The global outlook for 2014

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London-based economist Andrew Hunt looks ahead and wonders what 2014 will be like for the markets. He says there may be moments of economic optimism within certain economies but in general he expects another year of essentially lacklustre growth in the global economy that will be inconvenient for many governments and policymakers. Here he explains his reasons for this view.

Wednesday, November 13th 2013, 9:05AM 2 Comments

by Andrew Hunt

If we were to cast our minds back 20 years to this time of the year in 1993, we would have found that the world economy was in the doldrums. The US economy was plagued by a large budget deficit and seemingly struggling to emerge from the recession that had followed the Savings and Loans Crisis; Japan’s Bubble Economy had burst and left behind it “mountains” of debt; the European ERM Crisis was upon us; and many feared that the emerging markets were in the midst of an unsustainable bubble.

Over the next few years, though, economic growth picked up, US tax revenues soared and the economy entered a period of “Goldilocks growth” that we believe owed very little to the central banks and everything to the advent of the personal computer and the Internet revolution. The Golden Age that was the mid-1990s was hugely positive for financial markets and it was due, in our view, to the surge in productivity, value added and supply-side-led growth that proved both profitable and socially “inclusive”.

Unfortunately, the PC revolution had run its course by the late 1990s and, with no obvious replacement, this led to a slowdown in productivity growth and “real” wealth creation (what economists call value added) that the authorities implicitly attempted to conceal first through the use of a corporate sector-based credit boom in the late 1990s, a household sector-based credit and mortgage boom in the mid-2000s and, more latterly, a public sector credit boom. These successive credit booms have not generated real wealth (hence the volatile but essentially flat trend in financial markets) and they have not been socially inclusive; all that they have succeeded in doing is creating periods of artificial growth in aggregate demand, while leaving the supply side of the economies not just unchanged but compromised.

Described at its most basic level, the total sustainable output of any economy can be defined by the level of employment multiplied by the average level of productivity. Long term employment will be determined by education, entrepreneurship and other “real world factors”, while the level of productivity is a function of past capital expenditure, innovation and business efficiency. In practice, these factors will be affected by a mixture of social factors, politics and even luck, but what will have only a relatively small impact on these real factors is the level of nominal money or credit within the economy. 

Even in the US, in which the central bank has been pouring money into the system, capital spending and high value-added employment trends remain very weak. Central banks almost by definition can only control (and even then only up to a point) nominal factors and there is little that they can do to help the real economy over the long term except perhaps to create a stable monetary environment in which private economic endeavour can flourish. Unfortunately, quantitative easing policies (QEP) seem to create financial volatility rather than stability in our experience.

Based on these factors, we would argue that if the authorities do wish to create a sustainable recovery in the global economy, then they should seek to gradually exit their manipulation of the monetary and nominal economy and instead focus on the types of supply-side reforms and encouragement of innovation and entrepreneurship that made the mid-1990s so successful. Were they to succeed in this task and trend growth rates were to pick up in a non-inflationary way, then not only would the private sectors prosper but so too would the governments’ tax receipts and this would do much to solve the public debt problems that we hear so much about.  

It is worth remembering that not only did the Clinton administration inherit a budget surplus as a result of the tech boom, the UK government was able to escape from a massive public sector debt burden at the beginning of the nineteenth century as a result of the supply-side-led growth that accompanied the industrial revolution. The Bank of England paid little or no role in inventing the industrial revolution, the repeal of the Corn Laws and the expansion of global trade in the early 19th Century, but it was arguably the UK economy’s most successful period.

Therefore, we believe that if the world economy is to truly emerge from its now six-year-long slump (and somewhat longer in the case of Japan), we need bold governments that seek to deregulate, re-educate, encourage supply-side growth and that attempt to make their own “luck” with appropriate policies.

Unfortunately, if we look around the world today, we do not find much sign that this is happening. Currently, the US government system seems, from the outside at least, to be almost dysfunctional despite the last-minute budget agreement; Merkel and the German political parties are still attempting to form a workable coalition; the populist Abe government in Japan has so far failed to initiate any of the reforms that it promised; and the UK government is firmly focussed on the approaching general election. Even in China, the much heralded reform process seems to have stalled and consequently we hold out little hope of there being a supply-side revolution in the near term (unless it is simply as a result of “luck” or a chance invention).

As a consequence, we expect that 2014 will, in reality, look very similar to 2013 or 2012 or any of the previous three or four years. There may be moments of economic optimism within certain economies as inventory cycles ebb and flow (as we have just witnessed in the Eurozone and are now witnessing in the UK) but in general we expect another year of essentially lacklustre growth in the global economy that will be inconvenient for many governments and policymakers. 

As we have noted, the optimal response to this continued lacklustre economic (and political) situation would be long-term supply-side reform, but it seems that we do not currently have the governments in place that are likely to embrace this agenda (regardless of their ideological standpoint) and so we also fully expect that 2014 will see the authorities fall back on the same de facto policy response that they have used since 2007 – namely more central bank action and more “money printing”.  

We fully expect the US QEP to remain in place for the foreseeable future (perhaps with only a token moderation in mid-2014) and we would expect the Bank of Japan to become even more aggressive in terms of its own QEP in the near term. It would also not surprise us if the European Central Bank attempted another LTRO or similar policy stance while China’s central bank seems to have already given up any pretence of tightening.
 
In fact, we would argue that the way is effectively clear for the central banks to indulge in yet more money printing as a result of the recent fall in global inflation. Despite the expectations of many, the recent decline in world trade prices and particularly in the fortunes of some of the emerging markets has resulted in falling rates of inflation around the world and this seemingly bond-friendly event will implicitly allow the central banks even more room to experiment with their unconventional policies. 

In such an environment, we would expect risk markets to continue to exhibit a trend towards higher prices and while the major currencies may be volatile from week to week, we suspect that in reality all we will see is a “merry-go-round” of weakening currencies that ultimately sees large moves in exchange rates in the near term but little change in rates over the longer term once every one has “had their turn”.

In short, while we doubt that the central banks will be able to conjure a global economic recovery any time soon, we suspect that they will be able to conjure up periods of “risk on” in financial markets over the next few months. Ultimately, these monetary experiments will have to end and, as history has shown (most notably in 2000 and 2008), credit-fuelled rallies in financial markets are rarely sustained without fundamental supply-side growth.

We fear that any risk on rally will eventually be curtailed either by an eventual change in policy by the major central banks or more probably by an enforced tightening in China next year (in which inflation remains high and the balance of payments are deteriorating) but in the near term, there may be a period of rising bond and equity prices as the central banks launch another effort to hide the lethargy in the global supply side.

Andrew Hunt International Economist London

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