The latest edition of the IMF’s World Economic Outlook carried the rather cumbersome subtitle ‘Recovery Strengthens, Remains Uneven’ in a sort of good cop-bad cop allusion. Put another way, the IMF’s economists draw comfort from the weakening headwinds to the global recovery, but they harbour lingering concerns about the nature and characteristics of what is, to be blunt, nothing more than a cyclical economic pick-up.
It certainly is a mixed picture. Equity market levels remain elevated, but they have succumbed to a lot of sectoral volatility, and there remain continuing doubts about earnings momentum. Bond markets have confounded those who thought Fed tapering would cause a sharp rise in yields, but since markets are now starting to discount policy rates going up over the next 12-18 months, it would be complacent to imagine that this might happen without market consequences.
In the US, the economic picture is brightening again after a significant weather-related setback in the early part of the year, but it is questionable that growth of close to 4% can be sustained for long. The household savings rate has fallen again, the best of the housing market recovery is behind us, and wages and salaries have not risen along with levels of employment – not yet, at least. The UK could be the fastest growing economy in the industrial group of countries this year, but this performance is now based largely on a government-nurtured housing pick-up. In the Eurozone, competitiveness is rising, the region’s external surplus will exceed that of China this year, and positive growth will be ubiquitous, but the tempo will remain anemic, and in southern Europe, exceptional economic hardship and unemployment will persist. Japan’s consumption tax rise looks as though it has dented, not ended the economic upswing, but Abenomics isn’t turning out to quite as transformational as many had hoped, and the Bank of Japan may well have to boost its QE programme to support growth.
Behind the positive economic headlines, welcome as they are, we are still carrying a lot of structural baggage six years after the financial crisis. Other than in the US, where some credit intermediation has resumed, bank lending and the overall financial health of the financial sector remain sources of concern. In most advanced economies, labour market and wage formation weaknesses persist, as well as the negative growth consequences of high income inequality. The risks of protracted low inflation, or even deflation, especially in Europe, should not be under-estimated, especially as several countries could be just one shock away from outright deflation. The consequences of the Federal Reserve’s tapering policy have been weathered so far, but the closer we get to the possibility of higher policy rates there, and possibly in the UK, the more volatile the economic outlook may become. And last but not least, clouds are gathering over growth prospects in several emerging countries, not least in China.
This year, in fact, is likely to see growth in the world economy tilt a bit away from emerging to developed countries. After accounting for 75-80% of global growth in 2011-13, the contribution of emerging and developing countries may slip back in 2014-2015 to around three-fifths. This slippage looks more than cyclical. Several countries, including China, Brazil, India, Russia, Turkey, and South Africa are facing slower medium-term growth prospects, and a few have tightened monetary and financial conditions as a consequence of currency market and capital flow stresses earlier this year.
In the coming year or two, emerging countries could face further instability arising from the expected normalisation of US monetary policy, or from local or geopolitical events that cause investors to repatriate capital. Although few emerging countries face external debt and payments constraints that typified instability in the 1990s, most may struggle to live up to investor expectations about growth, and many have yet to tame strong credit creation trends that were allowed to take root in recent years.
The biggest problem for emerging countries, especially commodity producers, and for the global economy is likely to be the slowdown in Chinese economic growth. China has already slowed down from 11-12% to about 7%, but further weakening is in prospect as the government endeavours to rebalance the economy, tame credit creation and off-budget borrowing by local governments, and implement extensive economic reforms and changes in the governance of SOEs and local governments.
Notwithstanding a strong anti-graft campaign, which may itself be suppressing consumption spending, and a so far resolute determination not to use credit and infrastructure spending to reverse the economic slowdown, China’s economic prospects hang in the balance. Rebalancing and reform would normally be expected to cause investment growth to slow sharply, and to have a particularly strong impact on the all-important property sector, where transaction volumes and construction outlays, but not prices yet, are already in retreat. Since property investment accounts for about 14% of GDP, and real estate occupies a crucial role in banking sector collateral and in the balance sheets of SOEs and local governments, the sector needs to be watched closely.
In April, the government announced mini-stimulus measures designed to speed up railway investment, and social housing investment, for example, to help arrest the economic slowdown, which took first quarter GDP to 5.8% per annum, compared to the last quarter 2013. If growth remained weak, and importantly job creation slowed too, the government might decide to ease monetary and other policies, including those governing the exchange rate. The consequences may be positive for the economy and for markets in the short-term, but this would only make for a harsher economic adjustment in due course. One way or another, China’s economic trajectory is on course to change, but it is highly uncertain how this will happen, or what the political consequences will be. Whatever the long-term arguments for China-based investing might be, investors should remain cautious.