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Column by Neil MacKinnon, Global Macro Strategist at VTB Capital, for Euromoney

10 December 2014

Global economy’s end-of-year verdict: ‘Try harder’

There is an elevated risk of a global recession in 2015 given eurozone stagflation, setbacks in Japan, a debt-ridden China, the risk of the oil-price collapse triggering geopolitical risk and diminishing returns from G7 monetary stimulus.

Somebody recently asked me to imagine I was a teacher and what grade I might give the global economy’s performance in 2014. I answered that I thought C minus might be accurate, with the words "must try harder" written in bold letters across the report.

C minus might appear harsh. After all, solid growth in the US, UK and a number of Asian countries has surprised many. Even Japan’s economy temporarily discovered its animal spirits. Stock markets are generally performing well, and business confidence is slowly starting to return, although not to anywhere near pre-crash levels.

However, optimism must be tempered with caution. If the student appeared to be turning a corner, some of the old problems persist. With dangerously high levels of public and private debt and a number of high-profile banking scandals, the UK Prime Minister was right when he said last month that the red lights on the dashboard of the global economy are flashing.

What is driving all this pessimism? A big reason is the chronic uncertainty in markets that have for a long time been the lifeblood of the global economy. China, so long top of the class, has seen its economy cool significantly in 2014. Its growth is uncertain, given the potential fall-out from the credit bubble and rising corporate default risk. Projections for longer-term growth trajectory are even more depressing as the economy makes its necessary shift away from investment to a more consumption-led economy.

Overall, in 2015 global economic growth is likely to be 3.6 percent, but it is expected to drop further to 3 percent in 2016. I recently said at a media roundtable that there is about a 40 percent risk of the world economy tipping back in to recession in 2015 and I stand firm behind that.

The Eurozone, with CPI inflation at 0.3 percent, can easily tip into outright deflation in the months ahead, which will put more pressure on the European Central Bank (ECB) to be seen to 'do something’. Escaping economic stagnation will prove difficult.

Japan’s economy, after recently showing positive signs, has now reverted to type. Elections are due and the voters may not endorse Prime Minister Shinzo Abe again. Moody’s have cut Japan’s credit rating to A1 from AA3 and cited uncertainty over the country’s plans to tackle its debt problems. Sound familiar to anyone?

One of the other major developments of 2014 has been the huge fall in oil prices. As I write today, the Brent price has dropped below $70 a barrel. Whatever the reasons behind the decline in the oil price, at some point it could impact US shale producers’ debt levels, hurt Organization of the Petroleum Exporting Countries (OPEC) producers’ budget positions, and possibly reduce non-OPEC capital spending. It could easily spark fresh escalation in geopolitical risk.

However, I believe that oil and commodity prices will stabilise at some stage in 2015. It is worth remembering that from 1976 to 2000, the oil price moved in a price range between $10 and $40. The post-financial crisis high in July 2008 of $150 was partly a function of quantitative-easing (QE)type monetary policies increasing speculation in commodity prices that inflated financial asset prices generally. Cheap money has been the norm for the last five years, so expect more of the same. The risk policymakers are acutely aware of is that QE continues to prove ineffective and Draghinomics ends up the same way as Abenomics.

The ECB’s recently published Financial Stability Review highlighted three key risks: an abrupt reversal of the global search for yield amplified by pockets of illiquidity and growing signs of leverage in the non-bank financial sector; persistent sluggish bank profitability in a weak and uneven macroeconomic recovery; and the re-emergence of debt sustainability concerns.

What the ECB failed to properly focus on is the risk of deflation, especially the increases of debt, which has increased significantly since 2008. In the event that QE proves ineffective if the ECB overcomes German resistance to such plans, this leaves it without much policy ammunition. What next? It does not take much for there to be talk of debt restructuring (Greece and Argentina style) or just debt-monetisation as a way out.

Against the backdrop of such uncertainty, the US so far remains resilient. The dollar is strong and shale production looks solid. For US consumers, real disposable income has been boosted by the impact of lower gasoline prices which now stands at $2.80 per gallon, the lowest level in four years.

Nevertheless, the astronomical debt of $17 trillion remains a major issue. In 2015, dealing with the debt may be one of the only areas where President Barack Obama can reach across the aisle and work with a hostile Republican-led Congress.

Where else is debt a major issue? For emerging market economies, total debt stood at 157 percent of GDP this year (China’s total debt is 229 percent of GDP and South Korea’s total debt is at 220 percent; Russia has one of the lowest debt levels at 85 percent). A bias amongst the major central banks to ease rather than tighten monetary policy has contributed to a build-up of debt and increased financial vulnerability.

According to the Bank for International Settlements (BIS), the only way out of the 'debt overhang’ is for debtors to gradually build saving balances. Other options such as default, higher inflation and financial repression are regarded by BIS as being inconsistent with central bank mandates of price stability.

However, the reality is that policymakers might end up resorting to one or all of these options. Disinflation and deflation increase the real value of the debt burden. Disinflation and deflation increase the level of real interest rates which drags on economic growth.

This increases the dilemma facing central banks like the Fed and the Bank of England (BoE), which seem poised at some stage during 2015 to raise interest rates now that their QE programmes have been concluded.

They also face another dilemma: that the best of US and UK economic growth might already be over. This means that the Fed and the BoE might start tightening when both economies are in the downswing phase, which suggests that both short- and long-term interest rates are set to be much lower than expected.

Ultimately, the outlook for next year remains unpredictable, though the global economy will continue to make a gradual and uneven recovery.

However, for the Eurozone stagflation seems likely. Emerging markets will continue to slow down, but continue to be the driver of global growth.

The report card is clear: the prospects are gloomy. All things considered – C minus doesn’t seem bad in the context.

However, the real challenges lie ahead and it is vital to knuckle down and focus on the job in hand. Everybody’s future depends on it.

http://www.euromoney.com/Article/3408890/Global-economys-end-of-year-verdict-Try-harder.html

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