By: John Greenwood, Chief Economist, Invesco Ltd.
The economic recovery has been strongest in those economies where balance sheets are least impaired — primarily the emerging economies of Asia and Latin America, and those developed economies such as Australia, Canada, Sweden and Germany that avoided the worst excesses of the housing and credit bubble. Among the crisis-stricken, underperforming developed economies there is a clear ranking becoming visible: Those that have repaired their balance sheets most are doing best in terms of economic growth (relative to their potential) and stock market performance.
Thus the US is leading the way, having reduced by half the debt-to-GDP (gross domestic product) ratio that had built up between 2000 and 2008. The UK has made much less progress in deleveraging, and consequently growth is lagging that in the US. Meanwhile much of the euro-area is still in recession, having hardly deleveraged at all, with growth in the core economies adversely affected by the long depression in the periphery. Although emerging market economies generally have less indebtedness, and as a result enjoyed strong recoveries from 2009 through 2011, their high degree of export-dependence on developed markets reduced their growth rates in 2012 and will continue to do so in 2013.
In the US, I expect 2% to 3% growth at best during some quarters of the calendar year as tax increases agreed to under the fiscal cliff negotiations and spending cuts implemented by the sequester restrain both private and federal activity levels. There should be some offset from recovering housing and business investment, but I expect overall growth will continue to be subpar.
In Europe and the UK, the picture remains more subdued with growth restrained by public sector austerity and weak wage growth in the private sector. In the UK, the Bank of England is likely to embark on additional quantitative easing (QE) during the year, possibly before the new Governor Mark Carney takes over in July. But in Europe, the European Central Bank (ECB) has been shrinking its balance sheet while commercial banks reduce their lending to customers. The Cyprus crisis is likely to exacerbate the mood of risk aversion. Inflation remains a challenge for the UK, but in the euro-area there could be a risk of deflation within a year or two.
In Japan, the new government of Shinzo Abe is pressing forward with both monetary and fiscal expansion to overcome deflation, but may have to wait until it gains seats in the Upper House elections in July before it can ensure passage of its more ambitious restructuring plans. Another reason why the July election matters is that the current constitution requires a two-thirds majority in each house of the Diet to be amended. If Prime Minister Abe achieves this, General MacArthur's 1945 constitution can at last be updated.
In the emerging economies, growth will necessarily remain largely dependent on domestic drivers such as consumer and private capital spending as no strong rebound in exports is in prospect. As such structural rebalancing in economic activity requires years rather than months; the results will be slow to show up in enhanced growth rates. Accordingly, growth is likely to be slower than full potential in the emerging economies in 2013. Inflation should only be a problem in a small minority of these economies such as Argentina and Venezuela.
In short, 2013 will be another year of subpar growth with low inflation as the dual problems of balance-sheet repair in the developed economies and structural rebalancing in the emerging economies restrain overall spending growth.
In financial markets, the S&P 500 Index has largely ignored the problems of Europe, extending its rally since last November through the first quarter for a cumulative rise of 15%. However, despite the deepening economic downturn in the eurozone, the FTSE Eurofirst 300 Index increased by about 14% in US$ terms over the same period.1
Real GDP in the fourth quarter of 2012 was revised upwards from -0.1% as originally reported to +0.1%, mainly due to a 0.5 percentage point swing in the contribution from net exports. However, this downturn in performance should be viewed as a one-off event driven by the slump in defense spending and business inventories ahead of the fiscal cliff and unlikely to be extended in coming quarters. Growth in the first quarter of 2013 is likely to be in the neighborhood of 2.5%, with improved housing values and rising wage rates counterbalancing the higher income and payroll taxes imposed under the fiscal cliff agreement. Nevertheless the Congressional Budget Office projects that the fiscal tightening — due to tax hikes and the sequester — will reduce economic growth by around 1.5% in 2013, creating a strong headwind for the private sector to overcome.1
Looking ahead to the second quarter and second half of the year, the US recovery is now broadly on track with personal consumption expenditure (PCE) and business investment likely to grow at solid, but unexciting, rates. PCE has been buffeted by the shifting of dividend payments into the final quarter of 2012 ahead of the expected income and payroll tax changes in the first two months of the year. However, with consumer confidence recovering, jobless claims falling, nonfarm payroll employment rising by 236,000 jobs in February and wage rates on the rise again, PCE should grow at a moderate pace over the remainder of the year. Likewise, business investment has seen some stabilization after the plunge in orders in the second half of 2012, with new orders within the Institute for Supply Management (ISM) data increasing by 4.5% in February to 57.8. Moreover, the ISM figures for manufacturing were strong across-the-board in February with a reading of 54.2
On the policy front, Congress has now extended the administration’s spending authority (essentially delaying deep spending cuts) until September, thus averting the danger of a federal shut-down at the end of March. Consequently most of the action is going to be in the hands of the Federal Reserve (the Fed), where there has been active debate about the appropriate size of the Fed’s $85 billion monthly asset purchases. Since the continuation of QE is now dependent upon the unemployment rate falling below 6.5% on a sustainable basis, it was of significant interest to see the Federal Open Market Committee (FOMC) members’ economic forecasts released after their latest meeting. According to the data, 14 out of 19 members do not foresee unemployment falling below the 6.5% threshold until 2015 or 2016, suggesting it will be at least two years before the Fed will start to unwind its balance sheet expansion. Even so, the Fed could start reducing its rate of monthly asset purchases from $85 billion per month to something less at an earlier time. In the words of Chairman Bernanke at the March FOMC press conference, “As we make progress toward our objective, we may adjust the flow rate of purchases from month to month to appropriately calibrate the amount of accommodation.”
Financial markets are likely to anticipate such shifts in strategy by the Fed, causing yields on “safe-haven” securities such as the Treasuries and mortgage-backed securities that the Fed has been buying to back up somewhat. Financial institutions have also been focused on the build-up of merger and acquisition (M&A) transactions and the increase in debt issuance by nonfinancial corporations, but the Flow of Funds data just released for the third quarter of 2012 suggest that the US as a whole is still in deleveraging mode, even if the pace of debt repayment has slowed. As long as these moves by the Fed or the renewed leveraging up in financial markets are not accompanied by any rise in the actual or expected inflation rate, or by any surge in the real growth rate of the economy, it seems unlikely that the shock to the markets will be comparable with the 1994-to-1995 episode when US long rates backed up nearly 300 basis points.2
Since I expect Consumer Price Index (CPI) inflation, which depends ultimately on broad money and credit growth, not the size of the Fed’s balance sheet, to remain subdued at around 1.7%, and real GDP growth also to be 1.7% over the calendar year, it is hard to envisage changes in Fed policy being the source of serious market disruption in 2013.
Euro-area real GDP declined by 0.6% quarter-on-quarter in the fourth quarter of 2012, reflecting not only the ongoing recessions in the periphery, but spreading weakness in the core. German real GDP contracted by 0.6% while France’s real GDP declined by 0.3%. Weak domestic demand has been accompanied by falling consumer and business confidence. The weakness has continued into the first quarter of 2013: The February composite manufacturing Purchasing Managers Index (PMI) for the eurozone fell from 48.6 to 47.9, and further to 46.5 in March, pointing to the prospect of a falling real GDP in the first quarter. New orders were just 45.2 suggesting further declines in the future. Even Germany’s manufacturing PMI declined below 50 in March to 48.9, while its services index slumped from 54.7 to 51.6. This was followed by Germany’s IFO Index, which measures business optimism, declining to 106.7. Meanwhile France’s manufacturing PMI fell to 43.9 and services to a very weak 41.9, suggesting France will also remain in recession.1
Although the eurozone economies have performed poorly, financial markets had until recently largely shrugged off the area’s economic weakness, buoyed by the upswing in America and by the strong assurances from ECB President Mario Draghi that the authorities would do “whatever it takes” to ensure the survival and integrity of the euro. However, the Cyprus crisis has rudely reminded financial market participants that the euro crisis is by no means over.
At least two aspects of the Cyprus crisis are worrying for the long-term outlook. First, the initial problems of Cypriot banks were caused by having to take 80% write-downs on Greek government debt when the Troika demanded a bond exchange to lower the value of Greek government debt outstanding. Cyprus has a smaller banking system relative to its GDP than Luxembourg, yet it is being compelled to ditch its successful international banking business in order to conform to a euro-area business model for banking. If this restructuring is forced through, then Cyprus will follow Greece, Ireland and Spain into depression.
Second, the nature of the Cypriot settlement, a 10 billion euro loan from the Troika worth 55% of Cyprus’s GDP, is bad news for the eurozone banking sector in the short term. Under the “bail-in” scheme, shareholders, bondholders and uninsured depositors of Cyprus’s second largest bank, Laiki, will lose almost everything, while the remaining insured deposits and “good assets” will be folded into Bank of Cyprus, the largest bank, which itself will be recapitalized with funds from uninsured depositors, equity shareholders and bondholders. This marks the first time, following 503 billion euros of taxpayer-funded rescue schemes for other peripherals, that the EU authorities have “bailed-in” other creditors. The implications are clear: Future eurozone banking problems will have to be solved by funding from creditors, not taxpayers. This implies euro-area banks will have to be much more conservative in their funding, leading to extended deleveraging.
In view of this outcome, it is clear that the euro-area orthodoxy implies further austerity and almost endless depression. To achieve the necessary structural adjustments in the euro-area economies, the austerity programs enforced by the Troika are likely to need to continue much longer than had been planned. This means that the prospects for GDP recovery in the eurozone in 2013 or 2014 are diminishing by the month. My forecast is for real GDP growth of -0.2% (compared with an estimated -0.5% in 2012). In short, there will be no meaningful recovery in 2013, and there is a risk of the downturn extending into 2014. Inflation, too, should remain subdued at 1.7%, held down by low money and credit growth, high rates of unemployment and spare capacity, with some deflation in the periphery. The longer term danger is a “Japanization” of Europe as growth stalls and deflation takes hold.
In the UK, the first quarter of 2013 was notable for three significant developments: the downgrade of UK government debt from AAA status by Moody’s on Feb. 22, the further increase in the projected public-sector debt ratio (to 85.6% in 2016-2017) announced in the budget on March 20, and the chancellor’s decision to amend very modestly the remit of the Bank of England’s Monetary Policy Committee.
Moody’s downgrade of the UK followed the release of the real GDP figures for the fourth quarter of 2012, which showed a contraction of 0.3% quarter-on-quarter, confirming the persistent weakness of UK economic performance. For Moody’s, this translated directly into lower tax revenues and therefore higher borrowing requirements in the future. Normally one would expect borrowing costs to rise as a result of such a downgrade, but in this case — like the US in the summer of 2011 — gilt yields actually edged downward in the week of the announcement, and the main impact was on sterling, which fell 6% on a trade-weighted basis over the quarter.
Britain’s macroeconomic data continue to present a complicated picture. On the one hand, overall GDP remains stagnant with 0.2% growth of PCE in the fourth quarter offset by a decline of 0.4% in gross fixed investment. But on the other hand, if net exports are excluded, the rest of the economy (i.e., domestic demand) increased by as much as 1.8% in the year to the fourth quarter of 2012. These figures strongly suggest that the main problem for Britain is the weakness of exports — despite the depreciation of sterling — and especially the economic weakness in Europe, which accounts for as much as 40% of Britain’s exports.
Another paradox is the apparent mismatch between the stagnant output and expenditure figures on one side and the relatively buoyant employment figures on the other. Thus, despite the fact that real GDP grew by only 0.2% over the year in 2012, employment increased by 300,000 jobs in 2012, and the OBR expects the creation of another 300,000 jobs in 2013, a growth rate of 1.0%. For every job lost in the public sector, six jobs have been created in the private sector. Moving to the January-March quarter the PMI for services showed a healthy increase to a five-month high of 51.8, and February retail sales volume showed a strong upturn of 2.1%.
However, with the Office of Budget Responsibility (OBR) reducing its growth forecast for 2013 to just 0.6%, the budget figures showed that progress in reducing the current budget deficit has essentially stalled, with public sector net borrowing (PSNB) adjusted to eliminate one-off factors remaining at around £120 billion for the three financial years 2011-2012 through 2013-2014, and declining from 7.9% of GDP to only 7.5%. Subsequent projected declines in the deficit to 2.3% of GDP in 2017-2018 depend heavily on the OBR’s forecast of a recovery in economic growth (to 2.3% in 2015 and 2.7% in 2016).
Between the Autumn Statement and the budget announcement, the underlying position of the public finances had deteriorated sharply. Assuming the OBR forecasts are reliable, the cyclically adjusted current budget will now return to surplus in 2017-2018 instead of 2016-2017, and this means the ratio of government debt to GDP will peak at 85.6% of GDP instead of 79.9% a year earlier. Strategically the chancellor could not ease fiscal policy as this would add to borrowing, yet he could not cut borrowing as this would take demand out of an economy already suffering from weak aggregate demand.
The result was a neutral budget where tax cuts (such as an increase in the personal allowance to £10,000, a further reduction in corporation tax, the cancelation of a planned rise in fuel duty, and 1p off a pint of beer) were offset by revenue increases (tougher anti-avoidance measures and increases in national insurance associated with the revised state pension system from 2015-2016 onwards). The other key technique was to cut current departmental spending (which is inside the cyclically-adjusted balanced budget target) and increase capital spending (which is outside).
Finally, the Bank of England’s (BOE) mandate to keep CPI inflation at 2% is to be adjusted slightly in two ways. First, to take account of unintended deviations from target, the BOE will be required to spell out the trade-off that it makes, for example, by not tightening immediately in response to a commodity-price induced rise in the reported inflation rate. In such a case the BOE’s Monetary Policy Committee (MPC) might explain how an immediate tightening could undermine economic growth but fail to achieve any gain in longer-term price stability. Second, the BOE has been instructed to examine the feasibility of following the US Fed by issuing forward guidance, setting intermediate thresholds (e.g., for the unemployment rate) to influence expectations about the future path of interest rates. Furthermore, UK bank lending is still declining.
With inflation likely to remain around 2.8% for much of the year and wage growth likely to be weak, the scope for a real GDP recovery is inevitably limited. 2013 in Britain is expected to be another year of slow growth and balance sheet repair while waiting for a eurozone recovery.
The new Liberal Democratic Party (LDP) government led by Shinzo Abe has made significant changes to economic policy since the Lower House election in December, and these will continue through 2013. Already the changes in monetary and exchange rate policy are starting to have an impact. Fiscal policy changes should follow, and the third element of Abe’s program includes structural reforms and deregulation. Separately on the political front, constitutional changes are likely to be introduced after the July elections for the Upper House.
Anticipations of Prime Minister Abe’s return to power led the yen exchange rate to fall steeply from around 76 yen per US$ to 95 yen. This helped promote a strong rally on the Tokyo Stock Exchange, encouraged by the expected changes in policy at the Bank of Japan (BOJ). Initially the Abe administration effectively demanded the BOJ raise its self-imposed inflation target to 2%, and subsequently Mr. Abe has appointed Haruhiko Kuroda as the new governor, along with two new deputy-governors. The BOJ will no doubt embark on more aggressive asset purchases and balance sheet expansion, but the big question is whether the BOJ can induce changes in behavior among the commercial banks whose lending has been static or falling for most of the past decade, or among the firms and households that have been unwilling to increase their indebtedness by borrowing more.
One of the underlying problems is that neither households nor financial corporations, including banks, have done much deleveraging over the past few years, and debt ratios remain high. In the nonfinancial corporate sector, there was a substantial reduction of indebtedness between 1998 and 2005, but since then there has been very little further change, suggesting that most sectors have been happy to maintain their current debt-to-income ratios unchanged for the past seven years. Expanding the BOJ’s balance sheet should not be difficult, but inducing other sectors to join the expansive mood may prove a much tougher challenge.
The Cabinet Office revised the GDP figures for the fourth quarter of 2012 from a decline to a small upturn, reflecting higher estimates for PCE and fixed investment. For the year as a whole, the revised overall figure of 2.0% real growth benefitted from the downturn in earthquake-affected 2011. Looking ahead, the weaker yen and a gradual easing in monetary policy should ensure positive growth, but consensus expectations are for a modest 1.2% real GDP growth. Ironically, the weakness of the yen and higher imported raw material prices may give the impression that the BOJ is succeeding in attaining its target, but the real test will come over the longer term when it becomes clear whether the new monetary policy is percolating through to the commercial banks, companies and households. My forecast is for just 0.1% inflation for the year as a whole.
The other two economic objectives of the Abe government include a more expansionary fiscal policy focused on construction projects, and structural reforms or deregulation. The former reverses the previous Democratic Party of Japan administration’s mantra of “from concrete to people” (a redirection in public spending away from public works to social security programs) – in spite of the fact that these policies were singularly unsuccessful in the 1990s. The plan is to allocate ¥200 trillion over 10 years for public works, starting with a package of “emergency economic stimulus measures” amounting to ¥20.2 trillion (almost one-quarter the size of the annual budget) in the hope of creating 600,000 jobs and boosting real GDP to 2% growth. In the next fiscal year (from April 2013) it is proposed to raise public works spending to ¥5.5 trillion, compared to ¥4.6 trillion in the 2012 fiscal year.
The structural reforms and deregulation program will require the LDP to win a majority in the Upper House at the July elections, but even then none of the structural reforms or deregulation will be easy. Joining the US, Canada and Australia in the Trans-Pacific Partnership would imply a major shake-up of Japan’s politically powerful and highly protected farming sector and a commitment to open up service industries such as insurance to foreign competition. Similarly, relaxing health care and labor market regulations that currently stifle growth, or allowing more immigration and older-age employment would all face formidable opposition from vested interest groups.
If Prime Minister Abe continues to be as popular as his recent 70% approval ratings suggest, then he may also be able obtain the two-thirds majority that he needs in the Upper House to amend Japan’s post-war constitution and end some of the strictures imposed by General MacArthur under the US occupation after the Second World War. Japan under Mr. Abe faces some momentous decisions over the next few quarters.
CHINA AND NON-JAPAN ASIA
Following the National People’s Congress in March, China has recently completed a leadership change with Xi Jinping becoming president of the Republic, general secretary of the Communist Party and head of the Military Commission; and Li Keqiang taking over as premier with responsibility for economic policy. So far the leadership has indicated that continuity and stability will be their watchwords, but in reality there is a huge agenda that needs to be addressed.
Last year the Chinese economy slowed much more than the official figures suggested under the impact of both domestic and external factors. On one level, the policy response was held back by the leadership change, and decisions were understandably cautious rather than substantial. On another level, the policy options have been constrained by the unintended results of the 2008-2009 stimulus program — a property bubble and CPI inflation of 6.5%. Indeed, the authorities are still imposing new administrative restrictions in an effort to combat the unwelcome spike in property prices. Moreover, even though normal bank lending has largely been brought under control, “shadow bank” lending — or loans from nonbank financial organizations including property-related trust management entities — are still rampant, growing at over 35% year-on-year in the December quarter. It therefore makes no sense for the Chinese authorities to ease monetary conditions in the official bank sector at present.
On the external side, exports have started to recover modestly from the slump of last summer and autumn, but China’s extreme concentration on exports and fixed capital investment — both areas that are being hard hit by the subpar growth in the US and the recession in the eurozone — makes a rapid turnaround difficult in the face of weak global demand. The currency has been held broadly stable in the range of 6.20 to 6.40 against the US$ over the past 15 months, but what China really needs is more ambitious liberalization of capital flows as well as a faster pace of domestic interest rate deregulation. Unfortunately neither of these two objectives is likely to be tackled vigorously by the new leaders. These constraints on deregulation as well as the slow growth of China’s key export markets imply that growth in 2013 will be little better than last year’s 7.5%.
On the inflation front, there is no danger of a runaway surge in China’s general price level since broad money and credit remain basically under control, even though the authorities remain acutely sensitive about upswings in property prices, and there are liable to be further episodes of food price inflation. I expect overall CPI inflation to be about 2% for the year as a whole.
The picture for the rest of non-Japan Asia outside China is broadly similar to China’s outlook — constrained by continued weakness of key export markets and by their inability or unwillingness to pump-prime too much at home. In Korea and Taiwan, domestic demand is much weaker than in past business upswings, whereas in the Association of Southeast Asian Nations (ASEAN) region, conditions are more buoyant but the authorities are wary of allowing too much credit easing. Only in Indonesia is credit growth clearly excessive. Nevertheless, several economies have cut interest rates and eased credit conditions to try to offset the external slowdown, but these measures alone will not be sufficient to reverse the global trend toward slower growth and lower inflation.
Commodity prices have been subject to a variety of cross-currents in the past year. For example, the steep downturn in China’s growth rate in mid-2012 led to sharp falls in iron ore and coking coal prices. Looking forward, in contrast to previous business cycle upswings, it is highly unlikely that in 2013 any of the major economies will see a surge of liquidity or a sudden upswing in business activity of the kind that would be needed to generate a sustained surge in demand for commodities.
It is also the case that fears of inflation (e.g., from additional QE or a further cut in eurozone interest rates) are gradually dissipating. In other words, the expectations that dominated market psychology over the past year or two and that helped to feed short-term moves in commodity prices are no longer so prevalent. As central bankers keep saying, inflation expectations are well-anchored. The fundamental driver behind this trend is that balance-sheet repair is inherently disinflationary, or even deflationary. Consequently, as long as the major economies are in balance-sheet repair mode, commodity price surges can only result from weather or supply disruptions such as we see from time to time in the agricultural complex.
One other factor that has arguably contributed to more lasting moves in commodity prices is the large amount of financial capital committed to commodity investments in modern financial markets, especially through exchange-traded funds (ETFs). However, there are clear signs that some of the precious metal funds have been losing support as banking problems around the world are gradually resolved and inflation remains subdued.
Stock markets in the developed world have performed well over the past six months, led by the US. The underlying logic that explains this — at least for the US — is that the health of the US private sector is gradually recovering. After a traumatic shake-out in 2008 and 2009, US households are at last seeing their wealth and incomes starting to recover, US nonfinancial companies are enjoying healthy profits and can raise funds cheaply on financial markets, and the US financial sector is finally returning to growth and profitability, albeit at lower (and safer) levels of leverage.
The big question for investors is whether other developed economies need to see comparable changes in the financial health of their major sectors, or whether the US remains so dominant that it can drive the financial performance of other markets irrespective of local conditions. If other markets can ride on the coattails of the US upswing, then the urgency for balance-sheet repair diminishes. However, there is a risk to regions such as the eurozone and the UK: If they fail to repair their financially broken sectors, their economies could become a sort of sideshow, cut off from the global upswing — in much the same way as happened in Japan in the past two decades.
In the emerging world where balance sheets are generally in much better shape and where Asian and Latin American currencies are often tied informally to the US$, it is much easier for markets and economies to follow the lead of the US. The only problem is their heavy dependence on exports to the weaker parts of the developed world such as the euro-area and the UK. For this reason I expect a year of moderate growth, not exuberant recovery.