China is a key piece of the puzzle and much more so than people understand. Without weighty Chinese domestic demand growth the transition out of untoward monetary policy towards financial and economic stability is jeopardised further. Monetary policy had stabilised and propelled markets higher, but the time horizon for economic and financial normalisation is highly dependent on the timing of key transitions.
The world economy is changing, decelerating, maturing and transitioning. The world’s central banks, from the late 1990s onwards, co-opted the financial system to drive growth forward. We have suffered a number of shocks as a result, but the strategy of juicing growth has continued.
Our biggest immediate problem is not that the growth rate of expenditure is decelerating, or that populations are aging, but that the debt (and other contingent liabilities) that has been built up through a low interest rate and asset focussed monetary policy in the developed world and more recently, through infrastructure and other capital investment expenditure in the developing world, has created a mismatch between the supply and pricing of assets (debt and equity) and the economic growth rate on the other hand.
It is not that the fundamentals of underlying economic growth have become more volatile but that the relationship between monetary policy and assets and that growth has widened.
I have written on this issue many times in my posts: it is not the economy we should fear but the financial system, its volatilities, risks and divergence. Many still are ignorant of the shift in sensitivities from the economic to the financial: whereas in previous asset market history asset market movements had less impact on the here and now, their impact has become increasingly important. The centre of gravity has shifted as the weight and importance of assets and debt to growth and the financial system has ballooned.
There are of course other problems that are making things worse: increasing income inequalities and falling productivity growth and of course the global structural imbalances that have arisen as China took centre stage in global manufacturing supply chains.
Slower growth and aging populations are likely inevitable and natural depreciation of the capital stock at the margin, in the absence of a shift upwards in productivity, via a shift of flows towards current consumption and away from investment is natural and self adjusting. As flows shift away from capital investment we will also likely see lower growth rates in debt and money supply growth and the natural dynamics of decline means that this shift in flows may ultimately result in a decline in endogenous money supply growth, loans and other forms of debt and declining asset values.
What is happening is that the financial system is fighting demographic shifts, income inequality dynamics, transitional shifts between developed and developing economies, productivity stagnation in the hope that these dynamics are all transitory. Apart from the transitional shifts between global economies there is much less certainty with respect to the other factors. Importantly within discounted present value calculations, the largest component of value is held within the short to medium term horizon. So even if certain dynamics are transitory, the horizons are in conflict.
I see much potential volatility in the near term and much uncertainty with respect to fiscal and central bank accommodation of the divergence itself. What the slowdown in China is bringing into the open is the divergence, the importance of the time horizon and the risk that normalisation of the growth trajectory is not going to happen, at least within a time frame meaningful to supporting the asset price/GDP dynamic divergence. This is why markets are currently highly volatile and the major reason why the price adjustment is likely to continue.