Global Economy: Hovering Between Growth and Stagnation

By Tina Kremmidas

Six years after the onset of the financial crisis, words like “mediocre”, “brittle”, “disappointing”, “sub-par” and “uneven” are used to describe the global economic recovery.

British Prime Minister David Cameron went as far as to say that “red warning lights are once again flashing on the dashboard of the global economy.”
To be sure, the world is far from achieving the “strong, sustainable and balanced growth” G20 Leaders pledged to achieve when they gathered for the 2009 Pittsburgh Summit.

Europe’s woes

The epicentre of the economic worries is again Europe. The 18-nation euro zone is barely growing as geopolitical tensions in Ukraine and the Middle East have weighed heavily on business and investor confidence, especially in the large core economies. Germany has lost steam, Italy is in recession and France’s economy continues to languish.

The euro zone periphery appears to be holding up much better than its core. Greece’s crisis-stricken economy has returned to growth following six years of recession. It is now the fastest-growing economy in the euro zone. Spain is also outperforming in terms of growth. Structural reforms, especially in Spain, have helped to enhance competitiveness and growth, but significant challenges remain.

It’s not all doom and gloom in Europe. The UK will be fastest growing G7 economy in 2014. Nonetheless it is feeling the chill as its biggest trading partner and neighbour, the euro zone, sputters. The Bank of England recently cut its growth forecasts, but it still expects the UK economy to grow at above-trend rates thanks to the combination of lower effective interest rates, a strong labour market and improved pay prospects.

Land of the Rising Sun Falters

Japan’s economy unexpectedly slipped into recession in the third quarter of 2014. The world’s third largest economy raised its consumption tax in April to reduce the nation’s enormous debt, but the tax hike discouraged consumer spending and smothered the recovery. The Bank of Japan stepped in, injecting more money into the economy (more recently, by buying longer-term debt, namely Japanese government bonds) in an effort to keep borrowing costs low, encourage spending, get the economy out of a deflationary trap, and ultimately stoke growth.

Divergence among the BRICs

Emerging market economies are far from the dynamos they once were. Among the big four economies (i.e. Brazil, Russia, India and China), Brazil and Russia are in the worse shape. Brazil slipped into recession in the first half of 2014 amid political uncertainty and deteriorating business and investor confidence. In late October, Brazil’s central bank unexpectedly raised its benchmark rate to a three-year high to tackle persistent high inflation. It is prepared to do so again. The outlook for Russia is particularly precarious. Its economy was performing poorly even before economic sanctions were imposed in the wake of the Ukraine conflict. The sanctions have pushed the economy to the brink of recession. Additionally, the decline in crude oil prices is exacting a toll on government revenues. Heightened uncertainty has led to a significant increase in capital flight (estimated in the order of US$128 billion in 2014) and a plunge in the ruble. The Central Bank of Russia announced that it will let the currency float freely and that it will intervene in foreign exchange markets in case of an emerging threat to financials stability.

Growth in China—the world’s second-biggest economy—has softened on the back of a weakening housing market and more moderate credit growth. Fixed-asset investment grew at its slowest pace in almost 13 years in the first 10 months of the year. Policymakers have enacted targeted stimulus measures to keep growth within reach of the government’s 2014 official target of 7.5 per cent. Beijing has not announced an official growth target for 2015, but expectations are it will be around 7.0 per cent. Policymakers are aiming to shift the economy’s growth engine from exports and fixed investment to domestic consumption and services to achieve more sustainable and balanced growth. This rebalancing has implications for commodity prices and commodity producers because China is a dominant consumer of raw materials in the world. Demand for crude oil and low-grade metals (i.e. copper and iron ore) China uses to build infrastructure and to manufacture goods to sell abroad is expected to moderate over the long term, but demand for higher-grade metals (i.e. aluminum) used in consumer durables is likely to prove more resilient in the years ahead. This may adversely affect countries like Brazil and Australia who are major exporters of iron ore to China, and Chile who exports significant amounts of copper. Stronger demand for aluminum may ultimately benefit major producers in Russia, China, the U.S. and Canada.

India stands out among its peers, as it is the only country projected to see a pick-up in growth momentum. The government has stepped up economic reforms focused on cutting red tape and administrative procedures, overhauling outdated labour laws, implementing a national goods and services tax and opening up key sectors to foreign investment to put the country on a high-growth trajectory and to attract investment.

U.S. Economic Expansion

As many countries and regions struggle to sustain (and in some case, generate) growth, the U.S. economy has maintained positive momentum led by a strong expansion in business spending and hiring in the past year.

Employers added 229,000 net new jobs per month in the first 10 months of 2014 and are on pace to post the best yearly gain in employment since 1999. The burst of hiring drove the national unemployment rate to 5.8 per cent in October, a six-year low.
The financial position of U.S. households has also improved since the recession. U.S. household net worth (i.e. the value of households’ assets minus liabilities) soared to $81.5 trillion in the second quarter of 2014 — an all-time high — bolstered by improving home valuations and the gain in equity markets. The improvement in household finances has bolstered access to credit.

Americans are feeling more confident than at any time in the previous seven year, so confident they ramped up borrowing in 2014. Auto loans have been in high demand which helps explain why U.S. automakers are on track for their best sales year since 2006.

The housing market is recovering at a slow, gradual pace. According to the National Association of Home Builders (NAHB), 59 of the approximately 350 metro areas nationwide returned to, or exceeded their last normal levels of economic and housing activity in the third quarter of 2014, representing a year-over-year net gain of seven markets. The NAHB looks at building permits, house prices and employment levels. The National Association of Realtors notes that residential mortgage demand continues to underwhelm despite further signs of banks easing standards.

Adult millennials (i.e. those aged 18 to 33), who represent 60 per cent of first-time buyers, are delaying buying a house, preferring instead to rent. Renter households have increased by four million since 2010 while homeowner households have decreased by one million. As a result, multi-family housing starts have rebounded to normal levels reflecting strong demand for rental units, but single-family housing starts are still lagging.

The U.S. federal government is also making a positive contribution to growth as the fiscal drag from last year’s tax increases and mandated federal government spending cuts (i.e. sequestration) has faded. National defense spending is rising again, and state and local governments are spending after three years of belt tightening. Government employment is also rising, albeit at a slow pace, mainly because local governments are rehiring some workers laid off during the recession.

U.S. Poised for Stronger Growth

Recent gains in household wealth, the improving tone of the labour market and consumers’ willingness to take on more debt signal stronger consumer demand ahead. This bodes well for the U.S. recovery because consumer spending drives almost 70 per cent of the U.S. economy.

As demand for goods and services increases, businesses will have a greater incentive to hire and invest in structures (e.g. factories and plants) and machinery and equipment. They certainly have the capacity to do so given strong balance sheets and favourable financing conditions.

Investment in commercial real estate (office, retail and industrial) is also expected to gradually pick up as economic activity strengthens and hiring improves. There is an indication that banks are slowly easing their standards for commercial and industrial loans.

The housing recovery should gain strength in the months ahead. A growing economy, near historic low interest rates, steady jobs gains, rising household formation and significant pent-up demand will support single-family construction. With rent prices continuing to rise and vacancy rates falling, construction of multi-family units is expected to be particularly robust.

The U.S. Federal Reserve is expected to begin raising interest rates in the second quarter of 2015 as the U.S. economic recovery broadens. The federal funds rate is projected to rise from 0.25 per cent at present to 0.75 per cent by year-end 2015 and to 2.00 per cent by year-end 2016.

More favourable growth prospects in the U.S. and diverging central bank policies between the U.S. Federal Reserve and its peers should favour the U.S. dollar.
All told, the U.S. economy is expected to grow 2.3 per cent in 2014. Growth is forecast to accelerate to around 3.0 per cent in 2015 and then decelerate slightly in 2016 as the Federal Reserve gradually increases rates.

Can Weak External Demand Derail the U.S. Recovery?

The answer is, probably not. The U.S. economy is one of the least trade dependent countries in the world — U.S. exports of goods and services comprise 13.6 per cent of the U.S. economy whereas in Canada exports account for a little more than 30 per cent of GDP. U.S. exports are also well diversified across regions and trade links are generally limited, so a slowdown in one area may not have a big impact on U.S. GDP.  For example, roughly three per cent of U.S. exports head to Germany, three per cent to the UK, seven per cent to China, four per cent to Japan and less than three per cent to Brazil.

More than one-third of U.S. exports are destined for Canada and Mexico combined. Both countries are uniquely placed to hitch a lift on their neighbour’s coattails.
Nonetheless, the U.S. is not totally immune to global developments. Possible trepidation and uncertainty about the global economic outlook could derail consumer and business confidence, hampering the recovery. The good news is it is not happening at present despite the slew of disappointing economic data announcements out of Europe, Japan and elsewhere. Indeed, consumer confidence has continued to climb to a seven-year high.

Canada Performs Admirably Well

Canada’s economy has shown resilience as the global economy continues to disappoint. Factory sales advanced in eight of the first nine months of 2014. Canadian exports have been gaining traction in line with growing momentum in the U.S. economy and a weaker Canadian dollar; however, business investment remains soft, unlike in the U.S.

Consumer spending has remained a stalwart supporter of growth in Canada which seems even more remarkable given soft labour market conditions and lacklustre wage growth. Canadian auto sales have been in overdrive this year and are headed for their best year ever.
Canada’s housing market has continued to be a source of strength for the economy. National home sales are running above the ten year average and prices continue to push higher on a national basis. The big gains have been concentrated in Toronto, Calgary and Vancouver. Housing starts reached a nearly two-year peak in the third quarter of 2014.

Looking ahead, consumers are expected to contribute positively to economic growth over the forecast horizon (i.e. 2015-2016), but at a more moderate pace as they will be held back by tepid income growth, weaker credit growth and higher interest rates.

Housing activity should gradually moderate as interest rates start edging higher by the end of 2015.

The export sector is forecast to underpin growth over the next few years. Roughly 75 per cent of Canada’s merchandise exports head to the U.S.  A resurgent U.S. economy (underpinned by higher investment spending, consumer demand and residential construction) and the past depreciation of the Canadian dollar point to further export gains, particularly in the categories of machinery and equipment, fabricated metal products, building and packaging materials, consumer durables and autos.

Stronger export growth should lift hiring and business investment. Typically, business investment increases following a pick-up in exports, with a bit of a lag (within six to 12 months, according to the Bank of Canada). Conditions are generally positive for investment—balance sheets are healthy and financing terms are favourable.
Overall, Canada’s economy is projected to grow 2.3 per cent in 2014, 2.5 per cent in 2015 and then moderate slightly to 2.3 per cent in 2016 as higher interest rates crimp housing affordability and demand.

The Bank of Canada is expected to begin raising its key policy rate in the fourth quarter of 2015. The target for the overnight rate (which has been set at 1.00 per cent since September 2010) is projected to reach 1.50 per cent by the end of 2015 and 2.00 per cent by the end of 2016.
The Canadian dollar is expected to move towards 85 U.S. cents heading into the fourth quarter of 2015 and then strengthen modestly as the Bank of Canada begins to raise rates. The loonie has been under pressure from falling oil prices, continued strength in the U.S. dollar alongside better economic data south of the border, and the belief that the Bank of Canada will lag the Federal Reserve in hiking interest rates.

In Summary

Feeble demand is holding back the world economy despite highly accommodative monetary policy in most advanced economies. Luckily for Canada, the U.S. economy has positive underlying momentum and, as such, it should ride the coattails of its largest trading partner, the U.S.

Tina Kremmidas, Economics Contributor