Confidence in the global economy returned somewhat in the second half of 2013, and real economic data also picked up, albeit less vigorously. We are sanguine about the outlook and believe the months ahead should see further improvement, helping ‘hard’ variables such as industrial production, consumption and employment to begin nudging the levels they should be at according to these sentiment indicators. In this first Big Picture of 2014, I'll answer five questions and will discuss a number of risks facing the global economy.
In this first Big Picture of 2014, I'll answer five questions and will discuss a number of risks facing the global economy.
Han de Jong Chief Economist
1. Will the global economy grow faster in 2014 than in 2013?
Yes, I believe that it will. We´ve been saying for months that there should be more room for growth now that economic headwinds are easing. Budget spending cuts that have become less tough, less – reason for – debt reduction in the (US) private sector, less tension in the financial system and lower inflation are conspiring to contribute to a balmier climate for growth. Pent-up demand might prove robust after the long stretch of subdued growth, global trade would seem to have accelerated in the past few months and businesses are investing more. Positive data include recent durable goods orders in the United States and higher corporate investment as revealed in the euro countries’ national accounts. In fact, in a number of countries consumer demand would seem to be perking up. Leading institutions such as the IMF, the ECB, the Bundesbank and the UK Treasury have all revised their growth forecasts upwards in the past few weeks – hardly a coincidence in my view, more like a trend. In fact, I’d say there’s a distinct chance that 2014 growth figures will beat expectations for the first time in a long stretch.
2. So is the euro crisis over?
No, far from it – key risks still abound (see below). That said, major battles have been fought and won in this war: government finances are in better shape, the peripheral countries have become more competitive and their balance of payments deficits have melted. Governance in the eurozone has improved significantly and the region is implementing structural reforms. Of course, the glass is still half empty – or half full, for the bulls among us. What I’m trying to say is that policymakers have had to make so many tough calls that they’re unlikely to give up this late in the game. And Europeans have suffered so much to save their currency, I’d say it’s highly unlikely they’ll quit while they´re ahead. I’ll discuss the risks in greater depth later in this article.
3. Should we fear inflation?
Yes and no. The highly accommodating monetary policies since the start of the crisis undoubtedly carry a risk of inflation, but in the developed economies this risk is likely to remain very modest this year – and probably also in 2015. There’s still a lot of spare capacity in the economy and inflation expectations are solidly based. The big challenge facing central banks at this point is to bring monetary policy conditions back to normal at a pace that leaves enough room for the recovery and that nips any signs of strong inflation in the bud. Inflation risks are higher in the emerging countries, where some sectors have become overheated in the past few years and domestic currencies have lost value – with inflation increasing as a result. And it’s precisely because emerging countries are attempting to rein in inflation that economic growth there has fallen a little behind.
The risk of inflation in the wealthier economies would seem to loom larger for investments than for goods and services.
Some people wonder if we shouldn’t fear deflation right now. I’ll admit, with inflation in the eurozone well below target, deflation would appear to be a bigger risk in 2014 than inflation. That said, I reckon painful deflation is unlikely in either 2014 or 2015. The best defence against deflation is economic growth, of course, and we expect to see growth stage a solid, across-the-board recovery as the year progresses.
*) When talking deflation, we need to look at its causes and distinguish between two types. Deflation resulting from falling import prices or smartly higher productivity tends to be a good thing that helps boost living standards. Deflation turns painful if total demand consistently lags an economy’s production capacity, as prices and incomes fall and demand falls even further – a vicious downward spiral that can be hard to climb out of. A contracting economy is at the centre of this process – which is why I call economic growth the best defence.
4. What are the likely effects of tapering and an end to quantitative easing?
To be honest, nobody knows – we’re in uncharted territory. I covered this question in a recent study of the different periods of quantitative easing by the Federal Reserve and its tapering ‘test drive’ between May and September 2013.
My research threw up the following conclusions:
1. Bond yield increases are likely to be limited as the markets have already factored in tapering.
2. Equity markets in the developed economies look set for a bumpy ride, but tapering is unlikely to put a stop to rising share prices, as equities tend to be underpinned by economic fundamentals – and these are looking very conducive indeed.
3. The risk of massive capital outflows is highest in the emerging countries, and their currencies and equities are the most vulnerable.
All told, I don´t believe tapering will prove a major force to contend with.
5. What can we expect in terms of business behaviour in the current climate?
Companies have spent the past couple of years cutting costs and are now looking at a very favourable operational leverage. If the economy does pick up, and particularly if it picks up faster than is currently expected, they´d be looking at robust earnings growth. Companies tend to respond in two ways when that happens: they start to invest more – and we’re already seeing the green shoots of greater investment – and they take advantage of cheap capital to enhance their financial leverage, further adding to their profit numbers. I reckon 2014 will turn into a top year for companies, which should see their margins and net earnings expand on the back of more robust growth and greater operational and financial leverage. We’ll then embark on a period of pay increases and falling profit margins, but that will probably not be until well into 2015.
Although I´m altogether sanguine about 2014, I wouldn´t say that I´ve turned into a raging bull. The university of hard knocks has taught me not to be complacent, so here’s a serious look at the risks.
a. Tapering and the end to quantitative easing
We're in uncharted territory – I've said it before, and although I believe the effects of tapering will be limited, I can’t rule out panic in the markets at some point. US bond yields could start rising faster than we currently think, undermining economic recovery. Of course, the Federal Reserve and the markets would respond to any slowdown in the economy, but that would only serve to increase volatility, with riskier assets hit the hardest.
b. Return of the euro crisis
The euro crisis could flare up again for many reasons: the ECB’s wide-ranging asset quality review might uncover unpleasant surprises if banks are found to be less sound than generally assumed; a banking union might bring matters to a head between the different European government leaders; financial aid programmes for Portugal and Greece are scheduled to end this year, and hostility in the markets might cause them to knock on doors for more financial support; and Europe is set for parliamentary elections in May of this year, which might see euro sceptics win the day. We’ll have to wait and see how the markets respond: they may consider such an election result undermines policymakers’ resolve to keep the euro alive, and that this needs testing. What’s more, the recovery in France and Italy appears to lag behind the others. Neither country has achieved all that much in terms of fundamental reforms, and neither has therefore enhanced its potential for growth. With other EU countries having made more progress and bolstered their competitiveness, France and Italy have essentially seen their positions deteriorate.
c. VAT increase in Japan
The Japanese government is restructuring public finances and looking to raise VAT in April. It remains to be seen how Japan’s economy will respond. The 1997 VAT hike turned into a traumatic experience and tipped the economy into a major recession. However, this time the Bank of Japan is prepared to take additional measures to support economic activity and to weigh in with other tools if it needs to. Its aim would be to sharply devalue the yen, which could prove a destabilising force in the international financial markets.
d. Weak emerging economies
Policymakers in the emerging economies are still working hard to control some of the past decade’s excesses – in China, for instance, the authorities are trying to curb credit growth. The global economy stands to be affected if emerging countries’ policymakers do not get a grip on inflation or if they put too heavy a brake on economic growth in the process of doing so. Although the emerging economies are clearly crucial to the global economy, they would seem to follow rather than lead the economic cycle. Their growth strategy has a major part to play here: despite attempts to create more domestic demand, it continues to rely heavily on exports.