Thursday, December 20, 2012

Things to watch in 2013

As we approach the end 2012, the sense of crisis that has occupied much of the last two years appears to be abating.  But there is still considerable work to be done.  Much of that work is structural in nature and therefore requires a higher level of engagement from politicians than we have seen up until now. 

Next year is shaping up to be the year in which we refocus on some of the key issues facing the global economy.  These were first talked about in 2009 but then got sidelined as the various crises, and potential crises, unfolded. Here are some of things I’ll be watching (including some I’ll be worrying about) in 2013:

1)      Locking in and building on progress in peripheral Europe.

Considerable progress has been made in some of the key worry-countries in Europe in terms of reducing structural budget deficits and moving fiscal settings onto a more sustainable path.  But there is still a lot to do.  The costs have been high with significant losses of both output and jobs.  Progress has also been made in reducing external imbalances and lowering unit labour costs.  The job now is to lock in those gains. 

2)      Further Eurozone integration

Progress is being made on Eurozone integration, but it is arduously slow.  A banking union is on the table right now.  This is a critical step towards greater financial integration.  It’s important that the recent reduction in financial market tensions, thanks to the ECB and its Outright Monetary Transactions, doesn’t reduce the urgency that is required to press ahead with these reforms.  As I’ve said on many occasions, the OMT hasn’t solved anything in Europe, but it has opened a window of opportunity for the politicians to get on with the job.

3)      Medium term fiscal consolidation plans in America and Japan

Europe has been the focus of fiscal consolidation over the last couple of years, but in 2009 we said fiscal sustainability and government deleveraging (alongside household deleveraging) would be a key issue for all developed economies at least to some extent.  In America, the current ‘fiscal cliff’ negotiations are the start of the process.  America also needs a credible well-articulated plan, which will go a long way to reducing concerns over fiscal sustainability.  The same is required in Japan.  The new government also has a significant task ahead to develop its medium term plan. 

4)      Old headwinds in America, but a couple of new tailwinds

The US has been prone to bouts of weakness and fears of a double-dip recession.  As it has turned out, the US has recorded 13 consecutive quarters of positive growth.   While fiscal drag will likely double next year, the good news is that underlying fundamentals are improving.  In particular, the housing market is turning from a headwind to a tailwind.  A stronger housing market means improved confidence to spend.  Another recent headwind has been the impact of state and local governments getting their spending under control where they have made good progress.  While spending from this sector won’t become a growth tailwind, it is becoming less of a headwind. 

5)      Monetary policy: remaining supportive, moving towards normalisation, exit strategies, and inflation targeting

Monetary policy has more than played its role over the last few years.  As growth recovers next year, and assuming less bouts of angst and downside growth risk, minds will turn to the monetary policy normalisation process.  The US has already started that process in its December statement by shifting its forward guidance from being time-specific to being tied to real economic variables, notably the unemployment rate.  The debate about the appropriateness of inflation targeting is re-emerging and has gathered momentum since the appointment of Mark Carney to the Bank of England.  More on that topic next year.

6)      Hard landing averted in China, but no double-digit recovery

As growth in China has slowed over the last 18 months we knew the slowdown was part structural and part cyclical, the only question was the proportion of each.  As it has turned out, the bigger share of the slowdown has been structural by virtue of the fact the authorities have been happy to see the economy slow.  The post-GFC policy response saw a number of excesses emerge, particularly in some parts of residential property market which the authorities have been keen to eliminate.  Another feature of the recent slowdown has been a strong destocking process which has seen the growth rate of industrial production halve over the past 18 months.  Growth looks set to recover modestly in 2013 with industrial production likely to continue the recovery that emerged at the end of 2012, although continued weak developed economy growth will constrain exports.

7)      No free lunch – structural reform in the key emerging economies

One of our main post-GFC themes was that emerging markets would be the key contributor to global growth in the period ahead.  We tempered that somewhat by acknowledging that while the key emerging economies didn’t face the same structural issues, they faced a number of their own.  China’s are well understood:  the easy gains from urbanisation have been achieved, the competitiveness gap with the rest of the world is closing and growth in the working-age population will soon start to reverse under the one-child policy.  Key reforms will be building sustainable gains in productivity to allow wage growth without generating inflation and we would like to see further progress on capital account liberalisation.  India needs to give monetary policy more room to move by pushing ahead with good market reforms.  Brazil needs to lock in recent competitiveness gains by focussing on labour productivity and being attuned to signs of inflation.  

8)     Global rebalancing

I’ve already talked a bit about external imbalances in Europe in (1) above.  However, the issue is broader than just Europe.   Global imbalances go right to the heart of the causes of the Global Financial Crisis.  The US housing market was the manifestation of the problem, but the problem was more fundamental than that.  There has been some success in reducing imbalances, but a lot of this improvement could well prove to be temporary.  The challenge is to lock in these gains. 

9)     Reform of the global regulatory environment and financial system

There’s been a lot of talk but not much action.  As appeared likely in the aftermath of the GFC, the G20 has assumed the mantle of the pre-eminent multi-lateral grouping of governments, usurping the role of the G7.  When was the last time you heard anything meaningful from a G7 meeting?  Not recently, right?  That’s not to say the G20 has been a whole lot more successful.  The IMF regularly cites cross-border resolution and supervision, the too important to fail issue, consistent implementation of the reforms in the derivatives market and closing critical information gaps as key issues still to be addressed.  We concur.

10)   Geo-political tensions

No predictions here, just a list of things to worry about.  In no particular order: North Korea, Libya, Gaza, Iran, Iraq; and China, Japan and the dispute over the islands known as Diaoyu (in China) or Senkaku (in Japan).  The world is not just fragile from an economic and financial perspective.   Any or all of these, or others I haven’t thought of, have the capacity to add uncertainty and volatility in equity, bond and commodity markets.  Same goes for natural disasters (is it just me or do once-in-a-hundred-year extreme weather events seem to be coming around with monotonous regularity??) Watch this space.

In conclusion.....

While we are hopeful of a less angst-ridden year in 2013, there are still plenty of challenges ahead.  There is still considerable work to be done to build a stronger and more resilient financial, growth and job creation environment.  Furthermore, many of the challenges are structural and supply-side.  The growth constraint facing many developed economies is not simply a problem of deficient demand.

All things considered we see a slightly stronger global growth environment in 2013.  This pickup will be driven by stronger growth in the emerging economies (particularly China, Brazil and India) which we see growing a collective 5.4% in 2013, up from 4.9% in 2012.  Developed economies are expected to grow 1.4% next year, up from 1.2% in 2012.  Japan and Europe will be the growth laggards.  That emerging/developed combination generates 2013 global growth of 3.3%, up from 3.0% in 2012, but still below the longer run average of 3.5%.

Here at home growth will remain hard work.  The headwinds are well known: soft global demand, household spending restraint, fiscal consolidation and the high New Zealand dollar.  A modest pick-up in growth next year is very much predicated on a stronger construction sector with the Christchurch rebuild and stronger residential construction activity in Auckland.  The current account deficit will be a key focus for markets next year as the Canterbury rebuild generates strong import growth.  We see annual average growth of 2.5% in 2013, up from 2.3% in 2012.

This is the final post for 2013.  Have a safe and merry Christmas.  I’ll be back from mid-January.  Between now and then this blog site is going to get a bit of a refresh and a lick of paint.  Now there’s something to look forward to in 2013!