Confidence in the global economy started to strengthen in the second half of 2013. Harder economic data also improved, but less impressively. We are optimistic that underlying economic conditions will continue to improve in the months ahead, bringing the harder economic variables, such as output, consumption and employment closer to where confidence indices suggest they should be. In the first Big Picture of 2014, we raise five questions, suggest answers, and list a number of risks concerning the global economic outlook.
1. Will global growth be stronger in 2014 than last year?
Yes. We have long argued that the easing of headwinds provides scope for stronger growth. Less austerity, less (need for) deleveraging in the private sector (in the US), reduced stress in the financial system and lower inflation all create a more nurturing growth environment. And after a sustained period of weak growth, pent-up demand is significant. Global trade growth appears to have accelerated in recent months and investment spending is strengthening. Recently published data on US durable goods orders and eurozone national accounts – showing better corporate investment – are encouraging. There are also signs of strengthening consumer demand in a number of economies. Recent weeks have seen a number of upward revisions to growth forecasts by some authoritative institutions such as the IMF, the ECB, the Bundesbank and the UK Treasury. I believe this is not a coincidence, but a trend. 2014 has a decent chance of becoming the first year in a while to produce positive growth surprises relative to current expectations.
2. Is the euro crisis over?
No, certainly not. There are several risks attached to the euro crisis yet (see below). Nevertheless, in my opinion, the most important ‘battles’ in this ‘war’ have been fought and won. Public finances are improving, competitiveness of peripheral economies is stronger and their external deficits have disappeared. Governance of the euro has significantly improved. Structural reform is taking place. Of course, the glass is still half empty – or only half full – if you prefer. My point is that policymakers have taken so many tough decisions that it is unlikely they will throw in the towel now. And the people of Europe have suffered so much in order to save the euro that it would seem very odd for them to give up now. See below, however, for a discussion of the risks.
3. Is inflation a threat?
Yes and no. The sustained ultra-loose monetary policies we have experienced since the crisis started must imply an inflation risk. However, the inflation risks in the advanced economies remain very small for this year, and probably next year as well, as there still is a lot of slack in the economies, and inflation expectations remain well anchored. The next challenge for central bankers is to normalise monetary policy at a pace that will let the recovery develop, yet nip any serious inflation in the bud. Inflation risks are more acute in emerging economies, where overheating of some sectors of the economy in recent years and the currency depreciation have pushed inflation up. The efforts to keep inflation in check are one reason why emerging economies are growth laggards.
As far as inflation risks in advanced economies are concerned, they are more likely to appear in asset markets than in goods and services markets, in my opinion.
Some people wonder if deflation is a risk. Given that inflation is well below target in the eurozone, deflation does, indeed, look to be a bigger risk in 2014 than inflation. However, I think that painful deflation1 is unlikely in 2014 or 2015. The best defence against painful deflation is economic growth, and we expect a broad pick-up of growth this year.
4. What will be the effects of ‘tapering’ and the end of QE?
The honest answer is that nobody knows. We are in uncharted territory. In a recent note (see ‘Who is afraid of tapering?’, Macro Focus 18 December 2013), I addressed this question by looking at what happened during the different periods of quantitative easing by the US Fed and the ‘tapering dry run’ between May and September 2013.
The conclusions of that study were:
1. that the rise in bond yields in the US will probably be modest as the market has largely priced in tapering;
2. that equity markets in advanced economies will be more volatile, but that the upward trend is unlikely to be broken by tapering as the direction of equity markets will be determined by economic fundamentals which will be equity-friendly;
3. that emerging market currencies and equities will be the most vulnerable as these markets are most at risk of an exodus of money.
On balance, I believe that the effects of tapering will not be overwhelming.
5. How will corporates behave in this environment?
Corporates have focussed strongly on cost-cutting in recent years. The result is that there is a lot of operational leverage in the sector. Any acceleration of growth, in particular an acceleration above expectations, will provide a powerful stimulus to earnings growth. Corporates will respond in two ways. First, they will increase investment spending. The initial signs that they are stepping up investment spending are coming through. Second, corporates will increase financial leverage, using the availability of cheap market funding. This will further boost their earnings numbers. In my opinion, 2014 will be a ‘sweet-spot’ year for corporates. Stronger growth and using operational and financial leverage will boost margins and earnings. Eventually, this development will give way to stronger wage growth and falling profit margins. However, that is likely to be a 2015 phenomenon.
Risks on the horizon
On balance, I am optimistic for 2014, if not very optimistic. Having learned the hard way, I realise that we must guard against complacency, so we must have a serious look at the risks.
a. Tapering and the end of QE
As I said above, we are in uncharted territory and while I think that the effects of tapering will be relatively modest, neither I, nor anybody else, can rule out that markets will riot. It is possible that bond yields in the US will rise more than we expect, undermining the recovery. Of course, in that case, the Fed and the markets will respond again to the weaker economy, but that would boost volatility. Markets for risky assets could be hit hard.
b. Re-escalation of the euro crisis
There are various potential sources for a re-escalation of the euro crisis. The ECB’s Asset Quality Review (the thorough health check of banks’ balance sheets) has the potential to produce unpleasant surprises, with capital shortages possibly larger than generally assumed. In addition, the process of forming a banking union could lead to a stalemate between European leaders. Third, Portugal and Greece will end their bail-out programmes this year. It cannot be excluded that they will need further financial assistance if the markets are unfriendly. Fourth, the European elections in May could result in significant gains for euro sceptic parties. It remains to be seen how markets will respond. They might decide that the determination on the part of the policymakers to support the euro has weakened and needs to be tested. And last, France and Italy appear to be lagging the recovery. These countries have achieved the least in terms in structural reform. They have, thus, failed to raise their growth potential. As other countries have made more progress and improved their competitiveness, the position of France and Italy has actually weakened.
c. Weakness of emerging economies
Policymakers in emerging economies are still trying to get to grips with some excesses built up over the past decade or so. Chinese policymakers are at the forefront, trying to control credit growth. If policymakers of emerging economies fail to control inflation or depress economic growth too much in their efforts to do so, this will have negative effects on the global economy at large. While it is clear that emerging economies play a crucial role in the global economy, I continue to think that they are more ‘followers’ of the global cycle than ‘leaders’. This is largely because of their growth strategy which continues to be heavily dependent on exports despite efforts to move to a model more based on domestic demand.
d. Japan’s tax hike
The Japanese government is planning to hike the sales tax in April as part of their strategy to put the public finances on a sounder footing. It remains to be seen how the economy will respond. In 1997 they tried the same, but that became a traumatic experience as it pushed the economy into a nasty recession. This time around, the Bank of Japan is ready to step up efforts to support economic activity, using other instruments should that be necessary. In that case, the aim will be to push the yen significantly lower. This could have destabilising effects on global financial markets.
1 One should distinguish between various forms of deflation, depending on its causes. Deflation resulting from falling import prices or strong productivity gains is generally welcome and raises the standard of living. In contrast, painful deflation occurs when aggregate demand is consistently below the output potential in an economy, forcing prices and incomes lower, which then pushes aggregate demand lower again. This can become a vicious circle from which it is difficult to escape. The key in this process is a contraction in the economy. That is why I say that the best defence is economic growth.