Global recovery to shrug off bad weather

12 March 2014   Category: News, Asia, Global   By Asia Asset Management

Our [Schroders] updated forecasts continue to paint a picture of recovery in the world economy, led by the developing world. Forecasts for the latter are little changed this month, but we have edged down our numbers for the emerging markets once again. Overall global growth is forecast to accelerate to 3% this year after 2.6% in 2013.

In the near term this is consistent with the latest purchasing managers indices (PMI’s), which show the BRIC nations struggling to gain traction whilst the developed economies remain firmly in expansion territory, despite having softened recently.  Looking further out, our emerging market downgrade is in response to the tightening of monetary policy across the region which will weigh on growth, offsetting the benefits of a lower exchange rate. 

For the US we have left our growth forecast at 3% for this year and next based on the judgement that much of the recent weakness in activity has been due to the adverse weather. The number of heating days* this winter has been exceptionally high and the cold weather has taken a toll on the economy, particularly the construction and retail sectors. Signs are that with the cold having continued into February, the data releases in March will also be influenced by climatic conditions.

Not all of the weaker data in the US can be attributed to the weather: we expect some payback in the first quarter as a result of a surge in inventory building and capital expenditure in the second half of 2013. As a result the quarterly profile for growth has altered with a softer first quarter than previously expected. Nonetheless, we continue to look for a recovery as housing improves and the fiscal drag, which weighed on growth in 2013 fades. 

Elsewhere, we have pushed up our UK growth forecast to 2.6% for this year (from 2.4%) and have raised that for Japan slightly. Both changes assume that some of the momentum from 2013 spills over into 2014. However, we expect the UK to find 2015 challenging as political uncertainty weighs on activity. Japan is expected to experience a more immediate setback as the consumption tax increases. Our eurozone forecasts are largely unchanged, but within the region we have raised the peripheral economies at the expense of the core.

We have brought forward our first US policy rate hike to the third quarter of 2015, to reflect a faster than previously forecast fall in unemployment. We still expect the Fed to end QE by October this year. By contrast, the Bank of Japan is expected to step up asset purchases in the second quarter of this year as the economy weakens in response to the consumption tax increase.  Contrary to market expectations we do not expect the Bank of England to raise interest rates until 2016.

Since the US is the only of the major developed economies tightening policy over the forecast horizon, our forecasts factor in a stronger US dollar.

Risks and scenarios

The distribution of global risks is still skewed toward the downside for growth and inflation. Top of the list on the downside is a hard landing in China which then impacts the rest of the emerging markets, particularly the more vulnerable deficit economies – the China financial crisis scenario. While all but the most bullish commentators have recognised that China is going through a period of structural reform which will necessitate weaker growth, views diverge on the ability of the authorities to restructure the financial sector without a significant hit to growth.

Recent experience in the West suggests that de-leveraging an economy is fraught with systemic risks as, like a gigantic game of Jenga where players remove blocks from a tower, it is not always clear which loan default will prove to be the one which brings the whole structure tumbling down. We take comfort from arguments that the wealth management products which constitute the bulk of the shadow banking system are not leveraged and are more like fund management products than bank loans. Nonetheless, the reluctance of the authorities to allow a significant default suggests that there may be more risk in the system than widely perceived. Even without leverage the losses incurred by investors are likely to be a drag on activity as households try to make good their savings whilst making it more difficult to finance future projects.

If China does experience a hard landing the spillovers would be significant, but largely felt in the emerging world. For example, one recent model suggests a negative impulse of 1% in China’s GDP would reduce global growth by just under 0.5% after four quarters. Of this, 12 basis points would be the direct impact on China with the remainder coming from the rest of the world. Breaking this down further the emerging markets would experience a slowdown of about 75 basis points with the greatest losses in Latin America and EMEA. The developed world would lose 20 basis points in growth, a smaller hit as part of the shock from China is mitigated by lower commodity prices, which act like a tax cut to consumers.

Our other deflationary risk scenarios include the eurozone dropping into outright price deflation and one where Abenomics results in a significant move in the yen to 130 against the US dollar (Abenomics squared). Our final downside scenario – trade war – would take us in a stagflationary direction as the territorial island dispute between China and Japan escalates. Trade barriers increase resulting in weaker growth, whilst firms hoard commodities pushing up prices and inflation.

On the upside we see a G7 boom, an extension of our previous US boom scenario to Europe and Japan. The combination of pent up demand in the household sector combined with increased capital expenditure by the corporate sector results in a much stronger increase in activity. Such a scenario would require a significant shift in animal spirits and there is also likely to be higher inflation and tighter monetary policy.

*Heating degree days are a measure of temperature, weighted by population, calculated by taking the average temperature in a day. If this number is less than 65°F (18°C), it is subtracted from 65°F to find the number of heating degree days. If it is above 65°F, a score of zero is registered for the day. The heating degree days for a given month are calculated by summing the total daily heating degree days.