Beneath the gloom

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Concerns about the global economic outlook have built over recent days. Gloomy commentary by the IMF and weak German industrial data fueled these worries. Meanwhile, some FOMC officials signalled that weak foreign demand was a risk to the upbeat US economic outlook. A look beneath the surface suggests that the pessimism is overdone. The IMF is still forecasting a noticeable improvement in global growth over the coming quarters, as we are. The weak German data were partly depressed by a shift in the pattern of holidays, and we think that a recovery is on the cards even in the eurozone, albeit a moderate one. Eurozone policy settings are shifting to a more growth supportive stance.

The IMF sounds like the grim reaper. Nick Kounis Nick Kounis Head of Macro Research

The IMF sounds like the grim reaper

Financial market concerns about the global economic outlook grew last week. The IMF published its new outlook, which is a big event in the economic calendar. The commentary from the fund was so downbeat, you would think that the world was in the midst of major slump. The IMF admitted that a recovery was underway but noted that it was ‘weak’ and ‘uneven’ with ‘downside risks’. These included geopolitical tensions and the possibility that markets were too optimistic and that risk spread compression would reverse. In addition, it worried about weakening potential growth as a medium term problem. The commentary was certainly more negative than its actual economic forecasts. Its global economic growth projection has been revised down by 0.1 percentage point in 2014 and 0.2 percentage points in 2015, compared to its last update in July. This is hardly dramatic. In addition, the IMF still expects a noticeable acceleration in global economic growth next year, from 3.3% in 2014 to 3.8% in 2015. Given that average global economic growth since 1980 is 3.5%, this outcome would not be too bad at all.

How to sell good economic policy

The question arises why the IMF is laying on the gloom. It is fair to say that economic growth has been nothing to write home about over recent years, while risks to the economic outlook remain, especially in the eurozone and emerging markets. However, perhaps a more compelling reason is that the IMF is trying to encourage policymakers around the world to do the right things to encourage economic growth. Doing that against the background of doom, helps to sell the need for quick and determined action. Indeed, the IMF concludes that across the world there is an ‘urgent need for structural reforms’ as well as short-term stimulus in some cases. That is difficult to argue with.

Europe’s industrial powerhouse…what happened?

Another factor fuelling global growth worries last week was the release of a set of dramatically poor data from the German industrial sector, commonly seen as Europe’s powerhouse.

IMF World GDP growth

Factory orders fell by 5.7% mom in August, while industrial output declined by 4%. Both were the weakest since 2009. Given that the German economy contracted in the second quarter and the eurozone stagnated, it is no surprise that speculation about a recession gathered steam. However, the numbers very likely paint an exaggerated picture of weakness. In both cases, the drops follow a relatively strong July outcome. In addition, the Economic Ministry noted that a change in the timing of school holidays depressed output in August. It is impossible to know at this stage how big the impact of this was, though working day effects can potentially be sizeable. For instance, in a month with around twenty working days, two less would imply 10% less output, other things being equal. Overall, we think that a strong rebound is very likely in September. Given the way the numbers work, such a pattern could be indicative of somewhat less growth in Q3, and somewhat more growth in Q4. However, we think that the German and eurozone economies will escape a technical recession. Industrial production in other eurozone countries was better in August, with output up by 0.3% mom in Italy, 0.2% in Spain, while being flat in France.

German industrial orders and production

Draghi vs. Schäuble and Weidmann

Admittedly, policymakers do not always do a great job of promoting confidence. Europe’s economic titans often appear to be squabbling, and last week was no different. The divide is between those that want to go for more short-term macro stimulus, and those that are concerned about potential ‘negative side effects’ from these actions. ECB President Mario Draghi has suggested that countries with room for manoeuvre in their public finances, use it to ease fiscal policy. Germany is a prime candidate here, but finance minister Wolfgang Schaeuble has urged continued budgetary discipline. He may well be concerned that if Germany loosened the fiscal reins, this would spread through the eurozone. France, Italy and Belgium have recently signalled that they intend to push back their fiscal targets in coming years and appear to be heading for a clash with the European Commission. Meanwhile, Mr Draghi has also suggested a willingness to do more in terms of monetary stimulus, though Germany’s government and central bank are against government bond purchases. Indeed, Bundesbank President Jens Weidmann even opposed the ABS purchase programme that the ECB is set to embark on. He has gone out of his way to warn about credit risks to the central bank’s balance sheet.

The way forward

Typically, eurozone policymakers find a way through. Modest shifts in fiscal policy are unlikely to make a major difference to the growth outlook in any case. However, the ECB has already put a sizeable monetary stimulus in place and is ready to do more. Sovereign bond purchases are a ‘no go’ unless the situation deteriorates dramatically, given the opposition in Germany. However there are other steps the central bank could take if necessary. For instance, it could expand its asset purchases by adding debt securities issued by EU-level institutions, or corporate bonds. It could also make the TLTRO conditions even more attractive. Meanwhile, the central banks and regulators across the eurozone have been working behind the scenes on the comprehensive assessment of banks, which includes the asset quality review and stress tests. The results will be published later this month. A credible assessment and recapitalisation would be a crucial step forward in the eurozone’s path out of the crisis. After all, the completion of credible stress tests in the US in 2009 were an important watershed moment in its road to economic recovery. Given the eurozone’s bank-based financial system, they are arguably even more important in the single currency area. As well as macro stimulus and repairing the banks, structural reforms are important for the region’s long term prospects as underlined by the IMF. In this respect, Italy’s Prime Minister Matteo Renzi took an important step this week. He won a key vote of confidence in the Senate, which opens up the way to the passing of key labour market reforms. A lot depends on the details and more needs to be done in a number of other areas, but it is good to see some movement.

US initial jobless claims

FOMC doves speak louder

On the other side of the Atlantic, the Fed is carefully considering the pace of its exit from super accommodative monetary policy. Asset purchases will end at the FOMC meeting later this month, but the issue is when interest rates will go up. The minutes of the September FOMC meeting showed that some of the relatively dovish members more strongly put forward their view that the central bank should err on the side of caution. They point to low inflation, downside risks to foreign demand and the possibility of further dollar strength as arguments to wait. Markets further scaled back their interest rate expectations for next year as a result. With oil prices falling and the dollar rising, the US inflation outlook will certainly be in scope in coming meetings. However, it is worth noting that the FOMC’s September forecasts showed that most members judged that interest rates would need to rise a little faster in 2015 than they had thought previously. The most likely scenario seems to be that interest rates will start to go up from the middle of next year onwards. We think markets are likely underestimating where interest rates will rise to at the end of 2015. Indeed, labour market data since the September FOMC has been upbeat. The 4-week average of initial jobless claims fell to an 8-year low in the latest reading.

Beneath the gloom

Like the IMF, we expect an acceleration in global economic growth next year. This should be driven by strong growth in the US lifting other countries around the world, with world trade and global GDP growth rising as a result. US private sector balance sheets are in rude health and companies are well placed to hire more and step up investment. China’s authorities are focused on laying the foundations for more sustainable, yet slower growth. But at 7% next year, this is still going to provide significant support to global demand. Even in the eurozone, we think the most likely scenario is one of moderate recovery. The fall in the euro should boost net exports from current low levels. Stronger global demand should also help. Domestic drags are also easing. House prices are bottoming out, bank lending conditions have started to ease, while unemployment has been edging down. The hit to confidence from the Ukraine crisis is also likely to ebb given that tensions have eased. A final positive on the global level is the fall in the price of oil and other commodities. It is essentially a transfer of wealth from net commodity exporters to net commodity importers, which are more likely to spend the windfall.

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