Strategy & economics
The health of nations
Strategy & economics
The health of nations
The first quarter saw a marked rise in uncertainty over the outlook for the world economy. In essence, this reflected growing concern over adverse developments in key Asian economies and the potential for these to have negative consequences for the larger western economies. Central banks and independent forecasters alike, lowered their growth expectations for 2016, and there were even murmurs about the possibility of recession. We believe that the risks to the ongoing recovery in the West have been overstated by many commentators. The damage to growth in economies such as the US, UK and Germany from problems in China and elsewhere is likely to be less than some are suggesting. Indeed, the situation now prevailing is not dissimilar to that at the end of the last century, when there were fears that the Asian debt crisis would drag the world economy into recession. In the event, most major developed economies marched on largely unscathed.
Nonetheless, it is worth taking some time to understand the linkages between developing and advanced economies, and how weakness in the former could undermine growth in the latter.
The most obvious characteristic of the period prior to the ‘great financial crisis’ was the debt-financed escalation in demand in key western economies. During this period, emerging manufacturers and commodity producers thrived as their exports to the West surged. Excess demand in the West was reflected in growing trade and current account deficits. Since the recession, advanced economies have been forced to rebalance. This has resulted in reduced growth in overall activity and, crucially, much reduced increases in imports. Overall, this has meant that the current account position of advanced economies has moved from deficit to surplus. In other words, having been net borrowers, advanced economies have become net savers. Following a period during which emerging manufacturers and commodity producers invested heavily to increase production capacity, the current environment is characterised by excess capacity and has become much more competitive. In effect, commodity producers and manufacturers are capable of supplying much stronger demand growth in Europe and North America than is now evident.
So, prices of manufactured goods are under downwards pressure and those of many raw materials and energy products are falling. In itself, this is not harmful to the West. In fact, falling import prices provide a demand stimulus to most western economies. There are two main ways that this boost could be offset. First, exporters to emerging economies will find the demand environment in those countries much more difficult. Second, if growth problems in emerging economies lead to widespread debt defaults, this could feed back into the western financial system, were the exposure of banks to bad debt to limit their capacity to lend to western consumers and businesses. Taking the latter possibility first, there is no evidence to date that there has been any negative impact. In fact, lending to households currently seems to be gaining momentum. This is clearly something that needs to be monitored carefully, and even the merest hint of a problem will leave financial markets feeling very tense. On the issue of the West’s export exposure to emerging economies, this is more important to some economies, such as Germany, than to others, including the UK. Overall, however, the positive impact on domestic demand from falling import prices is more of a gain than slower export growth is a loss.
This does not mean we are feeling complacent or that we take no account of the potential for problems to occur. However, we do believe that financial markets have become over-anxious and that central banks’ actions may have been counterproductive. While in the US, the Federal Reserve’s decision to put on hold its plan to steadily raise interest rates during 2016 is understandable, the decision by the European Central Bank (ECB) to adopt a negative interest rate policy (alongside even greater quantitative easing) sends entirely the wrong signal and is more likely to restrict than improve the availability of credit. So, in Europe especially, there is a risk that the ECB talks us into believing there is a greater problem than actually exists. Indeed, the more important message with regard to the performance of the eurozone is that it is gradually gaining momentum.
Interestingly, although the UK has had one of the best performing G7 economies over the past few years, the Bank of England has yet to contemplate with any seriousness the need to raise interest rates. In the long term, it may live to regret not beginning the process of normalising monetary policy at an earlier date. However, it has been able to hide behind low headline inflation and clearly continues to consider that the greater risk is in raising interest rates too early.
Whether the Federal Reserve and Bank of England will prove right in their assessments remains to be seen. We are of the view that the tightening in labour markets in the US and UK could lead to appreciably higher wage inflation over the next 18 months than either central bank is currently contemplating. This would increase pressure to raise interest rates, and would leave financial markets feeling more exposed. The latter is likely to prove an ongoing issue.
During the period prior to the recession when growth in western economies was averaging around 3%, temporary dips below this rate did not feel particularly uncomfortable. With growth now averaging closer to 2%, the short-term dips leave us feeling much less secure. There is an obvious irony here: duller growth may be safer and have greater sustainability, but it does not give rise to such a strong feel-good factor.
While we remain reasonably constructive about the outlook for the larger economies in Europe and North America, we continue to have concerns about growth elsewhere. We have long been sceptical that the reforms encompassed by ‘Abenomics’ would change meaningfully the growth profile of Japan. We remain sceptical, and we have not been surprised by the economy’s evident failure to break out of its decades’ long phase of desultory gains in activity.
Meanwhile, it will take a prolonged period for emerging manufacturers and commodity producers to adapt to slower western demand growth. Gradually, the problems of excess capacity will diminish, but headline growth rates will remain under pressure. In this context, it is interesting to make the contrast between China and India. China has typified the issues of relying too heavily on export growth, and it has struggled to effect its desire to become more focused on domestic services demand and output.
On the other hand, India is a less open economy, and its growth prospects are more reliant on its ability to achieve internal political and economic reforms. Financial markets reflected these concerns and uncertainties, in the first quarter of 2016, with increased volatility and heightened correlations between risk assets. The continuing fall in the oil price unnerved markets, despite a general acknowledgement that this was a supply side phenomena (rather than due to weak demand), leading to significant falls in the energy sectors within equity markets and a widening of related credit spreads, most notably in US high-yield.
Despite lower oil prices being a good thing for many parts of the economy, mainly consumers who may have a greater propensity to spend their windfall, the losers tend to be fewer and thus harder hit. It is this focused risk that has wiped over US$2 trillion off the value of global oil and gas companies since June 2014, as lower oil prices have not just impacted earnings, but their dividend paying and debt servicing capabilities. Concerns over future dividends of the energy and mining sectors also weighed on the broader markets.
The changing sentiment of investors created significant movements in equity markets but also in bond markets where lower levels of liquidity exaggerated the impact of fund flows. While the US and UK equity markets recovered their double-digit declines early in the quarter, previously popular investment areas such as European and Japanese equity markets had the biggest downward moves of almost 20%, and did not fully recover. Similarly credit spreads overall ended a very volatile quarter effectively unchanged although European high-yield spreads closed a little higher.
Central bank action, and nonaction, continued to weigh on markets. Apart from the overtly pessimistic signal of negative interest rates, as mentioned, there are increasing worries that there are limits to negative interest rate policies and that they may actually dampen growth by decreasing the profitability of the financial system and thus the credit availability. It was no surprise that the financial sector was amongst the most volatile this quarter, primarily in Japan and Europe where this policy is being implemented, and with financial repression likely to continue for the foreseeable future, gold had one of its best quarterly returns in the last 30 years.
One of the positives out of the recent concerns is that corporate earnings expectations have declined to the extent that positive surprises are more likely, especially as the oil price appears to have stabilised. However, lowered expectations for global growth, as well as the deepening of negative interest rate policy, ensured that most government bond yields declined significantly over the quarter, even in the UK and US where core inflation is picking up. The divergence of market views across different asset classes is likely to ensure that volatility remains heightened for some time until we see a clearer view of regional growth rates and the inflationary impact of a tightening labour market in the UK and US. In such an investment environment, ongoing income provides both emotional as well as valuation support.
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