The global economy

The worldwide wobble

The world economy will have a bumpy 2014. But the recovery is not, yet, at risk

Feb 8th 2014

FOR much of 2013 the world’s big stockmarkets had a magical quality about them. They soared upwardsAmerica’s S&P 500 index rose by 30% last year, and Japan’s Nikkei by 57%buoyed by monetary stimulus and growing optimism about global growth. Over the past month, the magic has abruptly worn off. More than $3 trillion has been wiped off global share prices since the start of January. The S&P 500 is down by almost 5%, the Nikkei by 14% and the MSCI emerging-market index by almost 9%.

That investors should lock in some profits after such a remarkable surge is hardly surprising (see article). American share prices, in particular, were beginning to look too high: the S&P finished 2013 at a multiple of 25 times ten-year earnings, well above the historical average of 16. A few bits of poor economic news of late are scarcely grounds for panic. It is hard to see a compelling economic reason why one unexpectedly weak report on American manufacturing, for instance, should push Japan’s Nikkei down by more than 4% in a day. Far easier to explain the market gyrations as a necessary correction.

From supercal…to fragilistic

Prices always jump around, but in the end they are determined by the underlying economy. Here it would be a mistake to be too sanguine

Economists are notoriously bad at predicting sudden turning-points in global growth. Even if it goes no further, the dip in asset prices has hurt this year’s growth prospects, particularly in emerging markets, where credit conditions are tighter and foreign capital less abundant. Tellingly, commodity prices are slipping too. The price of iron ore fell by more than 8% in January.

On balance, however, this newspaper’s assessment of the evidence to date is that investors’ gloom is overdone. A handful of disappointing numbers does not mean that America’s underlying recovery is stalling

China’s economy is slowing, but the odds of a sudden slump remain low. Although other emerging markets will indeed grow more slowly in 2014, they are not heading for a broad collapse. And the odds are rising that monetary policy in both Europe and Japan is about to be eased further. Global growth will still probably exceed last year’s pace of 3% (on a purchasing-power parity basis). For now, this looks more like a wobble than a tumble.

The outlook for America’s economy is by far the most important reason for this view. Since the United States is driving the global recovery, sustained weakness there would mean that prospects for the world economy were grim. But that does not seem likely. January’s spate of feeble statistics—from weak manufacturing orders to low car salescan be explained, in part, by the weather. America has had an unusually bitter winter, with punishing snowfall and frigid temperatures. This has disrupted economic activity.

It suggests that all the figures for January, including the all-important employment figures, which were due to be released on February 7th after The Economist went to press, should be taken with a truckload of salt.

All the more so because there is no reason to expect a sudden spending slump. The balance-sheets of American households are strong. The stockmarket slide has dented consumer confidence, but investors’ flight from risk has pushed down yields on Treasury bonds, which in turn should lower mortgage rates. Fiscal policy is far less of a drag than it was in 2013. All this still points to solid, above-trend growth of around 3% in 2014. One reason this may not excite investors is that it no longer implies an acceleration. America’s economy was roaring along at a 3.2% pace at the end of 2013. The first few months of 2014 will be weaker than that, even though average growth for 2014 still looks likely to outpace last year’s rate of 1.9%.

China’s economy, for its part, is clearly slowing. The latest purchasing managers’ index suggests factory activity is at a six-month low. The question is how far and how fast that slowdown goes. Many investors fear a “hard landing”. Their logic is that China has reached the limits of a debt-fuelled and investment-led growth model; and that this kind of growth does not just slow but ends in a financial bust. Hence the jitters on news that a shadow-bank product had to be bailed out. 

Yet it remains more likely that China’s growth is slowing rather than slumping. The government has the capacity to prevent a rout; and the recent bail-out suggests it is willing to use it.

If fears about a hard landing in China are exaggerated, then so are worries about a broad emerging-market collapse. That is because the pace of Chinese growth has a big direct impact on emerging economies as a whole. Expectations for Chinese growth will also be a big influence on the desire of foreigners to flee other emerging markets, and hence on how much financial conditions in these countries tighten. After more than doubling interest rates, Turkey’s economy will be lucky to grow by 2% in 2014, compared with almost 4% in 2013. But in most places less draconian rate hikes will merely dampen a hoped-for acceleration in growth rather than prompt a rout.

The final, paradoxical, reason for guarded optimism is that the market jitters make bolder monetary action more likely in Europe and Japan (see article). With inflation in the euro area running at a worryingly low 0.8%, the European Central Bank (which met on February 6th after we went to press) needs to do more to loosen monetary conditions. Really bold action, such as buying bundles of bank loans, is more likely when financial markets are in a funk. That logic is even stronger in Japan, whose stockmarket has fallen furthest and where the economy will be hit by a sharp rise in the consumption tax on April 1st. So more easing is on the cards.

Still in need of a spoonful of sugar

If this analysis is correct, the current market pessimism could prove temporary. Investors should recover their nerve as they realise that the bottom is not falling out of the world economy. 

Our prognosis is a lot better than the outcome markets now fear. But it would not be much to get excited about. The global recovery will be far from healthy: too reliant on America, still at risk from China, and still dependent on the prop of easy monetary policy.

In other words, still awfully wobbly.

Turmoil in financial markets

Goldilocks and the bears

Investors have been forced to reassess their rosy view

Feb 8th 2014

EQUITY markets started 2014 in a buoyant mood, after 30% gains for American shares in the previous year. Investors seemed to believe that the worst of the financial crisis was at last over and that the global economy was returning to “Goldilocksmode, with growth neither so strong as to cause inflation nor so weak as to squeeze profits, but “just right”.

However, markets have been hit by a classic one-two punch in the opening weeks of the year. First, emerging-market currencies came under pressure, with the Argentine peso and Turkish lira, among others, falling sharply and several countries opting to increase interest rates. To add to the concern, Chinese economic data showed signs of weakness, with the purchasing managers’ index for manufacturing dropping to 50.5 in January, its lowest level in six months.

The second sandbagging came from America, where the purchasing managers’ index for manufacturing slumped to 51.3 in January from 56.5 in the previous month. That was accompanied by a 3.1% decline in vehicle sales in January compared with a year earlier and followed a surprise 4.3% fall in durable-goods orders in December

The news prompted a 2.3% fall in the S&P 500 index on February 3rd. Most analysts had dismissed weak employment numbers for December as an aberration due to exceptionally cold winter weather, but the run of disappointing statistics seems to have stirred second thoughts. Payroll data for January, which were due to be released after The Economist had gone to press, may assuage or amplify these misgivings.

Underlying all this is a third potential worry. The Federal Reserve’s policy of “quantitative easing” (creating money to buy assets) is widely credited with propping up equity markets as well as depressing bond yields. Now that the Fed is “tapering”—that is, gradually reducingits asset purchases, will the markets come under prolonged pressure?

As always, psychology plays a big role. The Fed is still buying $65 billion of assets a month, a significant level of support. The “forward guidance” it is giving suggests that an increase in short-term interest rates is far from imminent. Nevertheless, if investors expect the eventual withdrawal of monetary stimulus to prompt a decline in markets, it makes sense for them to sell in advance so as to reduce their potential losses. Indeed, the strong returns achieved from stockmarkets in 2013 may be reinforcing this process; investors are happy to lock in their profits.

The profit-taking trend seems well under way in Japan, even though the Bank of Japan is expected to maintain monetary easing. The broadly based Topix index fell by 4.8% on February 4th, having risen by 51% last year.

Profit-taking is not really the problem in emerging equity markets, since they have been underperforming stockmarkets in the rich world for the past three years (see chart). The worst-hit countries in recent weeks have been those with specific problems: political turmoil (Ukraine), a wide current-account deficit and high inflation (Turkey) or simply poor economic policy (Argentina).

But Raghuram Rajan, a prominent economist who is now governor of India’s central bank, has raised a broader issue. In the wake of the financial crisis of 2007-08, capital flooded into emerging markets, in part because their economies lacked many of the problems seen in the developed world and in part because central banks in rich countries had slashed rates so far that investors went abroad in search of juicier returns.

As this money flows back again, emerging-market currencies (including the Indian rupee) are coming under pressure. That presents the countries concerned with a dilemma: let the exchange rate slide and risk inflation, or increase interest rates to defend the currency and risk a recession. “The US should worry about the effects of its policies on the rest of the world,” Mr Rajan says.

Judging by the behaviour of markets in recent weeks, many investors have been consumed by the opposite concern: will the difficulties in emerging markets infect the developed world? Analysts at Macquarie, an investment bank, point out that five of the countries that have seen their currencies fall the most (Argentina, Brazil, India, Russia and Turkey) comprise 12% of the global economy. Around 18% of European corporate revenues derive from emerging markets, according to Goldman Sachs, and that rises to 24% for Britain and 31% for Switzerland.

About 15% of the profits of S&P 500 companies come from emerging markets. As yet, there is no sign of problems in corporate results

Bank of America Merrill Lynch estimates that, as is the custom, most American companies have beaten earnings forecasts for the fourth quarter. With 70% of companies in the S&P 500 having reported, earnings per share have risen at an annual rate of 7%.

But Wall Street does not have much margin for error. Profits are close to a post-war high as a proportion of GDP. Meanwhile, equities look expensive by two of the best long-term valuation measures, which are calculated in quite different ways. Price-equity ratios, which relate share prices to a ten-year average of profits, are now around 25, far above their long-term average of 16. Shares look equally expensive when measured against the cost of replacing companies’ assets, a metric known as the q-ratio.

Bad news for equities has proved positive for government bonds, even though the Fed is buying fewer of them. The yield on ten-year Treasuries dropped from 3% at the start of the year to 2.59% on February 3rd, and yields on ten-year German bonds fell from 1.94% to 1.56% over the same period

Whereas sentiment on equities may have been overoptimistic at the end of 2013, it may have been too pessimistic about bonds; inflation is lower than it was a year ago in America, Britain and the euro area. The Economist’s commodities index has dropped by 13.9% over the past year and copper, often seen as especially sensitive to economic conditions, is down by almost 15%.

The wobbles in financial markets so far this year can be explained as a timely reassessment of what had been an excessively rosy investor outlook. For the sell-off to turn into something more serious, it will probably need clearer evidence of a new economic slowdown, in either China or the developed world, or a significant hit to corporate profits.

Heard on the Street

Sleeping Easier in the Citi

By John Carney

Updated Feb. 6, 2014 2:52 p.m. ET

With concerns over emerging markets keeping many investors up at night, shares of the bank that "never sleeps" have taken a beating. Investors shouldn't toss and turn too much, though.
Citigroup is up more than 6%.

In one sense, this is understandable. Citi has become a proxy for international, and particularly emerging-market, concerns. That is because it is the most globally oriented of the big U.S. banks. International markets generated roughly 56% of Citi's core revenue compared with about 25% at J.P. Morgan Chase, according to Bernstein Research.

And much of Citi's international business is in emerging markets, which contributed 42% of revenue in 2013 and about 55% of net income, Evercore estimates. Over a third of Citi's loans are in emerging markets.

But just because Citi is big in emerging markets doesn't necessarily mean it has a lot of exposure to the most troubled ones. So, barring contagion that leads to a systemic event, the impact could be more muted than many investors fear.

Let's talk Turkey. This is one mess Citi should be able to sit out. It exited from consumer banking there last year. Evercore estimates the corporate banking business still ongoing was responsible for just 0.3% of Citi's net income last year.

Swing around the globe to Asia. Here, Citi should be able to sidestep troubles in Indonesia and Thailand. While Citi is one of the largest foreign banks in each, the earnings they produce aren't significant to overall performance.

China, of course, matters. Citi has $4.7 billion in consumer loans there. If the broad mix of consumer credit to corporate loans in Citi's international book holds for China, the bank's corporate credit exposure is probably slightly larger than that

Evercore estimates China produced 2.5% of Citi's net income. But while growth in China has been slowing, and there are concerns about its financial system, the Chinese government likely has the wherewithal to contain problems for some time.

In Latin America, Brazil, Argentina and Venezuela are the main problems. Citi's credit exposure to Venezuela and Argentina are small enough that the bank doesn't break them out. 

Brazil is more significant, producing 3% of Citi's net income, according to Evercore. As with China, a full-blown meltdown in Brazil would hit Citi's bottom line and inflict large credit losses. But problems would have to be far larger than they are today.

Citi's biggest emerging-market exposure is to Mexico, with $31.3 billion in consumer loans, and South Korea, with $23.9 billion in consumer loans. Neither country shows up on the 2014 danger lists of most emerging-market bears, though.

On the investment-banking side, recent history might provide some comfort. The onset of taper talk caused disruption in many important emerging-market currencies in the third quarter of 2013. Investors then feared the bank's currency-trading operations could take a big hit. That didn't happen; in fact, it was Goldman Sachs Group GS that got caught offsides.

Citi shares, which started the year trading at about tangible book value, are now at a roughly 13% discount, the only one of the big U.S. banks trading below tangible book. So long as the emerging-markets storm doesn't turn into a typhoon, the stock shouldn't be so far underwater.