Economic trends

Time to get real

This year’s widespread perception of a recovery in the West and problems in emerging markets is out of touch with reality

It’s time for a reality check. Earlier this year, markets were telling us that this was going to be the year of the West, and that emerging markets were in trouble.

Since then, the consensus forecast for US growth has been revised downwards for the fifth consecutive year, and Europe’s fundamental issues have remained unresolved, while economies in Asia, Africa and the Middle East have performed more or less as expected.

Yet, the dominant narrative remains a recovery in the West (however elusive), and problems in emerging markets.

Whilst we acknowledge the risks facing emerging economies, we still expect these to outperform

Whilst we acknowledge the risks facing emerging economies, we still expect these to outperform.

We project global growth of 3.1 per cent this year. Whilst this is lower than we initially expected, we think economies in Asia (excluding Japan), Sub-Saharan Africa, the Middle East and Latin America will contribute more than half – about 1.85 percentage points – of this growth, with the US and the euro area adding only about 0.8 percentage points.

The West effect

Emerging markets are outperforming developed economies, but they cannot escape what’s happening in the West. The performance of the US and euro area economies impacts the rest of the world.

Europe’s weak growth is a problem for the global economy. So is its large current account surplus, which could get even larger this year as the euro remains relatively weak. A current account surplus in the euro area means current account deficits elsewhere in the world, which will weaken growth in other economies.

The policy backdrop is set to become more complicated in the second half of the year

Emerging economies have responded by cutting interest rates. The rate cuts in 29 countries in the first half of this year were a textbook response to an exogenous shock. They were made possible by low US interest rates and the drop in oil prices, which kept inflation subdued. The policy backdrop is set to become more complicated in the second half of the year.

The Federal Reserve (Fed) is preparing financial markets for an interest rate hike this year; we expect the first hike in September. It will be difficult for emerging economies to continue to reduce interest rates as the Fed begins to hike. The expected rise in oil prices will also limit room for further interest rate cuts.

A Fed hike, following years of close-to-zero interest rates and three rounds of quantitative easing, will be a significant development. Currencies are the ‘shock absorbers’ of emerging economies.

Flexible exchange rates

Weaker currencies are not necessarily a bad thing, though. Most Asian countries now have flexible exchange rates, which adjust constantly, protecting the domestic economy against external shocks. Currency crises are usually associated with fixed exchange regimes, where misalignments between fundamentals and the exchange rate lead to economic imbalances, speculative attacks and ultimately a currency collapse.

A weak currency becomes a problem when a country has high levels of foreign-currency-denominated debt with short-term maturities. We do not see this as a major risk for Asian countries, although Turkey is more vulnerable.

The impact of Fed hikes on the rest of the world is receiving a lot of attention and rightly so. But the market is ignoring the risks of Fed hikes to the US economy itself. The IMF has warned that hiking prematurely could lead to a reversal of interest rates later on.

The market is right to be concerned about the impact of Fed hikes on the rest of the world, but it’s wrong to ignore the risks to the US economy itself

We see an additional challenge. M4 broad money supply in the US grew by only 2.8 per cent year-on-year in May, according to the Center for Financial Stability, an exceptionally low level. Low M4 growth suggests that actual monetary conditions in the US are tight. The risks associated with hiking interest rates in an economy that contracted in the first quarter, and where monetary conditions are already tight, are underappreciated. We see this is a key risk for the second half of the year.

The market is right to be concerned about the impact of Fed hikes on the rest of the world, but it’s wrong to ignore the risks to the US economy itself.

This is yet another year when consensus views on the US have been revised lower and existential threats to the euro area are strong. Slower growth in emerging markets is a result of the true problem facing the world economy – inadequate demand in the Europe and the US. Yet, many in the markets remain focused on the perception rather than the reality.

 

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