Global Worries (And Some Benefits)

In the latest update of its World Economic Outlook, the IMF revised lower its expectations of global growth in 2014 and 2015. None of that should have surprised anyone. At this point, the IMF expects that European GDP will be relatively weak in 2014 (+0.8% 4Q14/4Q13) and should improve in 2015 (+1.6% 4Q15/4Q14). However, risks are weighted predominately to the downside. Weaker European growth and a stronger dollar will have a significant impact on many U.S. firms, but may have some benefits for the economy as a whole.

Global investors have worried a lot about Europe in the last few years. However, the key fear, that we’d see a breakup of the monetary union, was largely put aside when ECB President Mario Draghi promised to “do whatever it takes.” Issues present at the creation of the monetary union had finally come to a point where they had to be addressed. Critics cautioned early on that Europe needed a banking union and a fiscal union to make the monetary union work. European authorities have made progress in recent years, but still have a long way to go.

While Europe’s crisis of the last few years has been called a “sovereign debt crisis,” government debt was not the catalyst for weakness. It’s been a crisis of capital flows. With lower borrowing costs, money poured into the peripheral countries when the euro was introduced (contributing to housing bubbles in Ireland and Spain), then capital started to flow out during the global financial crisis. Many had expected Europe’s difficulties to lead to a flight-to-safety in the U.S. dollar. However, the safety flow went largely to Germany, leaving little impact on the exchange rate. More troublesome, the misdiagnosis of the cause of the crisis led to the bad prescription: austerity.

Government budget deficits and debt levels are important long-term issues. There are well-known concerns about using fiscal stimulus (lower taxes, increased government spending) to boost growth (how big, how to unwind), but what’s clear is that fiscal tightening (higher taxes, reduced government spending) in an economic recovery is a bad idea. It contracts the economy. Growth will be slower than would have occurred otherwise. Moreover, slower economic growth means a slower recovery in tax revenues, and less budget improvement than was anticipated. It’s a self-defeating policy.

Europe is now in a much more precarious phase. Inflation is trending very low. Economists note that it’s real (that is, inflation-adjusted) interest rates that matter. For any given level of interest rates, lower inflation implies a higher real rate of interest – and slower economic growth than you’d see otherwise. The European Central Bank has lowered benchmark interest rates to near zero (and in case of the interest rate on the deposit facility, negative). It can’t go lower.

Saddled with the zero lower bound on interest rates textbook economics (granted, graduate-level textbooks) suggest that the central bank can expand its balance sheet to support economic growth. The ECB is embarking on an asset purchase program, but this is more akin to the Fed’s TALF, the Term Asset-Backed Securities Loan Facility (from March 2009 to June 2010). The central bank receives asset-backed securities and gives the banks cash, which they will use to make more loans (or at least, that’s the theory). This is different from outright quantitative easing, but has similar economic effects in the short-run. The ECB is widely expected to undertake real quantitative easing (the outright purchases of sovereign debt) in the months ahead (at the clear objections of the Germans).

Whether the ECB’s efforts to spur growth will work soon enough is an open question. The key point for financial market participants is not that Europe’s economy will necessarily fall apart, but that the downside risks are considerable. Weak European growth will have a negative impact on countries like China, which remain dependent on exports (China may also have to contend with the collapse of a housing bubble).

European weakness will have a significant impact on many U.S. firms, which are expected to see weaker earnings growth from Europe and a loss in the currency translation (due to the stronger dollar). However, while we should see a decline (or at least softer growth) in exports to Europe, that weakness is unlikely to drag the broader economy down.

There may be some parallels with the Asian financial crisis of 2007 (of course, there are many more differences than similarities to the current situation in Europe – just hear me out). In the Asian financial crisis, the hit to U.S. exports subtracted a full percentage point from GDP growth. However, the crisis put downward pressure on inflation and boosted capital inflows, which was far more significant. Similarly, we are now seeing a stronger dollar put downward pressure on commodity prices. Increased capital inflows should help keep long-term interest rates relatively low and the stronger dollar will likely delay the Fed’s first increase in short-term rates.

Gasoline prices have drifted lower in recent months, but not enough for a sharp boost in consumer spending (note that gasoline prices normally fall about 12% from May to December, and have fallen about 10% so far this year). However, gasoline prices are likely to fall faster in the near term and a further decline (to below $3 per gallon) would add more significantly to consumer purchasing power into early 2015.

The Asian financial crisis had a negative impact on the U.S. stock market, but that turned out to be a great buying opportunity. We may see some imbalances develop (a wider trade deficit), but the U.S. may benefit from Europe’s weakness.

© Raymond James

© Raymond James

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