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Saumil H. Parikh
The global economy has just experienced one of its slowest expansion years in recent history. According to the International Monetary Fund, global GDP (translated into nominal U.S. dollar terms) expanded just +3.0% in Q2 2013 from the prior year, with downside surprises coming predominantly from Europe and the major emerging market countries.
In the U.S., nominal GDP growth slowed (as PIMCO expected) to +3.3% in the four quarters through Q2 2013 from +4.5% the prior year, as fiscal policy tightening combined with a slowdown in global trade took a large bite out of both domestic and external demand growth.
In Europe, nominal GDP growth slowed to just +0.4% from +2.1% the prior year, as the sharp rise in sovereign bond yields accelerated concerns of a widespread run on European banks, inducing a significant rise in both public and private sector precautionary savings.
And in the major emerging market countries – China, Brazil, Russia, India, Mexico – nominal growth (in local currency terms) slowed to +9.1% from +10.0% the prior year, but large currency depreciations versus the U.S. dollar due to a loss of investor confidence and fears of a global liquidity squeeze meant that their contributions to global GDP growth were close to zero in nominal U.S. dollar terms.
Despite this substantial slowdown in global growth over the past year, PIMCO’s cyclical outlook for the year ahead is cautiously optimistic for the following reasons.
First, fiscal policy (in the U.S. and Europe) is likely to be less of a drag on global growth in the year ahead than the year just passed, although we expect U.S. sequestration to affect growth over the next few months. Second, measures of global financial wealth have recently increased quite substantially, which will act to strengthen private sector confidence in the year ahead. And third, global central banks will likely continue to use monetary policy to clip financial tail risks, with the European Central Bank (ECB) rising to the occasion during the sovereign debt crisis of 2012, and high quality emerging market central banks doing so more recently during the emerging market liquidity crisis in Q2 2013.
Having listed the positives, let’s not forget some of the persistent old – and potential new – negatives.
First, household balance sheets in developed countries will continue to reduce debt relative to income in the year ahead, limiting the developed market economies’ ability to achieve the credit traction and breakout growth rates expected by the consensus. Second, the rise in global interest rates during Q2 2013 will result in tighter financial conditions to the most interest-rate-sensitive components of the global economy, tempering positive growth impulses from U.S. housing and from emerging market corporate spending going forward. And third, Japan’s extraordinary fiscal and monetary policy expansion of 2013 will be closely watched for a successful handoff, with implications of failure being particularly costly to Japan and the global economy in the year or two ahead.
Hanging in fine balance between the positives and negatives will be the outlook for global corporate profits, a key measure of success when it comes to determining the handoff to self-sustaining growth going forward.
Global corporate profits growth stalled in 2013 with the dramatic slowing of global GDP growth. Particularly hard hit were cyclical sectors linked to global trade and commodities. In the past, the transition of a business cycle expansion from assisted growth to self-sustaining growth has always passed through a period that requires global corporations to look through the diminished support from fiscal and monetary policy and continue with plans for expansion in both capital and labor inputs. Successful handoffs are achieved when household income and spending pick up just as fiscal and monetary policy effects wane, such that top-line growth and capacity utilization for global corporations remain healthy. But failed handoffs occur when household income and spending growth do not accelerate to neutralize fiscal and monetary policy drag, particularly when capacity utilization is low and corporate profits growth and pricing power are weak.
This interplay between fiscal and monetary policy drag, household income and spending growth, global corporate profits, pricing power, and confidence will be the most important distinguisher between a realized global cyclical outlook that beats, meets or disappoints consensus expectations.
In the U.S., we expect growth to accelerate, but to disappoint elevated consensus expectations. While fiscal policy drag will be lower in 2014, monetary policy drag will be high as market interest rates reflect anticipated Fed actions, and household income growth will be persistently weak due to the low quality nature of jobs being created. The increase in household wealth, however, will serve to buffer against weak household income growth, but a question remains as to the distribution of household wealth and therefore the multipliers of aggregate wealth to aggregate spending going forward. We expect household credit formation to remain subpar due to these distributional effects, and as such, household spending to remain in our “New Normal” zone of around 2% real, 4% nominal going forward.
In Europe, we also expect growth to accelerate, but just barely, to a range between 0% and +0.5% real: still below consensus expectations. While the ECB has clipped the left tail of a run on European banks, fiscal and monetary policy remain too tight in Europe to forecast a return to steady potential growth over the cyclical horizon, and household income growth is expected to remain flat to modestly negative for the year ahead as corporations and governments continue to restore competitiveness in Europe through internal devaluations and cost cuts. Europe has the potential to surprise further to the upside of both our and consensus expectations. Monetary policy in Europe has scope to be eased further, particularly in countries where internal devaluations are progressing nicely and current account surpluses are being used to deleverage balance sheets smoothly. Easier monetary policy would go a long way in reducing the cash flow pressures from deleveraging on corporate and household demand going forward.
In Japan, we expect growth to remain steady and close to potential over the next year, but heavily reliant on the continuation of aggressively expansionary fiscal and monetary policies. Any volatility or deviation in policy that induces a growth drag will likely result in large downside surprises in the Japanese cyclical outlook, which remains the biggest known unknown for global growth in the year ahead. We also expect the global policy community to limit the extent of further yen depreciation, which will likely reduce the tailwind for Japanese corporate profits growth in the year ahead.
Finally, in China and the emerging markets, we expect a stabilization in growth assisted strongly by high quality central banks using their large U.S. dollar reserves to regain control of currency and financial market conditions going forward. Large withdrawals of liquidity from emerging market economies during the first half of 2013 have tightened financial conditions considerably, leading to important questions about the growth outlook for emerging markets going forward. The high quality emerging market countries such as China, Russia, Mexico and Brazil will likely stabilize financial conditions and therefore grow the fastest. But lower-quality emerging market countries like India, Turkey and Indonesia will take some time to regain control of financial conditions, and might even need assistance from international balance sheets during the cyclical period ahead. China will be the key emerging market economy to follow in 2013, with upcoming structural and cyclical policy decisions weighing heavily on the outlook for sustained growth.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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