NOURIEL ROUBINI: What's going to be happening when the next recession occurs is that the headroom is going to be limited. The Fed has only now 150 basis points of headroom. The CBN BOJ already deeply in negative territory. Therefore, doing what has been done in the past, that is the usual unconventional quantitative easing with negative rates is not going to be sufficient. And that's why, I think, that the policies are going to become even more unconventional.
ASH BENNINGTON: Full disclosure. I used to run your macro economics blog, EconoMonitor. We've known each other for many years. It's a great pleasure to be here with Dr. Nouriel Roubini.
NOURIEL ROUBINI: A pleasure being here with you today.
ASH BENNINGTON: Most of our viewers will already know you from your incredible call in 2006 at the conference in September predicting the great financial crisis effectively. And not just predicting the crisis, but predicting the specific mechanisms that were going to trigger that crisis. You talked about mortgage defaults, the problems with the securities that were built around those mortgages. But you've actually been very constructive for many years since the crisis on US equities. Could you tell us a little bit about how you thought about the recovery, and how you've gotten to kind of where we are right now?
- Well, yeah, the recovery after the global financial crisis was bumpy. Of course, it was a u-shaped recovery. It was not your typical v-shaped recovery, because this was not a regular recession. It was a recession caused by financial crises, and a financial crisis was caused initially by too much debt in the private sector and then a build up of public debt.
And as we know, whenever you have a financial crises, you have a painful process of deleveraging. And for a while, you have to spend less and save more in order to reduce that over time. And that great deleveraging implied that the recovery was anemic and was bumpy in many ways.
But there's been a recovery that in the US has lasted over 10 years now, the longest US economic recovery. And in the rest of the world, the recovery was stronger in emerging markets. Then there were shocks in the emerging markets. Europe was more fragile. It was a double dip recession in some parts of Europe, even a triple dip recession.
But I would say for financial markets, what has happened has been that for the last decade, there have been a number of the risk off episodes. And these risk off episodes were triggered by a variety of factors, concerns about the eurozone, concerns about the hard landing in China, concerns about what the Fed, concerned about oil prices, and you name it. But in each one of these episodes, that correction say correction of 10% plus in US and global equity has been followed by a recovery and then go into higher highs.
My explanation of it is that, one, those concerns that the world economy is going to end up into another recession turned out to be wrong. Growth recovered. And secondly, in each one of these risk off episodes, the policy reaction of Central Bank has been to ease more in a conventional and or unconventional way.
And therefore, where there was the Fed, the ECB, the POJ, the BOE, the PBOC. Central Bank have come to the rescue of economies and markets. So some of those tail risks turned out to be less severe than thought, and the Central Bank came to helping economies and markets. And therefore, we have had this sustained recovery of asset prices that has lasted for 10 years.
ASH BENNINGTON: Right, and that brings us to US equity markets. And US equity markets, obviously, we're sitting here in December of 2019 have had a very good year. Could you talk a little bit about how you view that in the context of the broader macroeconomic framework?
NOURIEL ROUBINI: Yes, I mean, I would say that to think ahead about what's going to happen to you and even in global equities. One is the first to start with what's going to be the economic outlook for next year and so on. And as you know, we're in the middle of what's called the synchronized economic slowdown, a slowdown that implies that growth is still positive. But it's slower than before.
You know, global growth two years ago was 3.8%. Last year was 3.4%. This year, the estimate is going to be only 3%. In spite of that slowdown in growth, this year, US equities have turned out to do very well. In part, because some of the tail risk that people are worried about during the year, where there was a risk of a full scale trade war between US and China, or a hard Brexit, or a war between the US and Iran in the Middle East. Those stories have turned out to be milder than previously expected, first point.
Then secondly, again, the Fed, the ECB, and other central banks, once they were aware of this, kind of a global headwinds came to the rescue of the markets. So yeah, it started with a Q4 last year that was very bad. But then given the change in stance of the Fed around the Central Bank and the attenuation of these tail risk, the market has done so far very well. Now the first question you probably have to ask yourself is, what's going to happen to the global economy next year? Because it effects then market and policies.
ASH BENNINGTON: That was my next question.
NOURIEL ROUBINI: Yeah, so in order to speak about US equities probably, you have to start with the real economy. I would say there are three scenarios. Scenario number one is the more optimistic one is the one that is being pushed by a number of say sell side firms on Wall Street. That says, well, a slowdown, but now some of these tail risks are disappearing. Financial conditions have eased because of what the Fed, ECB, and other central banks have done.
So we're going to go back to a economic expansion. Not very robust. Instead of having 3% growth like this year, you're going to go back to 3.4%. That is OK, but it's not as strong as it was in 2017, 3.8, for the global economy. And slight capping growth in US, and Europe, and Japan, and then other advanced economies, that's one scenario. And that scenario is part of a pickup in growth.
The argument goes that inflation has got to maintain. Because there are global forces that keep wage inflation and price inflation low. And therefore, central banks with ease are going to stay on hold. And that might be an ideal scenario for US and global equities.
You get reflation, trade. You got a pickup in growth. Earnings keep on doing well. Monetary policy remain accommodative, and then US and global equity could have, say, something close to double digit returns in spite of a valuation being very high. That's one scenario. I'm skeptical of it for a few reasons. Second scenario--
ASH BENNINGTON: What are your skeptical points when you think about that?
NOURIEL ROUBINI: Well, you know, my view of the world today is that rather than that scenario, we may have a continuation of this global slowdown. Where growth next year is going to be, say, slightly above 3%, but not as strong as 3.4%. And it's going to remain at current levels in the US, and Europe, and other advanced economies. Maybe slightly pick up in growth in some emerging markets, like Russia or Brazil, that did thoroughly poorly in the last couple of years. But I expect a continuation of that slowdown.
That's the bad news. The good news is there are more extreme negative scenario. That will be my third scenario would be of a global recession. And it would say, as long as US and China have a trade deal, as long as Brexit is solved, as long as we don't have a war in the Middle East between the US and Iran, and as long as Central Bank remain on hold, and accommodative policies probably currently the risk of a outright recession is right to be a lot.
So then the question is why not to be more optimistic about the global economy, like scenario one, and instead, believing in the scenario two of continuation of that global economic slowdown. My view is based on a number of argument. First of all, these argument that were at the bottom of this slowdown doesn't to be borne by the data. If you look at the data for Europe, for Germany, for China, for many emerging markets, yeah, things are not becoming worse. But they're not improving, and the US, maybe things are bottoming out.
ASH BENNINGTON: What are the key data sets you look at, Nouriel, when you talk about not seeing those decelerations?
NOURIEL ROUBINI: You know, there are, first of all, coincident indicators of economic activity, like current of the measures of employment, industrial production, retail sales, Capex. But forward looking data in the various PMIs, ISMs, and so on give you a sense of what's going on. And one other characteristic of 2019 was the significant collapse in global capital spending.
Banks were very sharply down. And of course, the reason for it was that there was a option evaluating given that you didn't know whether the trade wars with the US and China and other ones are going to escalate or not. If you have to make major investments of billions of dollars in your factories, and you don't know whether things are going to be improving or worsening. Then you're going to wait and see.
And while a trade deal between US and China is likely, I think that's going to be a truce in a medium long term trade, currency, technology, and even Cold War between the US and China. And therefore, the sources of uncertainty that keep Capex down maybe are going to remain with us. I think that's an important part of this story, I say.
Second part of this story, my view is, as I pointed out, if you look at the data around the world, we're not yet seeing a bottoming out of this economic slowdown. It may be happening in the United States, but the data from any advanced economy emerging markets are not consistent with that. There may be a truce between US and China. But we have a geopolitical situation that might be having an adverse effect on a trade deal with the US and China.
We don't know whether there'll be a media crackdown in Hong Kong. We don't know whether China is going to react in a violent way to say a pro-Independence candidate winning the Taiwan election and so on. So there are lots of geopolitical uncertainties are going to be weighing on the market, and the problems of Europe are not just problems related to Brexit.
It now looks like Brexit are going to be solved. You're running out of monetary stimulus option for the ECB, the country where fiscal space, like the Netherlands, could do more by not doing more. There are fundamental problems of populism in Europe. There is plenty of fragility in four of the key economies. Germany, France, Italy, and Spain for different reasons have political uncertainties.
There is a risk of auto tariffs, and there is a glut of capacity in the auto sector. And the economic reforms in Europe are occurring much more slowly than desirable and optimal. And therefore, potential growth also with a aging population remains limited. So I see a world in which while things are not going to get worse, there are going to strengthen significantly in 2020.
Now the good news, there's not going to be a recession. The bad news, we're going to stay in a slowdown. The other good news is that Central Bank, of course, are going to stay on hold. They're not going to hike. They're not going to ease more, most likely. And therefore, in that scenario, in a situation in which there is still a lot of debt in the world, public debt, private debt in US, in Europe, in China, in the case of the US, I'm very concerned about the build-up of corporate debt, whether it's leveraged loans, C loans, fallen angel in the high grade, or the spreads on high-yield being so compressed in spite of a build-up of leverage.
I think there are fragility coming. We have excessive debt ratios that could also imply something of a surprise, negatively, that leads to a risk of episode and a correction of US and global equities.
So my best scenario for 2020 for US equity would be that if you have positive returns, they're going to be in the low single digits, as opposed to high single digits or double digits. Valuations, of course, are stretched, if you're looking at Shiller CAPE, seasonally adjusted P/E ratios.
And there's also a wide range of political uncertainty related to the United States. We'll see how this impeachment is going to go. It's going to be probably noise. Markets are discounting it. But that could be a source of. Tension we'll see what happens with their nomination for the Democratic Party.
It's possible that a progressive candidate might be nominated. And if that's the case, and if there is a chance that he or she may win elections, then most of these progressive candidates are coming with proposals for taxing more wealth, taxing more income, taxing more capital, or taxing more the rich, and you could see that the nomination of such a candidate may also be a trigger for a risk-off episode and a correction in US equities as well.
So I would say the year is going to be an OK year, and a year probably in which after 20%-plus returns for US equity this past year, next year if you get low single digits, you'll be lucky. And there are plenty of triggers of a potential risk-off episode that could lead to a 10% correction at some point during the year.
ASH BENNINGTON: So now that we have the base case and the way you see the world, I'm curious if we could go and unpack some of those things that you mentioned, so for example, central banks being on hold. Policy has been remarkably accommodative for many, many years now. If you think about where we are with the federal funds rate, hundreds of basis points below the historical average. We have balance sheets all over the world at central banks. Whether we're talking about the Fed, the ECB, there's a lot that they own.
So it's interesting when you say that they're on hold. What does it mean, effectively, to stay accommodative at the level that they're at, and what influence can that have on asset prices and also on things like aggregate demand and potential for mis-pricing of assets?
NOURIEL ROUBINI: Well, accommodative has to do with the fact that there has been a global slowdown, and there is a risk that things will get even worse. And I think the easing of financial conditions, that additional accommodation is provided, helps avoid the tail risk of a global recession. It's also the source of some of the asset inflation we've seen this year.
I think that central banks, most likely, in my baseline scenario, even of a continued slowdown-- they're not going to do more. Some of them actually cannot do much more. ECB and BOJ and other central banks in the smaller parts of Europe already with negative policy rates-- they're reaching the limits of how negative they can go. They are doing various versions of quantitative and credit easing. They cannot do much more, unless there is a severe recession. And of course, the Fed, with the economy doing OK, growing around 2%, is going to stay on hold.
Of course, the risk is that while the real economy, with low growth and low inflation, justifies this accommodative monetary policy, that then you're going to create frothiness in financial markets. And by some standards, US and some other risky assets-- for example, real estate is very expensive in many parts of the world. Credit, of course, is very expensive, with credit spreads being so low. Government bond yields are very low, and you could say government debt is also expensive.
So we live in the world in which many risky assets, whether it's public equities, private equities, real estate, credit, government bonds, are expensive. Of course, you need a major macro shock to trigger a significant not just correction, but something worse than that.
And of course, some risk-off episodes may be occurring in the coming year, tensions related to the US and China, something to do with wars, about geopolitical tensions around the world, the Issue of all these excesses of corporate debt and re-leveraging and this and that.
So I don't say we are in a bubble, but certainly we are in a period in which asset markets are frothy, valuations are stretched, and therefore, any macro shock can lead to a risk-off episode, can lead to a correction, and that correction may remain persistent, as opposed to being reversed. That's the risk we're facing right now. To have a recession, of course, you need a severe macro shock that is going to be persistent over time.
ASH BENNINGTON: One of the things I'm curious about-- do you think, in addition to the potential risk asset bubble, is it possible that we're seeing distortions, for example, in the financial system due to the fact that interest rates have been priced far away from where a Taylor rule would suggest they should be? we see things like compression of net interest margins in banks. Does that have the potential to have some sort of impact throughout the economy as well?
NOURIEL ROUBINI: Well, the distortion is that, of course, some of these valuations are excessive because interest rates are so low, both on the short end of the yield curve and on the longer end of the yield curve. And you have negative not only policy rates, but up to maturity of 10 years. You have about, depending on the week, $10, $12, $13 trillion equivalent of government bonds, and even some corporate debt not in the US but outside the US and Europe and Japan that have a negative yield.
So I think that we live in this dilemma that on one side, the real economy, we have a low growth and low inflation that justifies this very easy monetary policy. But on the other side, instead of goods inflation, we're having asset inflation. We might not be in a full-scale bubble, but we're certainly in a situation which is up on the doubt for a wide range of asset classes. Asset prices are too high, valuations are been stretched, and therefore, the risk of a meaningful correction is there as well.
But the dilemma is that the real economy justifies this accommodative monetary policy, including low inflation. But then the side effects and then the consequences of it might be asset inflation that eventually becomes asset frothiness, and asset, then, eventually, credit bubble.
And we are building up the seeds of the next financial crisis with this build up of excessive leverage, excessive risk-taking, and excessive debt. As I pointed out, in the US, it's really concentrated, one