John Kemp: The global economy and rising oil prices appear to be on an unsustainable trajectory

LONDON — No one likes to predict recession, but the global economy is likely to experience a significant slowdown before the end of 2019, and the slowdown may be necessary to relieve upward pressure on oil prices.

In its latest World Economic Outlook, the International Monetary Fund forecasts the global economy will expand at 3.9 per cent in both 2018 and 2019, slightly faster than the 3.7 per cent achieved in 2017.

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But beneath the sanguine headline numbers, the outlook provides a long list of downside risk factors, including mounting trade tensions, rising interest rates, political uncertainty and complacent financial markets.

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“Growth generally remains strong in advanced economies, but it has slowed in many of them, including countries in the euro area, Japan, and the United Kingdom,” the IMF admits.

“Even U.S. growth is projected to decelerate over the next few years, however, as the long cyclical recovery runs its course and the effects of temporary fiscal stimulus wane.”

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The broad global expansion that began roughly two years ago has plateaued and become less balanced, according to the Fund (“ Global expansion: still strong but less even, more fragile, under threat,” IMF , July 16).

The principal economies are still growingly rapidly, with high levels of business and consumer confidence, and contributing to optimism among investors, but there are signs of a potential future slowdown.

Global trade volumes are still increasing but the growth rate has slowed significantly since the second half of 2017, according to the Netherlands Bureau of Economic Policy Analysis

Leading economic indicators monitored by the OECD have weakened since the start of the year and point to slower expansion over the next six to nine months.

The OECD says that growth momentum is stable in the United States and Japan but is easing in the United Kingdom, Germany, France, Italy and Canada.

At global level, the expansion is exhibiting increasing signs of maturity, with commodity prices and interest rates rising and capacity constraints emerging in some sectors.

For example, aircraft manufacturers Boeing and Airbus are struggling to deliver orders on time as they strive to expand production and their supply chain, reports the Wall Street Journal.

U.S. trucking firms are complaining about the lack of qualified drivers, and U.S. airlines are preparing to cut their schedules in response to rising fuel costs.

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Late Cycle

In the United States, where growth remains strong, the expansion now shows unmistakeable signs of being at a late stage.

The U.S. economy has been expanding for over nine years, according to the Business Cycle Dating Committee of the National Bureau of Economic Research.

The current expansion is already the second-longest on record and will overtake the long boom of the 1990s if the economy is still growing in July 2019.

Unemployment is close to its lowest level for 50 years and at or below the levels seen at the height of previous booms. Industrial production is growing at some of the fastest rates for 20 years.

The Institute for Supply Management’s composite index shows one of the broadest increases in manufacturing activity in the last 70 years.

And the University of Michigan’s consumer sentiment index shows household confidence close to multi-decade highs.

But consumer prices are rising at the fastest rate since early 2012, canceling out hourly wage growth, despite a strong economy.

And the yield curve for U.S. government securities shows signs of inverting, which has often been a harbinger of previous economic slowdowns.

All these indicators show strong cyclical behavior; in every case, they point to an expansion fast-approaching the top of the cycle.

Oil Market

The global economy is rapidly running out of spare capacity and nowhere is that more obvious than in the oil market.

The oil market’s unused production capacity has fallen to multi-decade lows as a result of strong consumption growth and a series of output disruptions in Venezuela, Libya and elsewhere.

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Iran sanctions threaten to reduce spare capacity even further from the start of November, pushing it down to the lowest level since the oil shocks of 1973/74 and 1979/80.

Global oil consumption has surged by an average of 1.7 million barrels per day in each of the last three years, and is forecast to rise by a similar amount in 2018 and 2019.

The result is that the global oil industry is being “stretched to the limit,” according to the International Energy Agency.

Oil prices have already climbed by more than 75 per cent over the last year, putting upward pressure on global inflation, though they have subsequently eased back slightly in recent days.

Recession

In the past, the final stages of an economic expansion have usually coincided with a sharp escalation in oil prices, with prices dropping back during the subsequent economic contraction.

The causality between economic growth and oil prices runs in both directions, with economic growth as a key driver of oil consumption and prices, and oil prices acting as a check on expansion.

U.S. recessions in 1973/74, 1981/82, 1990/91, 2001 and 2007-2009 all helped cool previous rapid increases in oil prices by cutting consumption growth.

With the oil market running out of capacity, commodity prices rising and interest rates turning higher, it seems increasingly likely the global economy will experience a slowdown within the next 18 months.

The coming slowdown need not be as wrenching as the recession which accompanied the financial crisis in 2008/09. In fact, it probably won’t be.

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The last downturn was exceptional in terms of its length and severity. Most of the business cycle contractions since 1945 have been much shorter and shallower.

Like several previous slowdowns, the next one might be marked by a “pause” in growth rather than an actual decline in economic activity.

And it need not be global in scale. Some slowdowns were confined to a subset to economies, such as the East Asian financial crisis of 1997/98, while others continue expanding.

But the global economy and the oil market appear to be on an unsustainable trajectory, and the only way to resolve the growing contradictions is likely to be a slowdown in the next 18 months.

John Kemp is a Reuters market analyst. The views expressed are his own

© Thomson Reuters 2018