World Risk Developments February 2016


Global slowdown more likely than downturn

The recent turmoil in financial markets is most likely an overreaction to some of the weaknesses in the global economy. Our central view is that the impact from the selloff on Australian exporters will be limited with resource exports set to bear the brunt of the weakness through lower commodity prices. But other exports are also vulnerable to the growing risk of a global downturn should the selloff in financial markets persist over the coming months as it would start to impinge on the real economy, including trade.  

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Financial markets started 2016 on a sour note (Chart 1) as concerns over global growth, particularly in emerging markets, caused a mass sell-off. The US equity market lost US$1.8 trillion in the first 13 days of 2016, oil prices hit decade lows, and global equity markets and other hard commodity prices also trended lower.

Emerging markets have been amongst the hardest hit with portfolio net outflows estimated at $735b in 2015, with a further US$448b of outflows expected in 2016. Developing economies with large levels of external debt and a large reliance on oil exports are particularly vulnerable to investor sell-offs. To assess which EMs are at risk, we have rated each country on indicators of external vulnerability, leverage, economic stability and policy effectiveness.

Needless to say, countries reliant on hard commodities (Russia, Mongolia, Brazil) or with large debts (Turkey, Ukraine, Egypt) face a higher risk of crisis. Fortunately, most of Australia’s largest EM trading partners appear well placed to handle the current sell-off.

Is the global economy really that bad?

Concerns over the health of the global economy are warranted. The IMF revised down its global growth projections in 2016 to 3.4% p.a (previously 3.6%) citing a softer acceleration in US growth and ongoing weakness in emerging market demand. The softer global growth outlook has also caused a significant downward revision to growth in trade flows. The IMF expect trade will expand 3.4% in 2016, down from 4.1% in October.

But is the global economy headed for recession? Probably not. Deciphering the signals from recent financial market and high frequency data suggests global growth and trade volumes will weaken through the first quarter of 2016 (Chart 2), but a sustained contraction is unlikely. The OECD’s leading indicator has been a good barometer for global activity, picking the downturns from the 1998 Asian financial crisis, the tech bust in 2001 and the GFC in 2009. The current readings suggest global trade flows will weaken over the next few months, but the indicator has not fallen to a level consistent with prior crises.

The recent sell-off has dragged on commodity prices with the weakness in iron ore, coal and natural gas prices weighing heavily on the terms of trade and resource exports. But the recent falls in the Australian dollar (chart 1) will provide some comfort. Outside of resources, the lower AUD will improve the competitiveness of Australian goods and services abroad.

Service and agricultural exports are likely to outperform, after growing 10% in 2015. But prospects will be dictated by China and the demand from other emerging markets. Manufactured exports are more heavily reliant on advanced economies, with the US, New Zealand, Japan, Korea, UK and Singapore buying 45%. Forecasters are expecting growth in advanced economies to accelerate in 2016, which should feed through to stronger demand for Australian manufactured exports. The full effects of the lower AUD should start to manifest across the sector adding further upside to the outlook.

Risks are on the rise

Despite our relatively sanguine ‘base case’ outlook for 2016 the probability of downturn has risen in recent months and could come into greater focus if the current financial market sell-off were to persist over the first half of 2016 leading to tighter credit conditions globally. This would lift uncertainty and feed into the psyches of both consumers and businesses, with negative-spill overs to spending globally. There is also a growing risk of a Chinese hard landing, which could create tighter credit conditions and weigh on growth in other emerging economies. This would have negative ramifications on global growth and trade.   

The reaction of policymakers across the globe to this growing set of problems has been mixed; seven central banks have cut interest rates, while seven have raised them. The most radical has been the Bank of Japan which introduced negative interest rates in January to stimulate the economy and put further downward pressure on the yen. The European Central Bank also imposed negative rates in December 2015, with further rate cuts likely over coming months.

The growing use of unconventional monetary policy if successful will help resuscitate demand in Europe and Japan and will encourage capital back into higher yielding emerging markets (Chart 3), particularly given the long term hunt for yield among pension funds. But further capital inflows could also revive financial imbalances and cause de-stabilising asset price bubbles. This is particularly worrying given that private sector leverage (companies and households) in emerging markets, is currently well over 100%, higher than it was in advanced economies on the eve of the 2008 global financial crisis.

Fred Gibson, Economist

Cassandra Winzenried, Senior Economist

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