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International Economic Outlook – Running to Stand Still

By Martin Fowler
Posted: 5th July 2013 08:39
Up until mid-May global share markets were posting strong gains.  Much of these gains emanated from conventional and unconventional monetary policy initiatives orchestrated by Central Banks eager to promote growth and ward off a perilous deflationary spiral.  The main purpose of these initiatives has been to reduce the cost of funds to encourage both consumers and businesses to borrow to invest and to spend, which in turn encourages economic expansion.  Of course such strategies have had both intentional and unintentional side effects. 
As interest rates fell, investors, in particular those requiring an income from their savings, sought higher yielding riskier assets such as shares.  In addition some investors took advantage of the low interest rates to borrow to invest into the share market.  The flight into these riskier assets propelled global share markets over the past year.  It was perhaps no surprise then that share markets began to falter when the United States (US) Federal Reserve (the ‘Fed’) announced that it was going to begin to taper back its Quantitative Easing (QE) program.  The question which naturally arises is whether or not recent market falls reflect the underlying fundamentals of the global economy.  We will consider this issue further below. 
United States
The potential ending of QE should be interpreted as a positive sign that the US economy is reaching sufficient self-sustainability to be able to withdraw the stimulus that has been required to date.  It should be noted that the US has experienced 48 months of consecutive economic expansion. 
Nonetheless, the stimulus was needed because the US recovery remains the weakest in history with total growth of just over 8% since the trough of the GFC in 2009.  The growth outcome however is still meritorious when put in context of the asset price destruction experienced in both the property and share market during the GFC and the ongoing deleveraging by households, private enterprise and now the Government. 
Back in 2010, the initial phase of the recovery in the US was driven by the business sector.  Corporate's slashed costs during the GFC and, when pent-up demand began to emerge, profitability thrived.  This of course was assisted by a much lower interest rate environment and a significant depreciation of the US dollar, which enhanced the international competitiveness of its export industry.
Domestic demand however remained relatively subdued over this time.  In recent months the housing sector (historically a significant contributor to overall growth) has shown solid improvement and this coupled with improving business and consumer confidence may have encouraged the Fed to announce that it will soon begin winding back it QE program.   Nevertheless, we remain somewhat cautious on the outlook for the US for the following reasons. 
  • While new home sales have risen by almost 50% from the lows experienced in 2010 mortgage applications by US citizens have hardly moved at all.  Analysts believe that the housing market is being driven predominately by speculative hedge fund and foreign investors.  It should be noted though that house prices remain about 25% below the peak experienced in 2006.
  • Personal income per capita has risen by only 5% since pre-crisis levels.  This coupled with relatively high household debt means that ongoing deleveraging is likely to persist.  Debt reduction is becoming more difficult as incomes are being eroded by rising living costs.
  • The recent rise in the US dollar will modestly reduce the competitiveness of its export sector.
  • The necessary reduction in Government spending required to reduce the enormous Government debt burden and associated increase in taxes will provide a drag on future growth prospects.
  • The weak global outlook is set to continue.
On balance we expect the US recovery to continue but suspect that outright growth levels will remain subdued.
Europe remains mired in recession, posting a sixth consecutive quarter of contraction.  Encouragingly, the June Purchasing Managers Index (PMI) survey showed a moderation in the rate of contraction.  Both output and new orders fell at the slowest rates for two years.  This could lead to a potential return to growth (albeit off a low base) by the end of this year should the US recovery continue.
Recent data out of China shows that its economy continues to grow at a slower pace.  In 2010 China grew by 10.4%.  In 2011 it grew by 9.3%.  In 2013 we expect it to grow by between 7.5 – 8.0%.  The June PMI survey showed that business conditions in China's Manufacturing sector deteriorated at the fastest rate for nine months in June.  This portends further falls in production in coming months. 
Recent attempts to curb further speculative investment in the Chinese property market have resulted in higher interest rates and have had knock on effects in the form of slower investment, consumption and export growth.  But the real risk with China lies in the over-investment in infrastructure and property over the last five years.  A not insignificant proportion of the government financed infrastructure investment is believed to be unproductive.  (Bizarrely, China has literally built master cities that are totally unpopulated, including office buildings, apartment buildings, shopping centres, roads and rail networks).
After the initial boost to activity, this investment requires perpetual maintenance expenditure, absorbing scarce government funds.  It is not clear what percentage of these infrastructure projects have been funded by debt and what percentage has been funded by taxpayers.  Regardless, this is not going to end well.  Many of these projects will not generate sufficient cash flows to service the debts.  This means that a percentage of loans to the developers (local governments, state owned enterprises and private sector property developers have all borrowed heavily from the banking system) will not be repaid.  This will inevitably trigger significant bad debts and/or potentially require a bailout.  In turn, this will increase the Government's overall indebtedness and reduce the economy's future growth potential.  In all likelihood we foresee a situation where lower fixed asset investment, coupled with subdued global demand, will result in lower medium term growth outcomes (6-7% growth). 
In conclusion we expect growth in the global economy to remain well below trend in 2013 and 2014.  High debt levels will continue to limit consumption and investment.  This will constrain overall economic activity in both developed markets and emerging markets.  Unfortunately there is no easy panacea to the debt problems which continue to hinder the developed world.
Martin Fowler is a director of Moore Stephens Sydney Wealth Management where he provides financial advice to high net wealth individuals and conducts research into the social impact of economic policy.  He is also a director of Whitefield Limited, an investment company listed on the Australian Stock Exchange.
Martin can be contacted by phone on +61 2 8236 7700 or alternatively via email at

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