he was making progress, but it was gradual. And then when they decided to change their inflation target in January this year, at the same time that we started getting a little nervousness about inflation and U.S. yields were rising, people started to wonder about his credibility. Wait, he’s not sticking with his target. He’s changing it. What game are we playing? And then they have the bad luck to have a horrible drought. And the economy is very reliant on agricultural exports. So that revenue disappeared. So you have these global forces, you have some domestic unease, and then you have—you have the drought, which is just bad luck.

But you put it all together, and suddenly foreign investors take their money out. And with a lot of these emerging markets that aren’t terribly liquid, the exit door is very small. And so if the money leaves, it can have a very large impact quickly. The peso has fallen 20-25 percent year to date. So they were forced to jack interest rates up. But to me, it’s not that unusual that we went from hundred-year bond darling of the market to this today. There is a good explanation for it. I think their reaching out to the IMF to get a $30 billion credit line is very important. They still have—if I have my numbers right—about 60 billion (dollars) in reserves. But having that extra help should help support sentiment.

But to me, the big takeaway isn’t Argentina itself, it’s now do we think about emerging markets as we go into the end of the cycle? And as an investor, I, as a general rule, will try to avoid countries where you have a lot of foreign ownership of local markets that are not very liquid—so, think Indonesian bonds as an example. I try to avoid countries that have very large and/or growing current account deficits, because that means they’re reliant on foreign capital flows to keep their currencies stable. And countries that have a lot of debt, that could be susceptible to higher interest rates in the United States, and that affecting their debt payments.

So it still leaves you with places to play. There’s still a lot of good opportunities, I believe, in emerging markets. I don’t think everyone should paint them with the same brush. But one needs to be very selective.

MALLABY: Let me put one more thing on the table about Argentina and emerging markets and see if any of you want to pick up on this. So it seems to me that there’s been a bit of a shift, you know, since that famous moment, I guess, in 1997, when Camdessus, he head of the IMF, was photographed with this arms folded like this, looking over the Indonesian leader Suharto as he signed an agreement that essentially changed, you know, all the microdetails of the economy. And it was this sort of imagine of imperialist IMF imposition of shock therapy. And shock therapy, since then, went out of style. Both the IMF itself has been keen to look less disciplinarian, less demanding. And also emerging markets have said, you know, never again. We won’t submit to that humiliation. We’ll build up our reserves. We’ll protect ourselves. And we’ll go—we’ll go more cautiously.

So now we have a case study where, you know, Macri comes in. He inherits this terrible situation that you were describing from his predecessors in Argentina. And he tries to do it cautiously. He says: OK, we’re going to fix the fiscal deficit, but not too fast. And so some people may draw the lesson that, hey, you should—while things were better in the world economy, you should have taken that moment to do some shock therapy because you would have fixed your budget at the moment when you had the chance to do that. Now you’ve missed it and you have a bad harvest and you’re out of luck. Equally, the IMF now faces an interesting dilemma. You know, should they provide that 30 billion (dollars) credit line, despite the fact that if you don’t do it with conditions you’ll be backing a system that still has inflation of 25 percent, still has a big budget deficit?

It’s not obvious that the IMF under its rules should be doing that. On the other hand, if it refuses to do that, it’ll be back to the nasty, tough Camdessus, you know? So I don’t know if anyone wants to pick up on this, whether there’s a sort of—this shift from kind of pro-shock therapy, pro-tough IMF, to let’s be all nice, whether this, the niceness, is now going to be stress tested. Does anyone want to?

NORDVIG: Well, I’ll make the point that, like, when we had that Asian crisis experience, it was a pretty different world in the sense that we had pegged exchange rates, lots of them.

MALLABY: Pegged exchange rates? Yeah.

NORDVIG: Yeah. And obviously, Argentina has their experience with pegged exchange rate. And there’s just almost no pegs left, right? So we have this EM tension now, but it’s not around a sort of outright speculative attack on a peg. So it feels tense. We have dramatic rate rises in Argentina and so forth. But it’s not like binary situation, like is it going to break or is it not going to break, that we had before. That’s the same in Indonesia, right? They’re starting to lose reserves. The currency’s moving a little bit. The interest rates are starting to rise, right? But it’s sort of being released more gradually than this one-off explosion.

And the other thing I would say is that if you think about how vulnerable a currency is—and the currency is often key to how dramatic a crisis really becomes—one key parameter is, like, what is inflation doing. And obviously Argentina is a problem country, in that they have very sticky inflation. But if you look around the world, there’s a lot of emerging markets where inflation really is historically incredibly low. Indonesia is a good example of that. Brazil is an example of that. Even Russia is an example of that, right? Not really very high inflation. So that sort of—that does put an anchor on how far the currency can move, right? Because if you really need to have, like, a 40, or 50, or 60 percent move in the currency, it has to be because it kind of feeds on itself and generates inflation. If you don’t have that, you can have a correction in the currency, but then maybe 20 percent is really enough to really change the structure. So I think that’s one thing that’s different from the past.

PATTERSON: And I guess maybe just to answer your question on what should IMF do, be nice or be tough, I kind of think of the IMF—I mean, it plays a lot of different roles. But in these sorts of cases, this is the emergency room. This is—this isn’t the time to be nice. This is the time to make sure the patient doesn’t die. And in that case, being nice and gradual isn’t necessarily going to get you the outcome you want. So I appreciate that they need to be mindful of the local citizens of the country and how they’re perceived so they continue to be credible and welcomed around the world. I lived in Asia during the Asian crisis, for part of it. And there was a lot of backlash afterwards. But in this case with Argentina, if you have inflation running at 25 percent, you have your currency in free fall, you’re running out of reserves quickly, I don’t think you have much choice but to take whatever medicine they want to give you.

MALLABY: Let’s move to the U.S. So John Williams, the incoming president of the New York Fed, recently, you know, resuscitated that phrase from the ’90s—you know, the Goldilocks economy. So we have, you know, this fantastically balanced system. Unemployment’s super low, 3.9 percent. Inflation’s still, you know, at target or just a tiny bit under. Everything looks great. Do you share that view? Or do you feel—if you had to—if there’s something that worries you about the U.S. outlook, what is it?

ZENTNER: I think it’s the pro-cyclicality of fiscal stimulus this late in the game. And I don’t think that’s going to shock anyone. I think 99 out of 100 economists feel like it was ill-timed stimulus, to use former Chair Yellen’s words. The Goldilocks economy was before we enacted fiscal stimulus. I think of the best things that the U.S. and across DM broadly has had going for it is that we’ve had a latent cyclical pickup in capex that’s driving productivity higher, finally, off of very flat levels. And that is something that began occurring in the U.S. well before the election, and then kicked in across DM as we had this synchronous recovery.

And that is a cycle extender. The risk there is that you get a Goldilocks, but you get a Goldilocks for a shorter period of time than you would have otherwise, because pro-cyclicality, fiscal stimulus, can create a boom-bust cycle. This is—there’s no reason why this expansion can’t last for a good deal longer. I’m not worried just because we are about to enter our 10th year of expansion. But I think that the risk that we’ve raised from fiscal stimulus with, as you said, a 3.9 percent unemployment rate, inflation that is now rising, output gaps—estimates of the output gap are all over the place, but most of them are positive, that we now have a positive and rising output gap. I think that is the risk.

MALLABY: Well, let me just try an idea on you and see what you think. So one might thing, well, OK, you’ve got this fiscal impetus at the wrong time. So the central bank will offset that, no problem. I mean, you’ve got two tools and one of them is supposed to be independent. If it’s not—if kind of underlying your concern is the notion that it’s not actually obviously that the Fed will offset it, there’s two theories about why that might be the case, it seems to me. One would be that the habit of forward guidance has kind of locked in some limits to what the Fed feels able to do. It provided this guidance from the past, and now it doesn’t want to do something totally different. Theory two would be that it’s not actually as independent as it looks, because there are still these vacancies on the Fed’s board. You know, until those are filled the institution is weaker than it should be. Do either of those underlie your worry that the Fed will not offset? Or am I missing some third?

ZENTNER: No, I think that what the Fed is showing us in its likely path for rates, right, is that they are staying gradual now, but they will raise rates into restrictive territory in the out years, right? So that is reflective of a FOMC that’s trying to balance carefully the risk of overheating with the desire to very carefully guide rates back to neutral. And that is the tradeoff. So they absolutely feel that they would be prepared and ready to offset policy if needed to battle an overheating economy. But a lot of the data that tells us when the economy is overheating tends to be lagged, at least the economic data that policymakers rely on. And I know that this is something that chair—that former Chair Yellen has been focused on of late, that policymakers may be behind the curve. Similar to her arguments she was making in 2005, 2005, when the unemployment rate had dropped quite low and then wage growth had turned sharply higher.

So I think that this will be a discussion on the Fed as they try to balance those that do believe they are behind the curve, and those that believe they can remain gradual. But I think that we’re—you know, the fiscal stimulus puts us at a tipping point of where the Fed has to decide, at what point does it speed up rate hikes? Believe me, they do not want to have to speed up rate hikes. They would love nothing more than to remain gradual and extend the runway of this expansion as long as possible, because that’s the best chance they have to get rates as high as possible. But they may not be afforded that luxury, should stimulus come through in an undesirable way, because the economy is already fairly tight.

MALLABY: There’s two more things I want to get to before we bring in members into the discussion. So let’s go quickly to Europe, and straight to Italy where the news that there may in fact be a populist coalition, combining—Ellen was joking this sounds like a sort of soccer event or something—the Five Star Movement with The League. It’s actually politics, not soccer. A coalition between those two parties implies a lot of, you know, indifference to any kind of fiscal rules imposed on Italy by the EU.

And that, in turn, raises a question about whether there’ll be any reform that—you know, this was supposed to be the moment in the June summit of the EU when you got a move towards a fuller banking union and a move towards more risk sharing fiscally across the eurozone, to protect against a potential next crisis. So those things, it seems to me, with the Italian political system moving towards this populist coalition, those things were never going to be that likely, and now they are super unlikely. So maybe Jens can start off on that, but, I mean, how worried should we be, therefore, that Europe is simply not going to put in place the sort of structural strengthening that it needs in order to cope with the next economic downturn?

NORDVIG: Yeah. No, I think you’re making a very good point. That’s definitely a real risk that has suddenly arisen because of this constellation that is being contemplated. I want to make the point about the euro first, because I do think that is something that from a sort of systemic risk perspective is crucial. So last year I was invited by the Five Star Movement, believe it or not, and it was not the soccer team and it was the political movement, to speak at a conference in the Italian parliament. And that conference was about how should we essentially deal with the euro. And there was lots of discussions about, OK, should we have a parallel currency? Should we just try to improve the EU and so forth? But I think the main takeaway of that conference was that the Five Star Movement doesn’t really have a firm belief. So there’s been this perception that they were anti-euro for a number of years. And maybe when the movement was founded they were. But it’s kind of softened. And into this election, essentially it was cemented in the political program that they’re not anti-euro anymore.

So I think you’re absolutely right, that the risk now is something to do with fiscal discipline, as opposed to an explicit anti-euro stance. And this has a lot to do with how Europe systemically is going to deal with this, right, because if you watch what’s going on in the market now, like, we have a little bit of movement in the Italian bond market, but it’s really pretty miniscule in the scheme of things, right? So the market—as long as there’s not any systemic tension around the euro, views it as sort of a long-term issue it doesn’t have to be too concerned about. So the question is whether the market is too complacent now about the fiscal risk. And obviously Italy has a lot of debt. And the fiscal trajectory’s terrible, mostly because they’ve just had no growth for the last 15 years.

And it will be very interesting to see, right? Because you can also have the view that, OK, maybe fiscal policy has been too growth restrictive, right? If they can actually a constellation of measures in place that, OK, there’s going to be some fiscal spending, but maybe it’s actually going to release some growth, there’s two sides to that coin. So I think how that plays out, whether it really becomes populist not productive spending, that is the risk.

MALLABY: But you’re framing this issue in terms of what might make sense in terms of the multiplier you get out of fiscal spending. And that’s a perfectly good debate to have, especially in the U.S. context, you know, a few years ago. However, there’s political dimension in terms of EU interactions that, whether it’s right or wrong to have a fiscal stimulus, we know the Germans don’t like it. (Laughs.) And so therefore, the implications—but what do you think—

PATTERSON: Well, the irony right now is it looks like Germany is probably going to have some fiscal stimulus going into next year—the Germans, that’s Germans. (Laughter.) So Italy is the third-largest economy in the EU. So the fact that you could have this coalition government that isn’t going to play nicely in the sandbox with Germany and France is material. I don’t think it necessarily undermines the EU economy or creates systemic risk in the near term, but I think what we’re probably all circling around a little bit is that when we get to the next recession—and we know it’s a when, not an if—you haven’t seen a lot of the reform that you would have liked to around the banking sector and other parts of the European economy to prepare it to get through better next time than it did in ’08 or ’11.

And what’s interesting about Germany and its role—because you really expect Angela Merkel to drive this—but she’s been weakened so much by her own election, you know, taking four months to form this government. It’s a very weak coalition government. And I think it has forced her to completely change her last term in office. Instead of focusing on leaving Europe a better, stronger place, she just wants to make sure her party is strong so when she’s out of officer her party can continue to lead. So rather than focusing on reform, it’s been back-burnered. And she’s looking at fiscal stimulus—so, social spending, education, infrastructure, defense, helping the middle-class Germans who felt marginalized by the influx of refugees in recent years. She needs to do that in order to make sure her party is still in favor. But there’s a cost to everything.

So we will get a little pop of stimulus in Germany. Great. But we’re getting that at the cost of someone really leading the reform effort ahead of the next crisis, which I think puts Europe in a relatively worse spot when we get there, unfortunately.

MALLABY: So we’ve discussed a bunch of potential threats to this benign baseline forecast. We’ve got the oil price. We’ve got the emerging markets/Argentina issue, the possibility the Fed is behind the curve in the U.S., the question of Italy and structural reform in the EU.

The last one I want to put on the table quickly before we go to members is to ask Ellen about the trade picture. The news back from the recent meeting in China was pretty depressing. Both sides seem to be asking the other side to do things that they simply won’t do. So the odds of a trade war are going up? How impactful would that be? And how do you—how do you think about that?

ZENTNER: So I think just the ongoing trade tensions can impact the outlook through uncertainty, lingering uncertainty. Going back to the effects of the tax stimulus, OK, you’ve dropped my tax rate, my corporate tax rate, but am I willing to make those five-year, 10-year investment decisions now? Because I don’t know what my pricing structure is going to be like. If we’re going to put tariffs in place, I may not know how my supply chains might be disrupted.

I will say that thus far we’ve seen businesses respond in terms of the sentiment surveys saying these uncertainties are weighing on my decisions. Yet, you look at CAPEX plans in the U.S. and you look at business conditions in the U.S. and those surveys remain at or near record highs. So they’re expressing doubt and concern, yet they’re not—it’s not impacting real activity, what companies are doing, yet. But the more that lingers, the more it does create downside risk for the outlook.

The China-U.S. tit-for-tats, if you will, yes, have been disappointing. I think one of the things optically that bothers this administration is the Made in China 2025 campaign, which China is not going to back off of. And when you speak to China economists over there, it’s actually not sort of a headline that matters a lot for them and they don’t know why there’s so much focus on it. But it’s an easy focus, easy thing to focus on, because it’s, you know, like a Make America Great Again title, you know, Made in China 2025. And so that irks the administration, and that’s not something that’s going to change.

I think what we’re watching for on the horizon is that May 22nd is when the comment period ends for the latest round of tariff threats, and so President Trump will have the option of extending that up to a full 180 days, and we do hope he takes that option. That would be the wise choice because it would push that decision off until after the midterm elections, because of course the heartland are those areas that would be hit hardest by tariffs on China—and I’m speaking primarily of the agricultural community—and those are important voters for President Trump and his—the constituents of his party. And so that’s something on the horizon to look for.

On the NAFTA trade negotiations, there’s not been positive news on that in the last 24 hours. That is a roller coaster as well, where we seem to get great news that the talks are progressing and then news that the talks have broken down. And policymakers are starting to get nervous that they’re not going to have something to the Senate before the end of May to vote on, which would be the only way before the midterm elections you can secure a NAFTA deal before the end of the year. So, if not done by May, then it would just sort of linger out there as an uncertainty.

The automotive industry is the sticking point there, and also that the U.S. is insisting on a five-year renewal period, so each—every five years renegotiate NAFTA. And I don’t know about you, but for companies, right, nobody likes—that’s uncertainty. So are you going to be willing, again, to make investments when every five years those decisions may be impacted? So it’s—I guess the bottom line is it’s not going well. (Laughter.)

MALLABY: Did you want to add something quickly?

NORDVIG: Yeah. Like, I have to say, I think we are heading toward a new equilibrium. And I think in that equilibrium for U.S. trade policy, you have to differentiate between what’s going on with China and what’s going on with NAFTA. And I think it will be very different.

I think there is an asymmetry in what tariffs China has and the U.S. has. Those tariffs were agreed a long time ago. It might make sense to revisit them. There is an asymmetry in that it’s very hard for very large U.S. tech companies to do any business in China, that there’s an asymmetry there. Like, Microsoft doesn’t have a problem selling their software in Mexico. So it’s totally different. So I think you can also see that when we had the initial steel and aluminum tariffs, right, there was a major backlash from essentially both—the whole corporate sector and from the Republican Party that, OK, that doesn’t really make any sense.

So if you put all those things together, the negotiation for NAFTA is clearly tough, and I’m not saying we’re going to have a mission accomplished announcement in the next couple days, but I do think the equilibrium will be that we get that sorted. And then the big problem is the China relationship, because getting that sorted is not going to be easy. That’s going to require, like, major, major concessions, and that is going to be hard to achieve. Whereas in NAFTA space they are really negotiating like the details of the automotive rules, right? We’re talking about is it going to be like 75 percent NAFTA content or is it going to be something. We are really down to the details there. And in China’s case we have not even started yet.

MALLABY: Yeah, right. That’s a good point.

Let’s bring in members, please. Yes, I can see a question right now at the back in the middle. And if it’s about Italy, that’s fine. (Laughter.)

Q: Hello? Perfect. Oh my gosh, yeah, there we are.

PATTERSON: Buongiorno.

Q: Buongiorno.

So, Sebastian, yesterday Beppe Grillo, the founder of the Five Star Movement, was here in New York. So he is the spirit of what you defined as populism at all cost, and he’s far away from the government making. And I saw him, in fact, and he still has ideas about, you know, what should be right about distribution of revenue. But he’s here and he’s not there, and I think that that is a sign in itself.

About the fiscal stimulus, though, I am interested, because if Italy was in the situation that it was, it’s because starting with Mario Monti that followed Germany, started to impose very drastic measures that not only brought to nothing, but brought the populist parties ahead. So there is a big German responsibility, I think, in what is happening in Europe. America has been asking Germany to act on the fiscal stimulus since the Obama and Bush years and nothing has happened.

So I don’t know, maybe a change will be there. The markets, as you were saying, you know, are rather calm at this point. And I don’t think that if Germany will not do much at the next June meeting, it will be because of the government that is happening in Italy. Their position was negative about moving fast anyway since a few months, I think. But I’d like to hear what you all think about this, and especially what the risk that the market changes mood vis-à-vis the Italian debt risk, which is of course high.

Thank you. Sorry, it was a bit long.

MALLABY: No, sure, sure. I mean, it seems to me that—and I want to hear what the others think, but—one can consistently say that Italy was right in thinking that excess fiscal austerity was a mistake and that the Germans were being too restrictive. One can say that, and at the same time observe that if you openly say that you’re not going to respect EU fiscal rules, the chances of North European countries supporting solidarity go down. So I don’t think—I think we kind of can agree about that, probably.

And I also think you’re right that maybe the North Europeans would have blocked serious reform in the direction of further solidarity and risk-sharing anyway. So I think that’s a fair point.

But anyone else want to—

PATTERSON: I would just say that I’m grateful what is happening in Italy is happening right now against a backdrop of very strong and improving European growth. I mean, European growth has softened just a touch in the last few months, but overall it’s still a very healthy backdrop. And so if this were happening in 2011 or early 2012, we would see the euro selling off, we would see Italian bond spreads over German bond yields, widening dramatically. But I think having a strong economic backdrop cures a lot of ills. It allows people a little wiggle room to get through these things. So I don’t see a lot of chance that this becomes a major market event near term because of that economic backdrop.

Now, if something were to happen, and maybe not even within Europe, that creates worries over the economic backdrop—it could be a surge in oil prices that affects sentiment globally. It could be China-U.S. trade discussions that completely go off the rails, or perhaps the U.S. decides it will impose tariffs on European steel and aluminum. If you had any trigger like that that was material enough to cause risk appetite to deteriorate, suddenly Italy will be seen in a slightly different light.

It’s my impression—it sounds, sir, like you know quite a lot more than I do right now—but Italy needs to pass a budget this summer. And there is a small chance if you don’t have a government in place or you don’t have the right government in place, that doesn’t happen, and I guess in a worst-case scenario maybe you have a government shutdown, and that creates some additional worries around their debt in the near term. So that would be another just little factor to watch.

But I had the opportunity to live in Italy when Berlusconi first ran for office. I was actually a journalist following him around. And I guess the other thing I’d say that gives me comfort is Italy has grappled with this sort of thing before, in different ways but many times, and they always seem to get through it. And the private sector in Italy, especially the small- and medium-sized businesses, seem to thrive almost regardless or despite.

MALLABY: (Laughs.) Maybe just we’ll go—I want to ask Jens one thing about the currency situation because one reason that growth might have softened a little bit is that the euro had been quite strong. If you think the dollar is now going to go back into a period of relative strength, this could help Italy, presumably, and cushion some of this political trouble.

NORDVIG: Yeah. Like, I think during the last year if you sort of surveyed different countries in the eurozone as to what level of the currency are they comfortable, like if you go to Germany, they say like 1.40, 1.50 no problem, right? And if you go to Italy, they say, OK, 1.25 is not so good. So it clearly differs by country what level is desired. So now it’s back to 1.18 and think that clearly is helpful. I think even for the ECB it’s something that’s going to make them more comfortable with the situation. They clearly communicated this year that, OK, the degree of strength we have seen was not really fully commensurate with the strength in the economy.

So I think that is something that’s helpful. It’s also something that’s going to feed into the inflation picture and make things potentially go a little bit more smoothly there.

But in the end I think it really comes down to, OK, what policies are going to be put into place? Is it going to be something that really looks populist, or are these parties going to come together and for the first time govern, right? The Five Star Movement had some experiences where they had won local elections and it was not so easy to actually have power. We’ll see what they come up with. But I think, as the question implied, it is very interesting that Beppe Grillo is sort of out, and it’s actually the young generation of the party that is defining it now. And that could mean that we could see something that’s a little bit surprising and perhaps more constructive than we’ve seen in the past.

MALLABY: It’s also interesting, by the way, Jens, that the Five Star Movement reaches out to you, a New York-based financial markets economist. That says something about their openness, perhaps.

But did you want to comment on all this European—not particularly. OK, fine.

ZENTNER: No. (Laughs.)

MALLABY: Right. Yeah, so let’s go over there.

Q: Good morning. Rick Niu from C.V. Starr. Good morning, Sebastian.

I have two questions, if I may. First, there seem(s) to be a global debate about the effectiveness of multilateral trade regimes versus bilateral trade regimes. What is your point of view—this is to all of you—the pros and cons for each?

Secondly, do you predict that China—or is still makes sense for China to continue with the capital outflow control policy? Thank you.

MALLABY: Ellen, do you want to talk about multilateral versus bilateral?

ZENTNER: So I think—I think in support of both of those, right, is that the only way to win a trade war is simply to not fight one. It’s always rather than tariffs and tit-for-tats, trade negotiations that result in some sort of longer-term agreement are always more preferable. There’s more certainty with those.

I don’t have a particular opinion that bilateral is better than multilateral, and multilateral is more difficult to negotiate just because there’s more parties involved. And so if you want quicker wins, if you will, you do bilateral trade agreements. And that’s something that’s certainly been the focus of this administration, that you sort of push the other party into a bilateral trade agreement by carrying a big stick first, with threats of tariffs.

And so I think for policymakers by and large it’s just easier to get quicker wins from bilateral trade agreements. But trade agreements overall are the preferable way to go versus trade wars or trade tensions and threats of tariffs.

NORDVIG: Maybe I can come on the Chinese part.

PATTERSON: Sure. I’d probably add one on each very briefly.

I think, given how interconnected the global economy is today and how global supply chains are, to the degree one can take the time and get everybody—the cats herded, so to speak, to do multilateral, there’s probably a lot of sense that comes from that, just thinking about all the different players involved. And I do think updating trade agreements makes a huge amount of sense. The world changes. It’s dynamic. What we wrote for NAFTA, there’s so much that needs to be done. And what a shame because TPP would have actually done a lot of that.

On the Chinese capital controls—I think about this a lot—I feel like they’ve missed an amazing opportunity several years ago. There has been some very good academic work on when do you open your capital account, and you want to do it when you have strong growth at home because that way your local residents don’t want to take all their money out of the country; they’re actually happy to keep it in place, so you have less risk of capital flight. And you want a strong global economy so confidence is there.

So at this point you still have a pretty good Chinese economy, so there might be a reason some—I mean, Chinese want to diversify, so you’re going to get capital flight regardless. But perhaps the degree could be better if you have strength at home. The global situation is not terribly conducive because if you were to open the capital account now, and you had Chinese taking advantage of that to diversify their assets, and you have a weaker renminbi given the heated trade rhetoric right now, it’s very likely to be interpreted in a different way by the U.S. administration: they’re devaluing, they’re trying to take advantage.

Now, the Chinese renminbi is up I think it’s about 10 percent against the dollar in the last 12 months, so it’s actually back to where it was before they had the very small devaluation in August 2015. So I think China would be in their right to say we want a slightly weaker currency, and maybe if we open capital controls a smidge we can take a little of that pressure out. But again, to do that against the current political backdrop I think could be incredibly risky.

What you don’t want to do is open your capital controls in a time where your economy’s slowing or there’s nervousness among investors because that could speed the capital flight at a time when people are already jittery.

MALLABY: Yeah, there’s sort of a contradiction between the Made in China stuff and the kind of economic nationalism on the one hand, and any agenda which involves opening the capital account and essentially, therefore, inviting foreign capital in. You can’t be inviting the foreign capital unless you create the mood music around it that seems conducive to coming in.

But, Jens, what did you want too—

NORDVIG: Yeah, so just two comments on that.

The first thing is so one of the things we do in my company is we try to track these capital movements in real time. So every morning when I get up I get an alert that sort of tries to estimate, like, what was the capital flight measured by how much the PBOC had to fill the gap? So the bottom line from doing that type of tracking is that the policies overall have been very successful since early 2017 in terms of, like, stabilizing the balance of payments. And a part of that is the controls, but a part of that is also that the inflows have improved.

So this year in particular we are seeing something totally new, and that is that there’s significant demand for a Chinese bond from global investors, and it’s mostly central banks. So at the moment we are tracking at around $100 billion in terms of foreign buying of CNY bonds, which is going to be mostly from reserve managers around the world. So they are attracting some capital flows, and this is in line with their strategic goals. And eventually, if that flow picks up to the degree where they say, OK, this looks significant, I think that is going to be the key to them actually lifting the controls that were put in place in ’15 and ’16.

MALLABY: Another question. Yes, let’s go back there. The blue tie.

Q: That’s sort of—Ed Cox, NY GOP.

That sort of leads to the question of how much do strategic issues overwhelm business and economic issues with respect to trade negotiations? Generally, our major trading partners have been allies. In fact, since World War II and Cold War, allies, we wanted to see their economies grow, prove free markets work, capitalism works. And now we—our major trading partner, China, is really a strategic and potential military competitor. Does that overwhelm the economic considerations and business considerations that normally drive our trade negotiations?

MALLABY: Rebecca, you want to take that?

PATTERSON: Oh boy.

MALLABY: Well, while you’re gathering your thoughts, I would—I would say that—

PATTERSON: Yes, thank you. That’s a big question. It’s a great question, and I do think about it. But I’m trying to figure out how I say it in a concise way. Do you want to—

MALLABY: In terms of tech competition, which is what you’ve got going on with China, I think part of the reason why the China relationship is so difficult is that you’ve got the fear that, you know, look, they’ve created more market cap in terms of high-tech companies in the last five years than Silicon Valley has. So this is a competition not in something like steel or whatever where, you know, it’s a lower-tech thing, we’re happy to import some and then use it to make higher-tech materials here. This is threatening us at the level of AI and kind of cutting-edge stuff.

If you think—if you want an—if you want an analogy for that, it’s really the memory chip fights in the 1980s with Japan, a sense that the memory chips—which at the time were kind of a cutting-edge technology—the U.S. was being threatened in that core strength by Japanese semiconductors, which were perceived to be competing a bit unfairly. Now, Japan was an ally, and yet it still turned incredibly nasty.

China is not an ally. And on top of that, some of this tech material has embedded within it, potentially, spyware and so forth. So the Huawei issue, which is being treated differently by British authorities, which seem to be more open to the notion that you can buy Huawei’s routers without taking a risk than the U.S. But, I mean, so there’s various views about this. But clearly, that’s a factor further poisoning the relationship. So I think—I’m not sure it overwhelms the commercial logic, but it certainly complicates it significantly.

ZENTNER: I think we see that China understands the importance of the relationship, and that’s why we’ve seen a largely careful and democratic response from them. You know, the—if you think about strategically, right, Xi Jinping will stay in power for as long as—you know, for a long time—(laughs)—versus President Trump, that may only have two more years, you know. So if you keep a very—the response very diplomatic and careful, then you—you know, I think that underscores that they understand the relationship is important and you don’t want to just get into all-out fights over trade. And we’ve seen, you know, them offer to import more U.S. oil, do something in the auto space, open up to financial services, you know, offering an olive branch, if you will, on certain issues to try to keep the conversation open and going.

PATTERSON: I think at the end of the day it’s like a very unhappy married couple. You know, we need each other whether we like each other or not. China buys a huge amount of U.S. debt. America benefits hugely, political stuff aside, from Chinese-made goods.

You know, I was explaining to my 9-year-old daughter this morning. I said, if we have a trade war and I give you $30, instead of buying three shirts at your favorite store that I hate you get one. (Laughter.) And that’s exaggerating it, but the point is trade wars are stagflationary.

So we need each other in a lot of different ways on a lot of different issues, and we know that. And we know America’s going to be better off if the rest of the world is strong—and that includes China, which is the second-biggest economy now. So we don’t want China to completely fail because that would have global consequences. At the same time, it is scary, I think, to a lot of people to see this economy become so large—to your point on the ’80s analogy—and how do you grow together and protect America’s place? I think that’s the domestic thought.

The national security issues are such a huge and important conversation. I had the pleasure of speaking with a woman who runs applied physics at Johns Hopkins, and one of the things they’re working on right now is what are the ethics around AI and military. So, right, the U.S., my understanding is that we have a policy that no weapon is fired without a human giving that signal. And if we have a swarm of drones, and maybe each drone is the size of my fingernail and we have thousands of them going somewhere to do something, it’s still a human who says go. And if other countries, including China, can develop the same or even better technology and don’t have the same ethics applied to it, are we putting our military at a disadvantage by playing by a different set of rules?

And I think the good news here is there are a lot of people on both sides talking to each other. It’s behind the scenes. It doesn’t get a lot of media focus, but I think everyone’s trying to establish a global rules of engagement so we can continue to be partners. Maybe we’re not the happiest married couple, but we’re not going to actually fight each other and get a divorce.

MALLABY: (Laughs.) Let’s get one more question. You have one here.

PATTERSON: Bettye.

Q: Bettye Musham.

What impact has the uncertainty and the corruption in Washington had on corporate decision-making? And what are you hearing from corporate CEOs?

PATTERSON: So I think Ellen made the point earlier if you look at the Federal Reserve regional surveys and other surveys, intentions to do more capital spending are at highs. So everyone seems very bullish. Actual capital expenditures have been trending up since the oil-related dip in ’15-’16, but they’re definitely lagging the optimism. If you look at the correlation between the two over time, they’re very strong, and right now CAPEX isn’t keeping up with the level of optimism. So there might be some effect there.

Some CEOs that I’ve spoken with recently say, Rebecca, there’s always a lag between the time I get a tax cut or some new information and the time I put it to work, so this is not necessarily unusual. With the fiscal package, the spending package in February, the 300 billion (dollars) over two years, a lot of that’s government contracts. That’s going to take a couple of quarters before the money gets in the ground, so we could see some pickup there too. And I think that’ll largely happen regardless of what happens with trade. So there is some growth stimulus could come from that.

The CEOs I’m speaking with—and that is a big part of my business—you know, there’s a lot of anxiety around it, and I think that does affect corporate behavior. But at the moment, to me it seems marginal because if you look at corporate activity, M&A is off to an incredibly strong start so far this year, and you are seeing CAPEX plans very high and CAPEX starting to pick up. So it’s there. It’s in the sentiment.

I think the bigger place you see it is the equity market. The equity market has definitely been reactive to a lot of the soundbites on trade and some of the actions on trade.

MALLABY: On China trade it was very obvious.

PATTERSON: Yes, in particular.

MALLABY: Do you guys want to come in on this?

ZENTNER: Well, I think that that raises a few points. Equities have reacted positively to the Tax Cuts and Jobs Act. You know, we’ve had a great earnings season. Earnings drives equities higher. That ends after the third quarter of this year because we don’t drop taxes every year. So one reason why, if you look at economists’ forecasts across the board, you’ve got a positive lift from the fiscal impulse this year, and still a positive lift next year, but it’s fading. And so you see a slower growth forecast in 2019 compared to 2020—sorry, 2018—because that fiscal impulse is fading. We don’t drop taxes every year. The comps are going to be very difficult after the third quarter when you think about earnings. And so there’s a downside to fiscal stimulus, and we’re going to be contending with that in 2019.

But yeah, you know, you’ll hear a lot of comments around, well, the first quarter GDP growth in the U.S. came in weaker—on the weak side, just over 2 percent, but we just enacted these huge tax stimulus policies. But I think it’s too early to just say that therefore we’re not getting some effect on the economy, because Rebecca makes a great point. Even the surveys that we conduct of our equity analysts, of all the companies in their coverage, the companies said—40 percent of them said they would do M&A with the tax benefit, and we’re seeing that; 50 percent of them said that they wouldn’t know until midyear how the tax policy will affect their bottom line. And so they know it’s going to be positive, but they’re not able to make some of the decisions around that yet. So I think it’s too early to just say we’re not going to get positive lift because we got sort of a weak Q1 number.

MALLABY: Jens, we’re kind of out of time, but you have one last comment if you’d like to. But—

NORDVIG: No.

MALLABY: No, OK. The silent Jens. All right. Thank you to all of you: Rebecca, Jens, Ellen. Thank you for coming. (Applause.)

(END)

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