by Andrew Hunt
As is perhaps now a tradition, many financial market participants began 2014 expecting a global economic recovery and rising bond yields. The Bloomberg consensus forecast for the closely watched US 10-year Treasury bond yield at year end was 3.4%. As it transpired, though, while the UK economy did expand by an impressive 1.6% in real terms over the first six months of the year (although even much of this may have been due to special factors), Germany only managed 0.5%, the US managed only 0.4%, France saw no growth at all, while Italy and Japan suffered minus 0.3%. Even in China, economic activity in the first half of 2014 seems to have been remarkably subdued – we suspect that annualised growth in Q1 was down to 3.5% and the rebound in the second quarter seems to have been quite modest. On a weighted average basis, we therefore estimate that G7 real GDP growth in the first half of 2014 was around 0.4%, while G7 nominal GDP growth in USD terms was only around 1.5% (at current exchange rates), although even some of that can be attributed to exchange rate movements rather than actual growth. Such weak rates of economic expansion – which have since been confirmed by a reported further slowdown in world trade growth – seem to resemble a global recession, rather than the much forecast and much hyped revival that was expected.
Quite simply, and contrary to the message offered by the ever buoyant but increasingly statistically flawed industrial surveys that companies have long since learnt to “game”, the global economy did not recover in the first half of 2014 and those investors who “bet” on no rate hikes/expanding liquidity seem to have performed better than those that adopted the presumed consensus strategy that was based on the premise of a global economic recovery. In fact, we might argue that against such a stagnant economic background, a US Treasury 10-year yield of 2.4% seems to make rather more “sense” than one at the 3.4% level that was expected.
Unfortunately, we can argue that the consensus forecasting record fares even worse when we look at the forecasts on a country by country basis. It seems that even Germany’s first quarter growth that, initially at least, appeared quite robust, was in fact boosted by mild weather rather than by an “inflationary boom”, as was almost universally assumed. Consequently, Germany’s second quarter performance was notably tepid by comparison.
Elsewhere, although markets probably were not expecting very much for France, even we have been surprised by the weakness in Italy – it seems that the renewed fiscal austerity programme has trumped even the impact of resurgent capital inflows on the monetary system. Canada’s economy has been losing momentum of late as its housing boom has receded and although some of the weakness in the US during the first quarter can be explained by the weather (although the bad weather did lead to a very significant increase in energy production and consumption that will have boosted total GDP), the much talked-about rebound in the second quarter was very modest. Excluding inventories, US real domestic demand growth in the first half of the year was only 0.5% annualised.
In the UK, mild weather may have helped GDP in the first quarter but the bulk of the improvement in domestic demand can perhaps be attributed to the one-off benefits of substantial compensation payments made by banks directly to households; we estimate that without these payments, UK GDP growth would probably have annualised below 1% as well.
Consequently, we believe that the ”bottom line” for the major economies is that growth was notably weak during the first half of 2014 and we would attribute this outcome to a combination of continued weak household income trends (particularly within the countries that are facing continued fiscal austerity) and also the continued very weak rates of credit expansion within the real economies. Looking ahead, while it is true that US household income growth has improved slightly of late, household income trends in Continental Europe remain very weak. Income trends are also soft in the UK but in Japan they are simply disastrous at present. Therefore, although we expect G7 growth to be a little better in the second half of this year than it was during the first half, any improvement in global growth rates should be quite limited.
Without a doubt, Japan has provided the biggest “miss” for the consensus forecasting community so far this year. By now, Japan’s economy was supposed to be in the midst of a monetisation-driven inflationary boom but instead we find that real M3 money growth year-to-date is now a negative 1.4% (that is, nearly minus three percent annualised) and real GDP has declined by 0.3% so far this year. Interestingly, if we take the average of the last seven quarters of Japan’s GDP growth, we find that growth has averaged at 0.3%, which is slightly less than the 0.4% quarterly average that was witnessed between mid-2009 and mid-2012 (despite the earthquake) and also over the seven years leading up to the GFC. If one investigates the statistical characteristics of the estimated trend in Japan’s real GDP over the last 20 years, the period of Abenomics turns up as a statistically significant negative influence on the economy, which is a long way from what the consensus was anticipating.
Away from the optimism over Abenomics, we find that during the second quarter of 2014, Japanese real private sector domestic demand excluding inventories fell at an annualised rate of just shy of 15%(!) and as a result the level of real domestic demand fell back to the first quarter of 2013’s level. If we combine the last three quarters, so as to allow for the effects of the pre-announced tax hike, we find that real domestic demand is contracting at a 1.5% annualised rate currently – essentially the same as the money supply. Interestingly, we also find that real government spending has also failed to expand over the last three quarters, thereby leaving rising real exports and falling real imports as the only source of real growth in Japan’s GDP – although even here we find that it is changes in the price deflators that are generating some of the positive movement in the real trade data.
In short, it seems that Abenomics has largely failed to gain any monetary traction, it has failed to include much in the way of public sector spending and it has so far included no worthwhile economic reform. Instead, all it seems to have involved is a consumption tax hike and an adverse terms of trade shock that have together undermined household incomes. We will be travelling to Japan next month, but from afar – and without the sell-side’s rosy spectacles – Japan’s economy looks to be deteriorating, rather than improving, to us.
Consequently, it appears to us that the world has been experiencing a situation in which the global economy has been notably weak but at the same time, and as a result of the central banks’ actions, global capital flows and liquidity have nevertheless been booming. Hence, we would argue that, despite what have been weak economic trends and simply awful geopolitical trends, financial markets in general have been able to hold up remarkably well and bond yields have become extraordinarily low. For the financial markets, the situation might be described as somewhat confusing but ultimately as being “even better than a Goldilocks Economy” from the point of view of the determination of asset prices. In fact, we might argue that financial markets’ perpetual belief in an imaginary economic recovery has actually been “even better than the real thing” for asset prices.
For the bulk of the world’s population that does not work or live within the financial world, though, the “real thing” of a true economic recovery is what they need and so there is already mounting pressure on politicians to come up with something better. As to whether the “next move” will involve a move to more “socially inclusive policies” or more reformist remains to be seen but, with the current preoccupation with income inequality, we suspect the former may occur before the latter.
Certainly, we feel that the risk of an approaching change in the nature and thrust of economic policies may be rising – policymakers may be under pressure to “try something new” and to stop trying endless QE’s. Political forces could quite conceivably – and quite probably – imply that the next set of policy experiments could be a rehashed version of 1960s-70s socialism, which we doubt that the markets would like, but we should also note that even the adoption of more reforms and liberalisation could be a problem for asset markets. While in the longer term the adoption of more imaginative economic policies – particularly more supply-side reforms – could be positive for global growth rates, the shift from demand-side focused to supply-side focused regimes could leave a hiatus in global liquidity growth with which markets have to contend.
Over recent months, the world has been locked in a low economic growth/high liquidity growth situation, which was of enormous benefit to the asset markets but this will not remain the case indefinitely – the five-year QEP experiment is, we believe, fast nearing its end date – as even some of the central bankers themselves admitted last month at their Jackson Hole shindig – and hence before too long financial markets may need to start thinking about what will come next. We therefore wonder if we are about to enter a period of greater financial market volatility in the months ahead.
Andrew Hunt
International Economist, London
Andrew Hunt International Economist London
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