article banner
Economic newsletter October

Spain continues to benefit from numerous tailwinds

With the world economy clearly showing signs of strength since the summer of 2016, those who said that very slow economic growth worldwide was the outlook for the foreseeable future are no longer as vocal as they used to be. Given the fact that a large number of countries are now growing significantly above potential, global trade has recovered quite considerably and that you have to try hard to find economies that are doing really badly right now, it is little wonder that the secular stagnation theory has lost much of its shine.

The so-called goldilocks economy seems to be the new game in town. Informally, what this means is that financial markets are now discounting a scenario in which the world is not only able to grow at a reasonable speed, but it is also able to do so without generating any kind of inflationary pressure (not now or in the very long run).

You could say that it couldn’t get any better for risk assets: their prices go up not only to reflect an upbeat macroeconomic scenario in terms of growth, but also because the discount rates used to bring future cash flows to the present remain at extremely low levels (the latter of course reflecting the fact that long-term, risk-free rates remain at rock bottom levels).

In our view, the market was short-sighted when it discounted secular stagnation with 100% probability and it is short-sighted again now thinking that this so-called goldilocks scenario is 100% likely to be the only game in town forever. For anyone willing to see, countries are not only growing above potential, but (by definition) they are also depleting spare capacity very rapidly (in fact some of the most important economies in the world already have positive output gaps). What does this mean? It means that, contrary to what happened for many years after the global financial crisis, labour is not abundant anymore and is actually scarce in key parts of the world economy. Of course what this means is that, unless we are willing to accept that the price of a production factor (or any kind of product for that matter) has no relation whatsoever to how scarce that factor (or product) is, the most likely scenario going forward is for both wages and prices to progressively accelerate. In other words, the Phillips Curve might have been dormant until now, but it is certainly not dead.

In terms of Spain, it would be a shame if political tensions in Catalonia threatened the increasingly strong and sustainable economic recovery we are witnessing. The authorities need to acknowledge this situation and focus their efforts on adopting measures to foster potential growth and guarantee the long-term sustainability of the country’s public accounts.

Our central scenario continues to be one in which central banks progressively allow for a normalization of monetary policies, against a backdrop of moderate reflation in the global economy. This means that long-term nominal interest rates should edge up not only to reflect progressively higher inflation, but also to allow for moderately higher real rates (those who say that real interest rates are bound to remain extremely low forever should also admit that this means that monetary policy remains accommodative for an indefinite period of time; for us this is quite a risky proposition in terms of the context described above, with the global economy growing above potential and output gaps being rapidly eliminated). 

At the same time, and even though until very recently, we thought that central banks did well by remaining cautious regarding raising rates, we fear that monetary authorities around the world are increasingly and rapidly falling behind the curve. What might be the consequence of this? It is by no means impossible that, if financial conditions remain this accommodative for much longer, inflation could end up significantly overshooting central banks’ targets. This in turn would force the monetary authorities to increase interest rates more rapidly and more intensely than even they are currently expecting, possibly with negative implications for global recovery within a 2-year framework.

Just as in our central scenario of moderate reflation, the inflation overshooting scenario would also lead to significant increases in long-term interest rates. How would both scenarios compare in terms of their implications for long-term rates? If central banks do not fall too behind the curve (moderate reflation scenario), the upward movement in long-term rates would possibly begin sooner and would also tend to end earlier. If, on the other hand, inflation clearly overshoots at some point, this would possibly mean that long-term rates remain low for a while but the shoot-up would be more abrupt and intense, as central banks are forced to implement restrictive monetary policies.