A Troubled World Economy

Contrary to what a booming stock market might be suggesting, troubles are coming to the world economy not as single spies but in battalions. The United States has a major public finance and commercial property market problem. China, the world's second largest economy, is struggling to deal with the bursting of its property and credit market bubbles. Germany and France's struggling economies are beset by dysfunctional politics, while the Italian and French economies are drowning in debt.

As if that was not sufficient reason for concern, the incoming Trump administration looks set to trigger an international trade war with a proposed 60 percent import tariff on China and one of 10–20 percent on the rest of our trade partners. Meanwhile, the ongoing hostilities between Israel and Iran could result in an international oil price shock and heightened tensions with China, especially around Taiwan, could result in supply disruptions of key components for manufacturing activity.

Start with the United States. Even before taking into account how the proposed Trump tax cuts might widen the budget deficit, the Congressional Budget Office warned that our country's public finances were on an unsustainable path. It estimated that under present policies the budget deficit would remain at above six percent of GDP for many years to come and that by 2034 the public debt to GDP ratio would exceed 120 percent. Against this background, there is every prospect that unfunded tax cuts of the variety that Trump is proposing would invite the return of the bond vigilantes. That would be sure to send bond yields soaring.

A spike in interest rates would complicate the already difficult situation in the commercial property sector. Presently that sector is characterized by very high office vacancy rates, steeply falling prices, and rising default rates. Rising interest rates would also add further strains to the banking system that has considerable loan exposure to the troubled commercial property sector and has mark-to-market losses in excess of $1 trillion on its bond and loan portfolios. That in turn could set off a wave of regional bank failures.

If our economy faces challenges, they pale in relation to those faced by China. Even before the Trump administration will take office, the Chinese economy is in trouble in the wake of the bursting of its housing and credit market bubble. Economic growth has slowed to the lowest rate in years and the economy appears to be on the cusp of deflation. At the same time, housing prices keep falling, property developers keep defaulting, and the finances of the local governments are going from bad to worse as land sales dry up.

In these challenging circumstances, the last thing that the Chinese economy needs is a body blow to its export sector in the form of sharply higher import tariffs on its exports to the United States. Yet judging from President-elect Trump's repeated pronouncements on the campaign trail and by his recent appointment of Chinese hawks to his administration, this is what is most likely to happen early next year.

The sclerotic European economy too is in no position to withstand the higher tariffs that Trump is proposing to impose on imports from Europe. Germany's economy is already in recession and now is experiencing political dysfunction that is adversely impacting investor confidence. Meanwhile, France and Italy now have public debt to GDP ratios that are higher than they were at the time of the 2010–2012 Eurozone sovereign debt crisis. Heightening the chances of another round of the Eurozone debt crisis is the seeming political unwillingness or inability of France and Italy to get their public finances on a more sustainable footing.

With all of these risks in plain sight, we have to wonder what the stock market is thinking when it sets its valuations at their currently lofty levels on the assumption that the world economy will continue to grow at a satisfactory pace. However, this would not be the first time that the stock market failed to anticipate very stormy waters ahead. As Niall Ferguson reminds us, the stock market failed to foresee the outbreak of the First World War that required the London and New York stock exchanges to be closed for several months to prevent an investor stampede for the door. The stock market also failed to anticipate the Great Economic Depression in the 1930s or more recently the 2008–2009 Great Economic Recession.

Learn more: Letter: US Budget Deficits Are Undermining Savings Rate | Will Donald Trump Restart America's Inflation Crisis? | Trump Trade Policy Follies | SA Needs to Prepare for Another Bumpy Trump Ride

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