In this last bulletin for the year, we look back at 2014 and forward to 2015.
A year ago, we made four predictions for 2014—a pickup in world economic and trade growth, a further expansion of Australian resource export volumes from new mines and gasfields built during the 2004-13 resource investment boom, further falls in commodity prices and the Australian dollar, and turbulence if not crisis in emerging markets caused by QE tapering
All four have panned out—more or less.
World economic pick-up
One can argue the toss about whether the world economy has picked up this year. It was stuck in the doldrums over 2011-13, and growth this year looks as if it may turn out to be the same as last—3.3%. Nevertheless, there has been an acceleration of activity through the year, paving the way for a stronger 2015. World trade growth (in volume terms) also appears to have picked up modestly, to almost 4% this year from 3% last
Resource export expansion
Other good news has been the further expansion of Australian resource export volumes. These began rising rapidly last year as ventures undertaken during the investment boom reached the production/export stage, and have continued this year as additional new mines have started. New capacity in the Pilbara has driven a 27% increase in iron ore export volumes, while the completion of the Caval Ridge mine (owned by the BHP Billiton Mitsubishi Alliance) and the North Goonyella expansion (owned by Peabody Energy) have supported a steady lift of coal exports.
AUD falls lag commodity prices
Commodity prices and the AUD continued to decline. USD prices have fallen 23% over the year to date, and are now 45% lower that their mid-2011 peak. The AUD has meanwhile been quite sticky— losing less than 8% against the USD and 3½% against the currencies of major trading partners since the start of the year (Chart 1). The commodity price slump and unresponsive dollar mean that the expansion of resource export volumes hasn’t been sufficient to prevent a decline in resource export values, which are now down 16% from their peak in January.
Emerging market selloff
In January, emerging markets suffered a financial market sell-off mainly triggered by the start of US Federal Reserve ‘tapering’. The so-called Fragile Five—Brazil, India, Indonesia, South Africa and Turkey—bore the brunt of the selling. But as we suspected, it wasn’t ‘Asia vu all over again’—investors quickly stepped back in, prompting a rally (Chart 2).
Tracking China’s slowdown
We devoted considerable time through the year to tracking China's economic slowdown. Overall, we were cautiously optimistic that the correction now underway in the housing market would not trigger a dreaded ‘hard landing’. Still, it is almost certain that China will miss its 7½% annual growth target, with GDP likely to come in around 7.3%. This is the slowest annual growth since the political upheavals of 1989-90—but also the 'new normal' rate to which both China and its trading partners will need to get accustomed.
Three fears proved to be unfounded.
The first was that interest rates would spike when the US Federal Reserve stopped buying government bonds under its QE program. In fact, it stopped in October, yet yields on US Treasury securities have actually fallen this year.
Thanks to a 'no' vote in the September referendum on Scottish independence, a second risk that didn’t materialise was the break-up of Britain. Had the vote been ‘yes’, break-up wouldn’t have been the only consequence. There would also have been a variety of knock-on effects, including uncertainty over which currency the Scots would pick, increased demands by Catalans for independence from Spain, and an increased chance of a Conservative victory in next year's British general election. The latter outcome would have allowed the Conservatives to fulfil their promise to hold an in/out referendum on EU membership. That would in turn have allowed British voters to vote to leave the EU.
The third non-event—for this year at any rate—is a US government shutdown. This threat arose earlier this month after some hardline Republican lawmakers moved to deny the government funding in a bid to stop President Obama legalising 5m illegal immigrants. In the event, however, Congress passed a bill that will fund the government till next September. A shutdown could have been economically costly. The previous one, lasting 16 days in October 2013, subtracted 0.3% pts (annualised) from December quarter US growth, according to the IMF, and also exerted a drag on other economies.
Though some things turned out to be non-events, four wild cards made an appearance—Ebola, Islamic State, the war in Ukraine, and the collapse of oil prices.
The outbreak of Ebola that began in March has had a severe impact on West Africa, but little effect on the wider world economy. We did note in October, however, that the epidemic has caused several mining operations in the Congo (Dem Rep) to suspend production and evacuate staff—some Australian.
The sudden and unexpected declaration in June by the Islamic State of a ‘caliphate’ over Iraq and Syria dramatically increased Middle Eastern instability, but didn't cause the misfortune many feared— a disruption of Iraqi oil supply. The jihadists managed to sabotage northern exports, but had less success in the south. Just as importantly, Iraqi export capacity remains on track to more than double in the medium term.
The Ukraine crisis that began in February with Russia's annexation of Crimea raised the prospect of a new cold war between Russia and the West. More narrowly, it caused Ukraine’s economy to slump, Russia’s to stall, and the wider CIS to slow down.
The oil price collapse that began in late June has been 42% so far. Most economists believe that a lower price, if prolonged, will bestow a net benefit upon the world economy—by redistributing income from thrifty oil producers to more freely spending consumers, and thereby delivering a demand boost to a world economy suffering from a chronic demand dExport Finance Australiaiency. But that is a longer run story, and a little simplistic. So far, the most noticeable effect of the price collapse has been to push already troubled oil producing countries into financial difficulties—Russia, Venezuela, Nigeria, Iran. High cost American companies producing shale oil and Canadian ones working tar sands are also facing strain—from rising borrowing costs as well as falling oil prices.
In our base case, growth in both advanced and emerging economies accelerates moderately in 2015, yielding world economic growth of 3½%. Among individual economies to accelerate are the US, India and Brazil, and among those slowing are the euro area, China, Japan, UK and Russia.
Though a 3½% world growth rate looks respectable—around the 20-year average—it does not absorb labour and capacity idled by the world recession of 2009. So many economies continue to suffer from a chronic demand dExport Finance Australiaiency, which presses down on already low inflation rates. To prevent inflation sliding further and provide some support for demand, central banks keep policy rates low. Safe haven bond yields also remain low.
Commodity prices bottom as demand picks up slowly and supply adjusts to lower prices. This is consistent with the RBA’s prediction that Australia’s terms of trade (the ratio of export to import prices) will fall a further 4% before flattening out in mid-2015 (Chart 3).
As for the AUD, Chart 1 suggests it is overvalued and therefore has further to fall. The RBA governor made a similar point last week. ‘I doubt that the adjustment is yet complete’, he said. ‘Probably US75c is better than US85c.’ Whether the market heeds him, of course, is another question.
Possible unpleasant surprises
With growth so mediocre and inflation so low, many economies are prone to upsets, few more so than the periphery of the euro area. Here a growth setback could lead to renewed sovereign debt difficulties that require euro area members to extend further bailouts and debt restructuring. Put another way, the euro area debt crisis has not been resolved—it is a chronic problem that could easily flare up again.
China is another economy prone to a sharper-than-expected slowdown. The government’s anti-corruption drive is reportedly weighing on investment—making key decision-makers reluctant to commit to new ventures. Yet with investment making up half of GDP, and a housing correction also underway, such hesitancy could exert a severe drag.
The risk of a 'hard landing’, in which growth slumps to 2-3%, is low, because the authorities have both the 'will and wallet' to respond to upsets such as bank runs and capital flight. Still, it would be over-estimating their finesse to believe that they can necessarily prevent growth slipping below the 7.2% level that Premier Li Keqiang says is the minimum needed to maintain healthy job growth.
How would a sharper-than-expected Chinese slowdown damage the world economy? Even ignoring the repercussions on other economies, a slump from 7% to 3% in 2015 would subtract 0.6% pts from world growth, simply because China makes up 15% of world GDP (4% of 15% = 0.6%). Then there are the knock-on effects. According to one estimate, a 1% pt decrease in Chinese GDP growth would shave US GDP growth by 0.2% pts. Weaker sentiment, heightened risk aversion in capital markets, and softer advanced economy exports could see the world economy shed up to 1½% points of growth in total.
Asian economies would be among the hardest hit because they sell a large fraction of their exports to China (Chart 4). Falling Chinese investment—a major driver of the world commodity boom—would also cause many commodity prices to fall hard, possibly back to their pre-boom, early-2000s levels if a hard landing occurred.
Low oil prices are another risk—one that could extend the drag of weak commodity markets from Latin America and Africa to oil producers in the Middle East and Russia.
Falling oil and other commodity prices are also adding to the risk of deflation, especially in the euro area, where core CPI inflation stood at just 0.7% (year on year) in November.
Needless to say, war in oil producing countries could snatch away the price dividend oil importers and consumers are currently enjoying.
Possible pleasant surprises
As painful as the low oil price may be for oil/energy-exporting countries, it could deliver a boost to world demand and hence growth—of ¼% pt for every sustained US$10/bbl price drop, according to the IMF. The boost could be quite large if, as now seems possible, oil prices remain low throughout 2015. The futures market is expecting prices of around US$70/bbl in 2015.
If the animal spirits of American CEOs improve, US capital spending could get a boost that adds ½-1% pt to US GDP growth. Funding should not be a problem—the corporate sector has amassed a US$2.5 trillion cash hoard to draw upon.
Will financial stability be maintained in emerging markets as the year rolls on and a US interest rate rise draws closer? Or will there be a renewed bout of volatility even worse than the one this year, and the 2013 taper tantrum? We are inclined to believe that emerging markets will, for the most part, continue to withstand periodic selloffs.
In Asia, for instance, low short term debt, large international reserves, manageable overall debt, shrinking current account dExport Finance Australiaits, flexible exchange rates, and improving international competitiveness rankings (such as the one compiled by the World Economic Forum) should enable economies to handle any volatility that comes along. There are some vulnerabilities, such as large private debt in Thailand and Malaysia, but they shouldn't cause systemic problems.
Better still, improving economic fundamentals will help policymakers respond to tighter financial conditions. Moderating food and fuel prices, for instance, are damping inflation, and giving central banks scope to cut interest rates.
A lasting impression of 2014 was that it was a year in which investors downplayed political risk.
Emerging markets did suffer some selloffs in response to QE tapering, the Ukrainian crisis and the rise of Islamic State—Russia in particular. But those events took place amid an increase in investor appetite for higher-yielding assets, assurances from central banks about ‘lower-for-longer’ interest rates, a worldwide government bond market rally, and the failure of Islamic State to disrupt oil supplies. As a result, taper-induced outflows from emerging markets at the start of the year quickly turned to inflows again, and financial markets in Central & Eastern Europe and MENA proved remarkably resilient.
Arguably, political risk is currently underpriced in many assets, which creates the risk of a market correction next year, especially if Ukraine and the Middle East get nastier. As we have already argued, this shouldn't create a widespread crisis among emerging markets, but it could disrupt the more vulnerable ones like Russia.
Roger Donnelly, Chief Economist
Cassandra Winzenried, Senior Economist
Fred Gibson, Economist
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