2015 Outlook: An Even More Policy-Dependent World
We believe 2015 will still be a transition year for closing gaps and divergences existing in the aftermath of the financial crisis. In an economic world where there are more downside risks than upside, time is running out. Fiscal policy cannot be postponed much further, as the still accommodative Central Banks cannot be the only game in town.
The Twin Challenges of Slow Growth and High Debt
Over the next decades, we think the global economy is likely to move progressively towards a lower potential growth rate, on cyclical (post-crisis legacies) and structural factors, not least an ageing population. Fertility rates are falling in the developing world, as workers migrate to cities, and we in the developed world are living longer. As lifespans increase and birth rates fall, a smaller working-age population will have to support a growing retired population.
We are also witnessing a precipitous fall in productivity. The growth we enjoyed in the nineties petered out in the run up to the recession. Despite advancements in living standards and innovations in technology, robotics and biotechnology that promise to change our lives significantly, we see little hope of a fresh short-term pickup in productivity as developed economies recover from the banking crisis.
The lesson we take from historical data is that economic growth potential halves in the decade following a crisis. Of course, no one can predict the future, but this can be of huge significance.
Nor is it just an economic concern: the first consequence is that, with a low projected level of growth, we have decided to downsize our internal returns expectations. The second is that it will become increasingly difficult for some economies to service their growing debt.
Contrary to popular belief, total debt (private and public) has continued to grow in recent years and is now 13% higher than in 20071.
The lesson we take from historical data is that economic growth potential halves in the decade following a crisis.
The private sector, led by financial services, has been deleveraging. The results are particularly evident in the US and UK, which both experienced a real estate bubble, and are on the path to normalisation.
However, this trend of deleveraging has been largely offset by a spike in government debt.
Since 2008 emerging markets, including China, have seen rises in leverage2. That colours our outlook for the year ahead. We anticipate uneven, sub-par global growth – our target is 3.5% for 2015 – and below Central Bank target inflation over the next 12 months. The growth outlook leaves several regions at risk of further economic slowdown.
High debt, low growth and low inflation can be apoisonous combination for debt sustainability.
Another Wave of Fresh Liquidity is Coming from Central Banks.
So, might we see major economies slipping back into recession in 2015?
In our view, it’s not likely. Central Banks are providing ample liquidity to buy time and at the same time fiscal policy is proceeding along the bumpy road for structural reforms. Notwithstanding the normalisation plans of the Federal Reserve and Bank of England, we do expect something like $600bn of newly met liquidity in the system this year - the largest since 20123. This is important because it will likely provide vital support for asset classes over the next 12 months.
Abundant Liquidity but Effectiveness Under Question
That said, the risk is that Central Banks are running out of weapons, if the fiscal policy does not start to play differently. On monetary policies, we doubt that the already announced measures - balance sheet expansion and covered bond purchases along with the Targeted Longer-Term Refinancing Operations (TLTROs) in Europe - will be effective in restarting growth, as credit demand remains weak and the size of the purchasable assets is disputable. Moreover, an economy and financial markets too dependent on Central Banks could be vulnerable to potential policy mistakes.
That’s why fiscal policy has to come into play. In recent years, through choice or mandate, fiscal authorities have tightened while monetary policy has loosened. To contain the threat of prolonged recession, governments need to implement structural reforms that will allow job growth to recover, while also investing in areas such as infrastructure. If new jobs are created, demand can surge and this will help to narrow output gaps. Once this stage is reached, good inflation picks up. When that happens, we believe the economy will be on the right track.
At this juncture in the global recovery, fiscal policy is the most sensible way to pass liquidity into the real economy.
We believe the call for fiscal policy is not negotiable.
It’s needed to promote deleveraging in developed markets and to finalise the transition through structural reforms to a more balanced global economy, with emerging markets sharing more of the growth burden.
Europe is at Risk of Downside
The policy imbalance is especially telling in Europe. As of October 2014, five million Europeans under 25 years old are unemployed in the EU4 . That is one in five youths without a job. The distribution of youth unemployment across the region is also disturbing, with 7.2% in Germany compared to 42% in Italy and 51% in Spain (based on December data). We believe this is a major challenge that undermines the recovery of the Euro system because it may cause income inequality and social unrest. There has been very little deleveraging by households, governments have taken on huge debts and we see a worrying lack of progress on macroeconomic policies. The European Central Bank could make an impact with a quantitative easing experiment. However, we believe these measures could hardly work if the transmission mechanism of the monetary policy is not restored and would not necessarily be effective as in the US, as we have a variety of government bond issuers. In any event, such moves should be treated as a last resort.
Europe is losing growth momentum at a time when it’s labouring under a huge amount of debt.
Could Europe go the way of Japan in the nineties and suffer a lost decade? We see striking similarities between the two crises. Both had ageing populations, political paralysis and a vast output gap. But we see Europe pulling through this crisis. The European banking system is healthier than the Japanese system in the nineties. Europeans are relatively more productive workers. Japanese corporations increased saving during the crisis, a behaviour we have not observed among European corporations. And Europe is not suffering a property bubble threatening the stability of the whole region. We should also remember that Japanese authorities at the time cut wages in response to the correction in a bid to maintain the level of employment. This had the effect of killing off consumption. Europe, however, has sought to maintain wages by cutting the size of its labour forces. In our view, this should prevent Europe slipping into a deflationary spiral.
2015 – Our High Conviction Ideas
One economy that does appear to be thriving is the world’s main economic engine: the United States. We see the US economy growing close to 3% in 2015 amid less fiscal austerity. Unlike Europe, the Americans have already gone through a painful deleveraging process and made progressive adjustments in their labour market.
The US economy is the growth engine among developed countries.
We remain optimistic about China's growth prospects. This year should see a policy-induced slowdown in growth. The Chinese government is instituting a series of reforms towards an economy driven by demand from domestic consumers rather than heavy infrastructure spending. The progress, so far, looks promising. They aim at improving resource allocation. Monetary policy is relatively cautious and China also has a relatively favourable debt profile, despite growth in private debt since 2008.
Emerging markets are still in transition. We see this bloc shaping the world over the next 10 to 15 years, but not in the next year. In the next decade or so, a number of economies will stabilise and converge to lower growth rates as control is tightened in planned economies and structural reforms are instituted. Beyond China, our favoured investment idea is India. It will likely take some time before the economy registers as a major force, but this democracy is undertaking ambitious and credible reforms. It is also not as dependent on commodities as some of its emerging market peers.
China and India are our favoured investment destinations in Emerging Markets.
In conclusion, we expect another wave of liquidity this year that will still provide vital support for asset classes.
We don’t think we’ll see deflation, but a low inflation environment driven by weak global demand and exacerbated by low commodity prices.
The global economy looks set to grow 3.5%, with the US and China – responsible for much of global GDP growth gains over the past year – remaining at the fore.
There are some downside risks to the outlook. These are mainly concentrated in Europe, where we believe fiscal policy is badly needed in tandem with monetary policy and inflation is extremely low, and in those emerging markets at risk of reform failures and threats to stability.
In Japan, there are some concerns over the long-term sustainability of the public sector and on the momentum of reforms.
The world might be transitioning into an era of progressively slower growth. Overall, our economic outlook for 2015 is slightly below par and perhaps slightly more volatile than in 2014.
Going forward, we believe we will see the economy characterised by a series of mini-cycles – as we have experienced over the last decade in Europe. That is to say, growth will be more fragile and susceptible to external shocks.
We expect another wave of liquidity that will still provide vital support for asset classes.
1Source: Central Banks, BIS Data, elaboration Pioneer Investments. The analysis includes Germany, France, Italy, Spain, UK, US, Japan figures available as of November 30, 2014.
2Source: Central Bank, Ceic, Bloomberg as of November 30, 2014.
3Source: Pioneer Investments elaborations on Central Banks data. Data available as of November 30, 2014.
4 Source: Eurostat. http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/3-28112014-AP/EN/3-28112014-AP-EN.PDF