Recoupling: Uneven Evidence, Uneven Risks
April 02, 2008
By Richard Berner | US
Our call for economic recoupling — involving spillovers from the incipient US recession to Japan and Europe — is playing out slowly and unevenly. In some ways, that’s not surprising – the US contraction is just underway, so the effects on other economies have yet significantly to show up. And while the financial turmoil that began last summer has triggered a US credit crunch, it hasn’t engulfed all markets. Finally, emerging markets are still largely decoupled from US woes. What’s the evidence for recoupling? And what are the risks?
We continue to think that Japan and Europe are most vulnerable to US spillovers and that some of America’s Latin American trading partners are next in line. A “stress test” of our forecasts to reflect the potential for further US weakness, higher energy prices, and a weaker dollar doesn’t change those rankings. While Japan and Europe face the common headwinds of higher energy prices and strong currencies, they are vulnerable for different reasons: The US slowdown unmasked domestic weakness in export-dependent Japan. In comparison, Europe’s domestic demand has fared better, but a mild credit crunch threatens that strength. Those differences may offer opportunities in markets, because there is more bad news in the price in Japan than in Europe. In both cases, slower growth should promote lower sovereign yields and depress risky asset prices. Although the ECB won’t ease soon, European yields in the wake of the recent backup may be attractive, and both transatlantic and transpacific yields spreads should reverse. And while our European strategy team expects a bear-market rally in the near term, European equities are likely vulnerable to worse-than-expected earnings surprises. Japan and Europe Vulnerable. There’s no mistaking the effects of the US slowdown on Japanese trade: As of February, Japanese merchandise exports to America (accounting for one-sixth of the total) contracted by 6% from a year ago, while exports to all other destinations rose by 12.9%. Both have decelerated over the past two years, when double-digit export gains lifted the Japanese economy; now, slower global growth and a stronger yen will keep exports tame. The export slowdown has already unmasked weakness in domestic demand, which is only now becoming clear. Policy stumbles such as the Revised Building Standards Law hobbled housing activity. Now, a ‘mini-recession’ is likely in the first half of 2008 as soaring energy and commodity prices have squeezed consumer incomes and profits, as deteriorating labor markets undermine consumer wherewithal, and as tighter financial conditions are beginning to limit capital spending, especially for small and medium-size enterprises. The slowdown in US trade is also evident in Europe, but both the export mix and the domestic demand stories are different. Exports to the US fell by 0.7% in the year ended in January, while deliveries elsewhere rose by 12.9%. Since exports to the US account for only 13% of EU exports, the strength of domestic demand in other markets, especially non-Japan Asia and oil producers, is a powerful offsetting factor, together with still robust (although unevenly distributed) domestic demand. Besides, Euro area manufacturers continue to report healthy demand trends according to business surveys. Our survey-based quantitative model is pointing to GDP growth averaging 1.7% (annualized) in the first half of the year. However, companies have started to scale down their production plans, and the analytics suggest the strength won’t last. A protracted credit crisis and a soaring euro prompted our European team to cut their euro area growth forecast from 1.6% to 1.5% this year and from 2.2% to 1.5% next year. Lower sales and higher costs will squeeze corporate profits and make both employers and lenders cautious. With the ECB wary of persistently high inflation, we think easier monetary policy is far off, and money-market illiquidity and credit concerns have widened quality spreads across the maturity spectrum. The combination will weaken business and housing investment; the bursting of the Irish and Spanish housing bubbles has already promoted growth slowdowns in those economies. Emerging markets: Decoupling continues, but not uniformly. In contrast with much of the industrial world, the fundamentals for several emerging market economies remain favorable, and they continue to grow strongly. Structural reforms, current account surpluses, and a favorable shift in their terms of trade have provided a number of emerging markets with inflows of direct investment and strong gains in income and wealth. Thus, China’s domestic demand dynamic continues to offset export weakness and to support Asia’s other economies, some of which are strong on their own. But signs of weakness are emerging. We expect faltering export growth and capital inflows, combined with high inflation and tight monetary policy, will begin to take their toll on Asian growth, especially in India. The rising cost of extracting base metals and fuels means that commodity producers continue to benefit from tight supply. Meanwhile, Latin American growth continues to boom, but there too we expect a slowdown. Risk scenarios. To test the strength of our convictions, our economics team conducted the following thought experiment: What would be the impact on global growth and inflation of a weaker US economy, persistently high energy quotes, and further weakening of the dollar against major currencies? The answers won’t surprise: Global growth would slow to a below-trend pace this year and next, and inflation would jump sharply this year and subside in 2009. In our baseline global outlook, we assume that Brent crude quotes decline from $106 to $98/bbl by the end of 2009, and that the dollar rebounds to $/€1.40 and ¥/$ 105 by the end of 2008. That’s consistent with our current view that a mild US recession will be followed by a sub-par recovery next year. The alternative "risk scenario" envisions a “double-dip” US recession, with 2008 Q4/Q4 growth slipping to zero (0.8% YOY) and a slightly more modest 2009 recovery. One factor behind the weaker outlook is a higher, supply-induced path for energy prices, with Brent averaging $110 through 2009. The dollar, likewise, might weaken further to $/€1.75 and ¥/$ 85. Importantly, too, this scenario probably would be accompanied by more risk aversion and volatility in financial markets — a key channel for exporting US weakness abroad. Such a scenario in our view would hardly trigger a global recession. But global growth would slump this year and next to the slowest pace in five years, with the lagged effects of the US downturn showing up most significantly in 2009. Four other conclusions are perhaps more important: First, such a scenario would postpone the chance of a recovery in global growth until 2010. Second, while higher oil prices contribute to the weakness in global growth, the prolonged slowing in demand could pave the way for bigger declines in commodity quotes, especially in base metals. In addition, the economies that would suffer the most are those currently under stress in our baseline outlook; the stress scenario does not change the rankings. And finally, those differences might contribute to wider differences in markets’ performance than what we envision in our baseline. Those regional differences are thus worth more discussion, especially for the economies most affected. For example, in Japan, this stress scenario would probably turn the mini-recession into a deeper downturn. Weakness in exports, capex, and consumption would be a triple threat to growth. The stronger yen and higher oil quotes would offset each other, leaving the outlook for core inflation intact. But the policy reaction would be sharper. The BOJ likely would return to ZIRP in 2008, and officials probably would commit to reflationary policies such as explicit inflation targeting and increased outright purchases of JGBs. Prolonged US weakness would also hurt the Canadian economy, although the supply-induced elevation of energy prices would be an offset. Core Canadian inflation would remain near 1%, permitting more aggressive monetary ease well into 2009, and thus a weaker Canadian dollar. A key risk for Canada is that weaker commodity prices could reverse its favorable terms of trade and depress both Canadian incomes and the Canadian dollar. Australia and some emerging-market economies in Latin America like Brazil (but not Venezuela) face similar risks. For the Euro area, the principal shock in this scenario comes from the stronger euro. As with Japan, the strong currency mutes the energy shock, and Europe is less directly exposed to US growth than in past downturns. But half of EMU trade partners are more or less in the dollar zone. And the influence of the currency on profits and the economy may prove important. That channel implies weaker capex and hiring, rising corporate defaults, and more risk for Euro zone financial institutions. But it would help inflation to drop significantly below the ECB's target and, together with weaker growth, perhaps convince the ECB to ease more aggressively. In Asia, we see India's economy as most exposed because its growth depends on capital inflows, so persistent risk aversion in the financial markets would hit growth further. In contrast, Chinese authorities welcome the current US slowdown because it helps them cool off the Chinese economy and relieve inflation pressure. Even with a deeper slowdown, China's strong fiscal position and massive FX reserves limit the downside risks. And other Asian authorities have room to prime the pump. For example, in Hong Kong, monetary easing would support HK$ assets and domestic consumption and investment, offsetting the negative impact on trade from weaker global growth. Korea’s export mix makes it less vulnerable to US weakness than in the past, and the new government might employ infrastructure spending to counter the external downturn. In contrast, Taiwan is more exposed to US weakness, and the new government does not have the room for aggressive stimulus measures.
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Paradise Lost
April 02, 2008
By Marcelo Carvalho | Sao Paolo
After years of upward growth revisions to the world economy, the global outlook has now become darker, with risks tilted to the downside. With plenty of momentum coming into 2008, the outlook for Brazil’s economy remains favorable for this year. But, with a time lag, we expect the global slowdown to hurt Brazil’s prospects for growth into 2009. The Times They Are a-Changin’ The last several years saw exceptionally favorable global conditions. The global economy steadily surprised to the upside. Indeed, the IMF’s forecasts for global real GDP growth were repeatedly revised up. In every single year from 2004 to 2007, global real GDP growth proved systematically stronger than initially foreseen. That picture is changing now. The global growth outlook is darkening. Indeed, in January, the IMF already cut its estimate for 2008 global growth by 0.3pp. And it looks bound to cut it yet again at the upcoming release of its semi-annual World Economic Outlook on April 9. Our global economics team sees global growth slowing by a full percentage point this year, from an estimate of almost 5% in 2007 to about 4% in 2008, with risks still biased to the downside. Indeed, with concerns that the US slowdown might prove to be deeper and longer than initially foreseen, it would not surprise us to see 2008 global growth figures eventually sliding towards the 3% mark. Our global team sees some recovery in 2009. But the recovery path remains short of the growth pace seen in 2007, and risks are that it could prove tepid. Is a new cycle of global growth revisions underway? In our view, the cycle of steady upward global growth revisions is clearly over. After years of systematic growth upgrades, markets could now be entering a new cycle of repeated downward global growth revisions. Brazil’s economy has decoupled so far. Can it last? Often overlooked, historically there is a significant correlation between global indicators such as the OECD’s leading economic indicator and Brazil’s industrial production, with a time lag of about six months. But data over the last year or so suggest a hard decoupling, as these two series have moved apart. Growth in the developed world has already slowed, but Brazil’s expansion has actually accelerated of late. This divergence reflects the strength of domestic demand conditions in Brazil. Can it last? History has not been kind to past episodes of tentative ‘decoupling’, as they often entailed a rapid deterioration in the external accounts – as is now becoming evident in Brazil’s worsening current account balance. Maybe ‘this time is different’, but these often prove to be the four most expensive words in the English language. It Is Chinatown Key for Brazil’s outlook are export prices, through China. Brazil’s export prices have historically reflected trends in China’s imports, with a time lag of about six months. That link should not surprise. About half of Brazil’s exports are commodity-related, and China plays a key role in commodity markets. Note that Chinese trade seems the relevant variable here, rather than China’s domestic growth per se. The experience around the 2001 US recession is telling. Forget about China’s official growth numbers: they barely budged back then. Yet, China’s exports (and imports) fell from growth rates in the 30-40% range to single-digit terrain, dragging along Brazil’s export price growth into negative territory, after a six-month lag. We do not claim an exact replica of 2001. But if history is any guide, the global growth slowdown adds downside risk to China’s trade numbers, with potentially negative implications for Brazil’s export price outlook. Paradise Lost What would softer export prices mean for Brazil? First, they would not help the currency. There is much talk about Brazil’s much-improved macroeconomic fundamentals, underpinning the steady appreciation of the Brazilian real over the last several years. However, a simple, mundane factor seems to go a long way in explaining Brazil’s currency swings over time – namely, export prices. True, there are deviations. For instance, the 1994 currency-based inflation stabilization plan meant that the then-managed currency stayed stronger than it should for years, until the shift to a floating exchange rate regime in 1999. Likewise, the currency undershooting of 2002 illustrates how market fears around the presidential elections temporarily weakened the Brazilian currency significantly below what export prices would suggest. Since 2003, however, there should be little doubt that Brazil’s export prices and its currency performance have gone hand in hand. Looking ahead, if export prices falter, the strength of the real could be called into question. Second, Brazil’s growth outlook would suffer. There has been a significant relationship between Brazil’s export prices and the country’s real GDP growth – more robust than many recognize, and probably stronger than the authorities would like to admit. The last ten years or so can be divided into two clusters. Times were tough before 2003. Global growth was far from spectacular. Brazil’s export prices were falling on average, and the country’s growth performance was dismal. By contrast, the sun has been shining after 2003. Global growth has been strong, international commodity prices have only gone up, Brazil’s export prices have increased steadily, and the country’s real GDP growth has accelerated. Average annual global real GDP growth jumped from 3.6% during 1999-2002 to 5.2% during 2004-07. Brazil’s export prices fell 4.4% per year on average in the first period, but jumped 11.5% per year on average in the second period. Brazil’s average annual growth increased from 2.3% in the four years before 2003 to 4.5% in the four years after 2003. Paradise lost? In other words, the period before 2003 was hellish. By contrast, the years since 2003 have been paradise. The risk is that Brazil might now be sliding back to purgatory. Note that there is a lag in perceptions. A good example is 2003. Many investors were downbeat at the start of the year. But, in retrospect, 2003 proved a transition year to a brave new world. This year might prove to be the mirror image of 2003. There is plenty of optimism about Brazil in early 2008. But, in retrospect, 2008 may eventually prove to be a transition year to tougher times. Good policies or good luck? It may be tempting for the authorities to think that good macro performance in recent years has derived from their smart policies. However, closer inspection suggests that there is less to celebrate than commonly thought. Brazil’s growth performance in recent years is surely positive by its own historical standards, but it remains below what has been achieved elsewhere in the emerging world. True, Brazil’s average growth was faster in the five years since 2003 than during the five years before 2003, but this has been the case for pretty much everybody else in the emerging world. In recent years − as before − Brazil has remained close to the bottom of the growth pack within emerging market economies. And the bulk of Brazil’s improving growth story appears to be explained by a series of external factors (see “Latin America: Growing Disconnect, Growing Risk”, EM Economist, March 7, 2008). Living in Lag-o-Land Our 2009 forecast is turning more cautious. What does this all mean for our macro forecasts? First, our long-standing, out-of-consensus call continues to see the trade surplus falling by half, to US$20 billion this year, and probably vanishing by 2009. While 2008 is proving to be a story of import strength, we suspect that export weakness will be the story going into 2009. For its part, after five years of repeated surpluses, the current account is dipping into deficit this year. We now see a gap in the range of 1-2% of GDP in 2008, widening towards 3% of GDP next year. Our forecast continues to see the currency weakening to 2.0 by end-2008, and we look for 2.1 at end-2009. Inflation should still remain consistent with the 4.5% official inflation target. But we are now removing all monetary easing we had penciled in for later this year and next year. The forecast now sees policy rates flat over the forecast horizon. We admit that rate hikes cannot be ruled out, as the odds of outright monetary tightening have risen substantially, in light of hawkish signs from the central bank. Growth to slow. As for real GDP growth, our forecast continues to see a slowdown from 5.4% in 2007 to 4.3% in 2008. The simple statistical carry-over from last year is already about 2.5%. And all evidence suggests continued domestic strength so far this year. So, it is hard to be too downbeat about Brazil’s average growth number in 2008. That said, net exports should prove to be an increasing drag on overall growth. And while real GDP growth has started strong in 2008, we expect that it will end the year on a softer note. Keep in mind that we are living in a land of time lags. Given lags, the full implications of global growth slowdown on Brazil’s growth performance will likely become more visible only by next year. We are thus cutting the Brazil 2009 growth forecast to 3.0%, from 4.0% before. If it materializes, such a number would be far from a disaster, but would probably frustrate those that got used to seeing Brazil as a 5%+ growth story. Bottom Line Brazil has enjoyed an exceptionally favorable global environment over the last several years. It was paradise. But the world is now changing. With a time lag, Brazil may well realize that the faster growth it enjoyed in recent years had more to do with favorable cyclical external conditions than with structural domestic advances.
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