• Global growth to remain below productive potential until 2018
• Japanese stimulus to drive stronger Japanese growth and greater global liquidity
• Fall in US unemployment will put pressure on Fed to end QE4
• New Japanese government determined to weaken yen
• We disagree with forecasts suggesting Chinese growth will return to 8%+
• The US dollar’s bear run is about to turn bullish
We are now halfway through the VILE decade, typified by Volatile Inflation and Limited Expansion. Limited expansion means growth that is above zero but below productive potential. Global growth will remain below productive potential for the remainder of the decade, but will be closer to full productive potential than the first half of the decade as the pace of deleveraging continues to ease and central banks maintain ultra-easy policies.
US consensus expectations are overly pessimistic
There has been a marked improvement in consensus expectations for the global economy over the past few weeks, which will be reflected in consensus economic forecasts over the next couple of months. The US economy is expected to grow by 1.9% in 2013, while the median expectation for the unemployment rate is expected to be 7.7%. The expected pattern is steady acceleration through the year although the first quarter will be subdued by the fiscal cliff and tighter fiscal policy.
This is too pessimistic. Consensus forecasts should be back up to 2.6% within months, consistent with the bulls’ view that annualised growth in the second half of the year will be 3.0%. Expectations of smooth acceleration through the year will inevitably culminate in predictions of reaching escape velocity in 2014 – the first rate hike taking place a year earlier than the Fed’s presumption.
Impact of Japanese stimulus
Consensus expects the emerging economies to return to productive potential during 2013, led by China and Brazil, leaving Europe as the laggard. Increased liquidity, deferral of deficit targets and the threat of massive Japanese buying of eurozone government bonds, is likely to lead to a yield grab as investors’ expectations of the tail risks rapidly diminish. Japanese stimulus will also drive expectations of stronger Japanese growth and even higher global liquidity. This will lead to forecasts of flat European growth, buoyed by modest growth later in the year. In the absence of material tail risks, markets are going to consign Europe to the level of regional growth deficiency and move on. The UK continues to be constrained by concerns over Europe, but activity will be buoyed by a series of special factors in the fourth, first and second quarters. This points to rising competition for capital and higher 5y5y forwards globally.
US unemployment rate
These expectations will define the market outlook in the first few months. The US economy will fall short of escape velocity during 2013 and 2014 with the real economy growing by 2.5% in both years. An important variation is that I believe this growth will be more evenly spread with the first half of the year considerably stronger than consensus. Sentiment indicators have been dampened by the fiscal cliff but underlying activity has continued to improve and should show through over the next few months. The Fed has placed huge emphasis on the unemployment rate as a measure of policy in the foreseeable future. Its presumption is that rates will not have to be raised until unemployment reaches 6.5%. The Fed also assumes that stronger growth will help boost the labour force such that this level is not achieved until the middle of 2015. However, the unemployment rate fell by 1.7% during 2012 and we doubt whether the rate of decline will slow precipitously enough to satisfy the central bank’s forecast. Indeed, projecting the recent pace of decline into the first few months of 2013 will lower the unemployment rate to 7.0% by the middle of the year. This will increase the pressure on the Fed to end QE4. This will lead to higher forward rates through the spring and summer, which together with an appreciation of the US dollar against the yen and euro will act as a constraint on activity as the year progresses.
Deleveraging and austerity
The defining features of the VILE decade will continue to be deleveraging and austerity. These constraints are balanced by ultralow interest rates and expansionary monetary policy. History shows that after a major financial crash, there is a prolonged period of deleveraging that leads to weak and volatile growth. Deleveraging is still a major factor, but the improvement in financial conditions over the past few months in the UK and Europe will lessen the pace of deleveraging. Initially the deterioration in the European economy will not be as acute as previously expected. And better financial conditions in the UK will lead to faster growth in the first half of the year. Fiscal austerity is part of the deleveraging trend, and its impact depends on the mix between revenue and spending as well as deleveraging in the rest of the economy.
Deficit reprofiling in Europe
Governments in Europe are seeking to re-profile their deficits. France is likely to be granted a one year extension to meet its deficit reduction target, with Spain and Portugal expected to be granted two additional years to meet their targets. Likewise, Ireland is expected to renegotiate its promissory note. This lessens, but does not eliminate the paradox of thrift, and means that European growth is likely to be less than zero but only marginally so. Sentiment should improve over the next few months; however improved sentiment is likely to be accompanied by an appreciation of the euro against the yen and US dollar. This will reduce the external competitiveness of the region and dampen hopes of positive regional growth in the second half of the year.
US Expansion
The US is where the greatest amount of deleveraging has already taken place and has the greatest potential to expand. The Fed’s aggressive MBS and treasury buying program is designed to lower debt servicing costs and encourage the re-leveraging of the US consumer and housing market. Debt servicing costs have fallen massively and the lowering of savings through a rebound in the housing market will provide an important offset to fiscal tightening during the first half of the year. This shows the importance of low interest rates and central bank buying in lessening the impact of deleveraging, and suggests that the US economy will remain the best horse in the glue factory during 2013.
New Japanese government determined to weaken the yen
The new Japanese government has been converted to the need for massive central bank intervention and stimulus through currency depreciation. The government will set a hard target of 2% for inflation, currently -0.2%, and will pursue this through appointing more dovish members to the Bank of Japan’s Policy Committee. It will also threaten to change the Bank of Japan law and purchase Y50tr or European government bonds if the yen does not weaken in line with its expectations. We believe that the yen will be allowed to weaken to Y100 versus the US dollar. Any further than this will be resisted by international competitors since it would provide Japanese corporates with too great a competitive advantage.
Will Chinese growth return to 8%+ rate? We say no
China has been relatively unconcerned about the weakening of the yen because of the impact of the recent domestic consumer boycott on Japanese products. There has also been an improvement in domestic activity as inventories are rebuilt, credit conditions are eased and increased investment feeds through. This has boosted expectations that once again the authorities have successfully negotiated a soft landing for the economy and that activity is poised to return to its previous 8% plus rate in 2013. We disagree, the economy is likely to slow in spring as the inventory rebuilding fades and the central bank seeks to dampen credit creation because of concerns over bad debts. Indeed, we expect Chinese growth to slow to less than 7% during the second half of 2013. This will help dampen commodity prices and commodity currencies during this period.
Most central banks to continue with stimulus packages
Rising global optimism over escape velocities in the US and emerging economies is likely to increase global competition for capital, leading to higher 5y5y real forward rates in the major industrialised economies. This is likely to be accompanied by bringing forward expectations for the ending of emergency interest rates. Apart from the likely decision by the Fed to cease QE4 purchases of treasuries, we do not expect global central banks to withdraw any monetary accommodation. Indeed, Japan is likely to add substantially to global liquidity by weakening the yen, while the ECB is likely to respond to the appreciation of the euro in the first half of the year by moving to negative interest rates over the summer.
Currencies
The yen is expected to be the worst performing global currency in the first half of the year, while the euro is likely to be the worst performing currency in the second half of the year. The dollar’s eleven year bear market is expected to end during 2013 leaving the currency to embark upon an equally long bull market.
Source: IGNIS A.M.
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