Global Economic Update Interaction of Developed and Emerging Business Cycles

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1 Global Economic Update Interaction of Developed and Emerging Business Cycles This marketing document is exclusively for use by Professional Clients and Financial Advisers in Continental Europe, Qualified Investors in Switzerland and Professional Clients in Dubai, Jersey, Guernsey, Isle of Man, Malta and the UK. It is not for consumer use. The volatility in financial markets in recent weeks, partly triggered by developments in China and other emerging economies, has raised important issues about global economic growth prospects and the interaction between the developed economies (DMs) and emerging economies (EMs). Some see this relationship as having changed, with the emerging economies now taking on a more important role in driving global growth prospects. This article assesses whether EMs have indeed become the driver of the global business cycle. John Greenwood Chief Economist, Invesco Ltd. Developed and emerging economic growth The developed economies went through a balance sheet recession in 2008/09 and have continued with a process of balance sheet repair since then. The emerging economies generally had stronger balance sheets going into the global financial crisis and, as a result, were able to stimulate their economies. Although the emerging economies have sustained higher growth rates over the last 25 years than the developed economies (see Figure 1), each of the main developed world crises (the US Savings and Loan crisis, the tech boom and bust and the subprime/global financial crisis) has led to a distinct slowdown in EM growth. That has reflected the fact that many emerging economies have built export-oriented economic growth models, and their growth was seriously hurt by downturns in the developed economies. However, looking at the relation from the other side, over that period the only major crisis to originate in the EM which impacted the developed economies was the Asian financial crisis of 1997/98. As Figure 1 shows, that led to some softening, but no marked downturn, in developed world economic growth. Indeed, the developed world s strong growth in the late 1990s enabled a quick recovery in emerging Asia after the crisis. Figure 1 US economy still the locomotive for global economy Real GPD of Developed and Emerging Markets %yoy Developed markets Emerging markets Asian Financial Crisis China Surge China Stimulus S&L Crisis & US Recession Tech Bust & US Recession 0-2 Sub-Prime Crisis Source: Thomson Datastream as at 9 September 2015.

2 Over that 25-year period, the growth of China has been one of the most important EM phenomena and it has now become the world s second largest economy. 1 Could it now be that weakness in China s economy will drag down growth in the rest of the world? Such claims must be treated with caution. There are several channels through which a Chinese slowdown could impact western developed economies: trade, financial markets and corporate earnings. Here we mainly consider the trade channel. China s imports can be split into three categories: raw materials, semi-manufactured goods, and finished goods. The slowdown in China is undoubtedly impacting raw material or commodity suppliers (both developed and emerging). However, the import of semi-manufactured goods is primarily for further processing or assembly in China for re-export to third markets, and these have been relatively little affected. Finished goods consist mainly of luxury consumer items or capital goods. In my view the main effect of a Chinese slowdown is on the first and third categories, and the economies most affected are therefore either commodity producers (emerging countries such as Brazil, Indonesia and South Africa, or developed ones such as Australia and Canada), or closely linked Asian manufacturing exporters such as Taiwan, Korea and Japan. The impact of a Chinese slowdown on most western developed economies would therefore be quite limited. In short, the US economy remains the main locomotive for global economic activity. US still main locomotive There are two sets of evidence suggesting that the US and other developed economies will not be dragged down by the slowdown in China or other EMs. First, the balance sheet problems which caused the difficulties in developed economies continue to be fixed. Private sector debt (which is a more important determinant of economic developments than government debt, although the latter receives much attention) has fallen as a share of GDP, most notably in the US (see Figure 2). Indeed, there are some occasional signs of a renewed increase in private sector borrowing in the US, although this is not yet significant. The UK balance sheet repair process is ongoing, on a similar trajectory to the US but lagging to some extent. In the Eurozone, where the private sector did not initially leverage up as much, the debt reduction did not need to be as great and has indeed been smaller. However, the European Central Bank s (ECB) adoption of quantitative easing (QE) since the start of 2015 means that further private sector deleveraging, where needed, is being facilitated. By and large, this deleveraging process in the developed western economies means that the recovery in these economies can remain on track, although it will be relatively subdued. Figure 2 Balance sheet adjustment in developed economies Ratios of private sector debt-to-gdp (% rebased to 2000 Q1 = ) Euro-area (LHS) UK (LHS) United States (RHS) Source: IMF World Economic Outlook.

3 The balance sheet-constrained, slow recovery among the developed economies implies some risk of a premature increase in interest rates. For example, Australia, New Zealand, Canada, Sweden and Norway (three of them being commodity exporters who benefited initially from the strong stimulus policies adopted in China in ) all raised interest rates in 2010/11 from what were seen as unusually low rates. However in the cold light of a slowing global economy they have subsequently all been forced to reverse course and cut interest rates since A second piece of evidence supporting the view that the developed economies will be the main drivers of growth relates to developments in the banking systems. In the US, the successful conduct of quantitative easing and effective recapitalisation of the banks means that US banks are now in a position to lend again and, indeed, they are doing so. The same is not true, however, of the shadow banks, which are still contracting. So, although banks have been restored to health, we are not seeing the same exuberance in credit markets as in the mid-2000s. In an important sense this is a good sign: it means we are more likely to see a sustained and moderate expansion, without premature overheating. In the Eurozone the recovery of the banking system is lagging behind that in the US, and it has taken longer for money growth to pick up, mainly because it took longer for the ECB to implement its QE policies. In the UK, where the Bank of England completed its QE programme in late 2012, money and credit growth remain modest. It is in Japan that monetary easing policies have been adopted most aggressively, with large-scale Quantitative and Qualitative Easing (QQE) since April That involves the central bank buying a wide range of assets (including real estate investment trusts and exchange traded funds) as well as government bonds (the main focus of US Federal Reserve and Bank of England asset purchases). Even so, due to various technical design flaws in implementation, there have been no significant changes in the rates of growth of broad money (M2) or bank lending since QQE started: both remain subdued. So, across all the major developed economies, although the banking sector and balance sheets have been, or are on the way to being, fixed, a major outbreak of inflation or a spurt in economic growth is unlikely anytime soon. Figure 3 Evidence of balance sheet recovery: Eurozone labour market still to recover Unemployment rates in US, UK and Eurozone Eurozone UK United States % It should be acknowledged that many commentators see a risk of inflation breaking out, with the most common reason cited being a Phillips curve relationship - that is, when the unemployment rate falls back to a low level (as it has done in the US and UK, see Figure 3) inflation picks up. That view is, in my opinion, mistaken. It is excess growth of money and credit that cause inflation, and there is absolutely no sign of such excesses at present, and therefore no basis for sustained higher inflation. Indeed, it is quite likely that the so-called equilibrium unemployment rates will fall to a lower level than in the past; the Phillips curve will once again prove an unreliable guide to inflation outcomes.

4 Emerging world The current problems in EMs are, in my view, predominantly of their own making for two reasons. First, although many went into the 2008/09 global financial crisis with strong balance sheets, they allowed the surge in EM economic activity largely stimulated by the expansionary measures undertaken by China to translate into a surge in money and credit growth. This was the root cause of higher inflation, asset price inflation and increased current account deficits in those economies. Second, many EMs have been on a roller coaster ride because of their reliance on commodity exports. The Brazilian real s gyrations have been highly correlated with food prices, as have the Russian rouble s fluctuations with oil prices. Such economies have not sufficiently diversified away from commodities or export-led growth models, leaving them still dependent on commodity exports. Figure 4 Exports of EM manufacturers holding up far better than EM commodity producers (Jan 2009=, 3mmav) EM manufacturing countries exports EM commodity countries exporters Manufacturing economies: China, India, Mexico, Philippines, South Korea and Taiwan. Commodity economies: Brazil, Chile, Colombia, Indonesia, Malaysia, Russia and South Africa. However, we should be careful to differentiate between those emerging economies reliant on commodities (such as Brazil, Chile, Colombia, Indonesia, Malaysia, Russia and South Africa) and those more reliant on manufactured exports (China, India, Mexico, the Philippines, South Korea and Taiwan). The exports of the manufacturing economies have held up well (see Figure 4), as have their currencies and economic growth (Figures 5 and 6, respectively). Figure 5 EM manufacturers currencies holding up; EM commodity producers currencies plunge (Jan 2010=) EM manufacturing countries currencies EM commodity countries currencies Manufacturing economies: China, India, Mexico, Philippines, South Korea and Taiwan. Commodity economies: Brazil, Chile, Colombia, Indonesia, Malaysia, Russia and South Africa.

5 Given the slow but steady recovery in demand in the developed world, this picture is likely to remain intact that is, a slow and gradual recovery with low inflation in the developed world, with commodity prices remaining subdued for an extended period. The revival in developed world spending would need to be much stronger before commodity producers would see a turnaround. Commodity prices may well stay depressed for several more years a pattern which is typically the case after a commodity boom. Even if there is a more vigorous recovery in the developed economies it is unlikely that commodity-based economies will recover quickly. Demand deficiency is much more difficult to address than supply-side weakness. Figure 6 Net Result: EM commodity producers entering recession while manufacturers continue to grow Real GDP of EM manufacturing and commodity producers %yoy EM manufacturing countries EM commodity countries Manufacturing economies: China, India, Mexico, Philippines, South Korea and Taiwan. Commodity economies: Brazil, Chile, Colombia, Indonesia, Malaysia, Russia and South Africa. Conclusions The US economy is still the major locomotive for the world economy. Balance sheet repair remains the dominant issue for developed economies and the evidence is that the US is leading in this process, followed by the UK, then the Eurozone and Japan. Low money and credit growth across the developed world imply continued low inflation, even as labour markets return to normal. In emerging economies, the problems are largely of their own making. Excessive growth of money and credit after 2008/9 led to asset bubbles, current account deficits, inflation and currency weakness. A structural problem in many emerging economies is the failure to diversify away from commodities. Such economies will remain more vulnerable than those with an established manufacturing base, although even these manufacturing exporters may need to diversify away from export-led growth models.

6 Important information This marketing document is exclusively for use by Professional Clients and Financial Advisers in Continental Europe, Qualified Investors in Switzerland and Professional Clients in Dubai, Jersey, Guernsey, Isle of Man, Malta and the UK. It is not for consumer use. The value of investments and any income from them will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. While great care has been taken to ensure that the information contained herein is accurate, no responsibility can be accepted for any errors, mistakes omissions or for any action taken in reliance thereon. Where John Greenwood has expressed opinions, they are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco professionals. All data provided by Invesco unless otherwise stated. Data as at 16 September 2015, unless otherwise stated. Issued in Austria by Invesco Asset Management Österreich GmbH Rotenturmstrasse 16-18, A-1010 Wien Issued in Dubai by Invesco Asset Management Limited PO Box , DIFC Precinct Building No 4, Level 3, Office 305, Dubai, United Arab Emirates Regulated by the Dubai Financial Services Authority Issued in France by Invesco Asset Management S.A. 18, rue de Londres, F Paris Authorised and regulated by the Autorité des marchés financiers in France Issued in Germany by Invesco Asset Management Deutschland GmbH An der Welle 5, D Frankfurt am Main Issued in the Isle of Man by Invesco Global Asset Management Limited George s Quay House, 43 Townsend Street, Dublin 2, Ireland Regulated in Ireland by the Central Bank of Ireland Issued in Malta by Invesco Global Asset Management Limited George s Quay House, 43 Townsend Street, Dublin 2, Ireland Regulated in Ireland by the Central Bank of Ireland Issued in Jersey and Guernsey by Invesco International Limited 2nd Floor, Orviss House, 17a Queen Street, St Helier, Jersey, JE2 4WD Regulated by the Jersey Financial Services Commission Issued in Switzerland by Invesco Asset Management (Schweiz) AG Talacker 34, CH Zürich Issued in the UK by Invesco Asset Management Limited Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK Authorised and regulated by the Financial Conduct Authority 59749/PDF/ CEUK549