Global Macro View – 2014Q1 – How could it all go wrong?

by: Nick Kounis , Aline Schuiling , Peter de Bruin , Philip Bokeloh , Maritza Cabezas

Global Macro View - 2014Q1 - How could it all go wrong? ()
  • Our central view is that stronger growth lies ahead: The global economy has been hit by a number of headwinds that are now abating. Stronger growth will be led by the US, where all the lights for above-trend growth have turned green. Following a period of deleveraging and recovering asset prices, private sector balance sheets are looking healthy, setting the scene for stronger investment and consumption. Stronger US demand will be facilitated by easier lending conditions, sky-high profits, improving job growth, and ebbing uncertainty, while in the eurozone drags on private domestic demand are easing. In addition, the pace of budget cuts has already dropped sharply in the US and eurozone, following aggressive fiscal consolidation last year. Stronger economic growth in the US and a slow recovery in the eurozone should lift exports around the world. For instance, three-quarters of Asia’s exports outside of the region go to the US and EU. However, a number of key risks to the economic outlook remain.
  • Emerging market risks have taken centre stage: There has been a wave of capital inflows into emerging market assets in recent years and there is a possibility that these flows will reverse abruptly, leading to plummeting currencies and asset prices. Our view is that EM fundamentals as a whole are healthy. They have a current account surplus on aggregate, external debt is low and currency reserves are extremely elevated. However, investors could simply get spooked by the few bad apples. More fundamentally, there are downside risks to the growth outlook in China. This reflects the combination of industrial overcapacity, corporate and local government leverage and bad debt that has resulted from the investment boom of the last few years. As the authorities attempt to transform the economy to a consumption-led growth model, to reduce the growth of leverage and allow market forces to determine prices, there is a risk that the correction in investment and leverage will be abrupt. Our central scenario is that the authorities will be able to manage the transition smoothly. They have the tools to manage the economy, while they also have the financial firepower to provide bail-outs where necessary.
  • Risks related to the US and eurozone: The unwinding of the Fed’s unprecedented monetary stimulus, could lead to financial market instability, manifesting itself in an unwelcome sharp tightening in financial conditions. In addition this risk could exacerbate or trigger capital outflows from emerging markets. However, with inflation low, the US central bank has the freedom to remove stimulus at a very slow pace. Meanwhile, there are very real worries that the eurozone could become the ‘old Japan’ given a combination of slowly deleveraging banks and deflation. Ultimately, we think that policymakers will take the necessary actions to avoid these risks. Finally, the eurozone’s sovereign debt crisis could re-escalate. Any event that damages the credibility of the ECB’s conditional sovereign safety net could lead to a re-escalation of tensions, though this still does not look very likely.