Reassessing Global Opportunities - 2014 Global Markets Outlook
2013 is likely to be remembered as the year of the ‘Great Divergence’, when the developed markets surged while the emerging markets unnerved even steadfast investors who have deep conviction about their long-term growth potential. The gap in relative performance between the developed markets and emerging markets was remarkably wide last year. The reasons for the difference in returns now appear obvious, with the benefit of hindsight, but at the beginning of last year they were not so evident to even the most seasoned investors. First, the improvement in the economic outlook for the U.S. and Europe was somewhat healthier than expected while Japan unleashed an aggressive plan to lift itself from economic stagnancy. Second, the prospect of bond purchase tapering by the U.S. Federal Reserve rekindled fears of reduced capital flows into emerging markets. Finally, the relatively more subdued growth outlook for the emerging economies brought to light the structural problems some of the countries have been facing.
As investors assess the prospects for 2014, the global economy appears to be in a better place when compared to recent years. The U.S. and Europe are expected to accelerate further while Japan is trying to counter the potential downside from consumption tax increases with more fiscal stimulus. Improved consumer and industrial demand in the developed world is lifting global trade volumes and the export growth outlook for most countries in Asia and elsewhere has turned brighter. At the same time, select emerging countries continue to face fiscal and current account imbalances while inflation risks have limited their ability to roll out stimulus measures to boost domestic demand. In this environment, are the market trends from last year likely to persist?
Which are the regions where the economic outlook could improve further? Are there areas of potential opportunities or risks that are not yet widely known? Finally, what are the data improvements we should expect to see before emerging markets regain investor interest?
The U.S. is once again the global growth engine
After several false dawns over the last five After several false dawns over the last five years since the recession, the U.S. economy finally appears to be on a more robust and sustainable recovery path. Several of the overhangs that prevented the economy from blooming in recent years have been gradually removed. To begin with, there is increased willingness by the two political parties to build consensus and avoid the confrontations that roiled financial markets in the past. The housing market revival and rising equity prices have helped build consumer confidence, despite the moderate labor market gains and the relatively high unemployment rate. The banking and financial services sector has gone through the necessary restructuring after the recession, and is healthier with tighter regulatory controls that could limit the excesses of the pre-crisis era. The substantial gains in domestic energy production have helped restrict the trade deficit, while plentiful and affordable natural gas has made some of the domestic manufacturers more competitive. Higher U.S. energy output has put a lid on global oil prices, and the stable gasoline prices have also lifted consumer optimism.
Most of these trends that drove the U.S. economy last year are likely to sustain in 2014 as well. If consumer sentiment remains buoyant, businesses are likely to step up spending for capacity expansion as well as for the replacement of older and less efficient equipment. With record high cash reserves and affordable borrowing costs, financing capital expenditures is unlikely to worry most businesses. Though the dollar has gained against most other countries, U.S. exports are likely to benefit from improved demand from Europe and elsewhere. In addition, unlike recent years, there is no pressure on the federal and state governments to reduce spending. While the relative share of the U.S. in global economic output has declined over the years, the country remains the largest economy by far and the biggest market for goods and services from the rest of the world.
Hence it follows that faster U.S. growth should lift the prospects of most of its trading partners and buoy aggregate global growth. The regaining of the growth engine mantle by the U.S. is likely to remain the most potent driver of the global economy in 2014, and possibly even longer.
Green shoots proliferate in Europe
A European recovery has been one of the most anticipated global economic events since the region slipped back into a recession in 2011. After repeated disappointments, the region finally emerged out of its longest economic downturn in almost four decades during the second half of 2013. While Germany has further strengthened its prominence as the bulwark that shields the Euro-zone economy, countries such as Spain and Italy that were previously fiscally stressed are also seeing signs of revival.
The most significant element behind the positive change in Europe has been the political consensus in the region and the resulting policy coherence. During the early days of the downturn, policymakers in European countries advocated dissimilar policy prescriptions and could hardly agree on a consensus agenda to revive the economy. The healthier countries, led by Germany, insisted on deep fiscal reforms and austerity measures in return for their financial support, even when the spending cuts led to violent demonstrations and political unrest in some countries. By early 2013, policy positions became less rigid and the countries facing difficulties were given more flexibility in managing their spending budgets.
The biggest risk for Europe was the potential breakup of the currency union, which could have resulted in financial chaos. Some commentators and economists considered it inevitable that Greece or another distressed country would be forced to drop the Euro, so that they could have their own currency which could be devalued to regain competitiveness. After the European Central Bank decided to back the Euro by declaring that it would do whatever it takes to defend the currency, this risk has mostly faded away. While the ECB has provided substantial medium-term liquidity support to European banks, the region’s banking industry is yet to completely rid itself of the legacy problems from the pre-crisis period.
The restructuring process of the banking industry has also been slow as even the biggest banks with substantial regional presence are supervised by national regulators. This is now changing as the ECB has been entrusted with the regulation of the region’s largest banks. As the European banking union is completed, many of the regulatory uncertainties should fade.
Despite the improvements in economic outlook, the relatively high unemployment rates in Spain and other countries should remain a challenge. The manufacturing sector in Europe has substantial overcapacity as some governments actively discourage corporate restructuring to protect existing jobs.
As the revival in consumer demand is likely to be gradual, businesses are unlikely to face capacity constraints anytime soon. This would likely delay the revival in capital spending, even if borrowing costs remain low.
Stubbornly low inflation is another challenge for the Euro-zone and the ECB has already voiced its concern. High unemployment and excess manufacturing capacity would likely limit potential price gains, even if consumer demand expands faster than expected. As the ECB has limited room for further cuts to its benchmark rate, this could force the central bank to roll out quantitative easing measures as in the U.S. and Japan. Outside the Euro-zone, the U.K. saw a stronger than expected recovery during 2013. The country went through a deep recession as its government was among the most aggressive in Europe with austerity measures. The improvement in the fiscal balance from the spending cuts has now been bolstered by the reviving economy, and the country is likely to maintain a healthy pace of growth in 2014.
Japan’s audacious policy steps
‘Abenomics’ was one of the most popular buzzwords in 2013, as the Japanese prime minister announced fiscal stimulus measures and forced the country’s central bank to introduce even more aggressive monetary policy steps. The substantial devaluation of the Japanese yen that followed significantly altered global capital flows and the trade competiveness of countries such as Korea. Encouraged by the new economic optimism, investors drove up Japanese equity prices last year to one of the biggest annual gains in the country’s history.
The results of Abenonmics so far have been mostly positive and the negative effects on Japan’s export competitors have been less than feared. Though domestic consumption growth has moderated after a sprightly jump during the first half of last year, consumer sentiment remains largely positive. The last quarter of 2013 saw appreciable gains in exports, and most large Japanese corporations have seen healthy gains in revenues and earnings after the currency decline.
To prevent the fiscal deficit from widening, the Japanese government has been forced to announce an increase in consumption taxes, which will be effective from April 2014. Though the government is trying to partly offset the potential drag on consumer spending with another fiscal stimulus package, the tax increases could restrict domestic consumption. Therefore, to sustain the economic revival, the government is under pressure to quickly and effectively introduce the fiscal reform measures collectively referred to as the ‘third arrow’.
Over the long term, faster economic growth, which should improve the government’s debt servicing ability, is probably the only solution to Japan’s excessively high public debt levels. However, a fast aging population and resistance to immigration would likely make it challenging to sustain healthy growth rates.
Emerging Economies settling to a sustainable growth trajectory
Ever since they burst into the collective imagination of global investors, there was a growing belief that emerging market economies would be able to sustain growth rates well above their historic averages. This belief was strengthened when emerging economies led by China bounced back strongly after the 2008 financial crisis.
It is now evident that the recovery was fueled by exceptionally large domestic stimulus measures in these countries and the easy global liquidity created by the U.S. Fed., and hence largely unsustainable.
The first phase of the emerging market slowdown started during the second half of 2011, as the ‘commodity super cycle’ started to unwind. The Brazilian economy came to a standstill in 2012 while other major commodity exporters such as South Africa slowed. Last year saw the second phase of the emerging market slowdown as domestic consumption growth declined when several countries were forced to raise interest rates or tighten liquidity to prevent inflation risks and credit bubbles. Countries with wide fiscal and current account deficits were deemed more vulnerable to capital outflows and their currencies saw steep falls. This forced more rate hikes and other policy measures, restraining domestic demand even further.
On the positive side, this growth moderation shifts the emerging economies to a more sustainable pace of expansion and should help them avoid asset price bubbles and other excesses that could elevate systemic risks.
Further, the undesirable side effects of rapid growth such as dangerous pollution levels are now visible across most emerging countries. A phase of slower growth to limit some of the damage is probably more desirable than paying very high social costs in the future.
In any case, it is apparent that these short-term challenges have not dulled the long-term growth potential of emerging economies, relative to the developed world. Most of these countries have significant demographic advantages that could drive domestic consumption growth for decades to come.
Productivity gains from innovation and larger scale of operation could also help sustain these economies, where the governments have become generally more responsive to business. Emerging market corporations are continuously growing their capabilities and increasingly challenging larger competitors for global market share. Even in a slower growth environment, the benefits of these structural trends should help the emerging economies.
Will the ‘Great Divergence’ persist in 2014 and beyond?
All available indicators suggest that the developed economies of Europe as well as Japan are the best placed to improve their economic growth this year. While they continue to face significant risks which could derail the recovery, both Europe and Japan are currently being pushed up by tailwinds that could become stronger.
At the same time, concerns about a Chinese slowdown as well as political and policy missteps in countries such as Turkey and Thailand have kept emerging market investors unnerved. If these trends hold true, it is likely that investors would remain more favorably inclined towards the developed markets.
Nevertheless, emerging market equity prices are likely to react positively and swiftly to signs of easing political risks as well as improvement in current and fiscal deficits. Whether China can restrain the growth of shadow banking without triggering a credit contraction will be keenly watched.
Policy steps initiated since last year have narrowed India’s current account deficit, but the country continues to face inflation risks and fiscal imbalances.
If the reforms announced by the new government are effective, Mexico could get a healthy boost. South Africa, Turkey, and Indonesia will likely need deeper structural reforms to address their deficits and prevent further currency declines.
Finally, several of the emerging countries that are facing economic challenges could see political change after elections scheduled this year. Emergence of reform-oriented and business-friendly governments could swiftly lift investor sentiment and drive the performance of these markets.
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