Is This How the Next Global Recession Begins?

In this series, we have outlined black swan events that, while extremely unlikely, would lead to extremely negative global economic consequences — a disintegrating European Union, massive interest rate increases in response to runaway inflation, a flash crash that reveals the perils of financial leverage and China’s disruption of the financial world order by pricing commodities in its own currency and asserting economic hegemony.

It has been roughly 10 years since the Great Recession, which in the U.S. seemingly came out of left field after years of strong growth and ascending markets. The preceding bullish cycle was driven by easy money that fed into an effervescent real estate market that eventually reversed and brought down the financial world with it.

In 2018, after years of slow growth and recovery aided by unprecedented easy-money policies, economies and markets around the world are riding high — very high. U.S. markets have notched repeated all-time records, corporate earnings growth is back in a big way and economic policy is marked by tax cuts and regulatory streamlining. This flourish comes after another record was set last year: The run off the lows of March 2009 is now the second-longest bull market in U.S. history, and talk of an inevitable recession is often met with “this time is different” arguments.

And this time is different:

The next U.S. recession won’t come from the financial skunk works of the world’s largest economy. It will come from the political cabal running the world’s second-largest economy — China.

In stark contrast to the West, China is a centrally planned economic and political system where state control is the modus operandi. While the Chinese Communist Party has strategically opened up its economy in previous decades, reshaping the economic world in the process, its central control has grown only tighter since Xi Jinping was elected president in 2013.

Xi has overseen a return to strict party loyalty, cracked down on corruption and presided over China’s transition to a consumer-driven economy. He also used his power to ensure favorable economic conditions going into last fall’s National People’s Congress, thus securing his reelection to a second five-year term that will end in 2023.

It won’t be his last. This week the party’s Central Committee amended the constitution to remove the two-term limit. Now it is Xi as far as the eye can see, and he will dictate the direction of central planning to an even greater degree, including a favorable economic environment going into the party’s centennial in 2021 and the next National People’s Congress in 2022.

For central planners, a hot economy in 2021 means stimulus in 2020, and to avoid a disastrous overheating of the Chinese economy in the interim, Xi will take his foot off the gas pedal in 2018 and 2019, which will result in a global recession.

That’s how influential the Chinese economy has become. Germany, the European Union’s economic powerhouse, increasingly relies on China to maintain its dominant position in the eurozone. In fact, 2017 marked the second consecutive year that China surpassed the U.S. as Germany’s biggest trading partner and, at $ 230 billion, the value of that trade rocketed up 35 percent from 2016.

China’s slowdown could feed directly into American worst-case scenarios — runaway inflation and reactionary interest rate hikes.

What happens to the German economy when China intentionally slows down in 2018 and 2019? For one thing, it could set the stage for economic devolution and make the unlikely black swan of an EU breakup a reality.

Although the U.S. is less reliant on China for trade as a percentage of its gross domestic product, the methods used for China’s slowdown could feed directly into American worst-case scenarios — runaway inflation and reactionary interest rate hikes.

China is in the midst of a sprawling international program known as One Belt, One Road (OBOR). Its goal is to establish Chinese economic hegemony for decades to come via massive infrastructure projects that will feed its developing, consumer-driven economy with resources from around the world. China’s rail and port projects in Pakistan are among OBOR’s central pillars.

OBOR can’t be interrupted, so Xi will need to tap the economic brakes in 2018 by tightening monetary policy and strengthening the yuan. That will engender weakness in the U.S. dollar — currencies are valued relative to other currencies — spiking inflation in the U.S. and forcing the Federal Reserve into an accelerated pace of rate hikes that annihilate the record bull market.

Similarly, the market tumult that would stem from such unexpected yuan strength will rattle markets that are carrying the most margin debt in history. One surprise announcement from the People’s Bank of China that strengthens the country’s currency could cause one-day market swoons unmatched in the past decade. The spiral of unwinding leverage and margin calls would create a negative feedback loop that brings U.S. business activity to a standstill like the worst days of the global financial crisis.

China’s historic expansion over the past three decades has fueled much of the world’s economic growth and helped to assuage the few real financial crises along the way. In 2018, though, China’s plan to slow down before it speeds back up will lead the world into a long overdue recession.

That is, unless a black swan disrupts even China’s best-laid plans.

Jeffrey Moore II is a senior analyst at Global Risk Insights.