Is the world headed for a global recession …. Fidelity Investments thinks not

By Michael Collins, Investment Commentator at Fidelity

September 2015

Remember the hype about the “super cycle” that justified record commodity prices? The term to describe “higher-for-longer” commodity prices was based largely on ever-climbing demand from the Chinese as the country industrialised. Amid the excitement, commodity prices soared by more than six-fold from 2004 to 2011, as measured by the Reserve Bank of Australia’s commodity price index.[1] That index has collapsed by 63% over the past four years as Chinese demand fell and supply increased after an investment frenzy to build more projects and the revolution in shale. (A high US dollar hurts too because it boosts prices in local currencies, thus curbing demand.) As at August 31, aluminium, copper, iron ore, nickel, oil and zinc had plunged 49%, 47%, 63%, 78%, 61% and 57% from their recent, and mostly record, highs.[2]

The collapse of the commodities bubble – for that’s what it was in hindsight – is buffeting emerging countries (such as Brazil, Chile, Colombia, Russia and Venezuela) that rely on material exports. And plunging commodities is only one of their problems. The prospect of higher interest rates in the US is sucking capital from emerging countries by boosting repayments on the US$4.5 trillion (A$6.3 billion) of US-dollar-denominated debt that these countries owe. Political uncertainty is dogging Brazil, South Africa, Turkey and Malaysia.

The trials of China and other emerging countries on top of the unresolved eurozone debt crisis, Japan’s inability to revive itself and the Federal Reserve’s likely imminent rate increase are fanning talk[3] the world economy is headed for recession. The underlying concern is that policymakers can’t combat any slump as high government debt hampers fiscal stimulus and interest rates are already at record lows. While no one can rule out a global recession because events somewhere could surprise much like the so-called Arab Spring did in 2010, the world economy probably has enough going for it to avoid such a gloomy outcome. Its key advantages are that the US is prospering while China is only slowing, not shrinking.

Judging whether the world might enter a recession requires defining what such a downturn would look like; a task more contentious that it should be. Some define it as annual growth as slow as, say, 2% while others voice that it must be a contraction in global living standards. The world should escape either fate, even if global growth is subdued enough to approach the more-relaxed definition. Still, it must be acknowledged that a growing US economy is less an asset for the world than it was. The world’s largest economy only amounts to 22% of global GDP now, as measured by the World Bank,[4] compared with about 40% two decades ago. While what’s happened to commodities is cyclical in many respects – greater demand and rising prices leads to a supply response that became a glut – the worry, in fact, is that the drop in commodities really reflects a slump in global demand rather than extra supply. The danger in this situation is that the drop in commodities will add to deflationary pressures in a debt-heavy world.

Investors, though, can be reassured that the collapse of the commodities bubble is different from the ending of the bubbles in, say, technology, which blew up stock markets and wealth, and US housing, which nearly crashed the global financial system. While the end of these bubbles just spewed venom, falling commodity prices come with advantages for the world. Diving materials prices are great for commodity importers, including emerging countries such as India and those in eastern Europe. They help trade balances, mend government finances, boost consumer spending power, reduce business costs and lower inflation. The global economy, overall, is better off. Commodities too are still double what they were a decade ago so commodities exporters are not facing a catastrophic decline. Authorities still have room to expand fiscal and monetary stimulus if needed, even if they have less scope than before. A further relief for investors is that China has enough remedies at hand to escape an imminent recession. Another comfort is that much of the increase in the US dollar is because the Fed is poised to increase interest rates. The Fed will only do this if it thinks the US upturn is strong enough to cope. So too is the global economy buoyant enough to handle the challenges thrown up so far.

Tougher hurdle

The IMF in 2009 tightened its definition of a global recession and in doing so defined away some slumps. The body used to say the world was in recession if GDP growth fell below 3% over a period but decided this made little sense. So the IMF toughened its recession definition to make it closer to the one credible bodies apply to countries – when they look at a range of key economic indicators, including GDP growth, to judge the business cycle. (The definition of a recession as two consecutive quarters of negative growth is amateur economics.) These days, the IMF says the world is in recession if a drop in per-capita GDP worldwide (measured on a purchasing-power-parity basis)[5] coincides with weak readings on key variables such as employment, trade and industrial production. By this definition, there have only been four global recessions since World War II; namely, in 1975, 1982, 1991 and 2009 (when per-capita output slid to 0.13%, 0.89%, 0.18% and 2.5% respectively).[6]

The change in the IMF meaning defined away global recessions in 1998 and 2001, years that are instructive of what may lie ahead now. In 1998, an upturn in advanced nations offset a slump in emerging countries, to ensure the world economy expanded 2.5%. In 2001, the opposite occurred – the emerging world counterbalanced their developed peers – such that the world grew 2.5% again.

Investors can take comfort that enough of the world’s economies will grow in the coming year to ensure the global economy expands, even if that’s at a sluggish pace by past standards. By way of comparison, in good years the world economy can expand between 5% and 5.5% – the record since 1980 is 5.7% growth in 2007. Another baseline is that annual average economic growth for the world over the past 35 years is 3.5% (a result that shows how absurdly high 3% was as a benchmark of recession.)[7]

The way economists forecast global growth is to study the outlook for different countries or classifications of countries (emerging or advanced) weighted according to their size in the world economy, and then studying consumption, investment, housing, public spending and net exports within those economies.

Let’s start with emerging markets ex-China, which comprise about 19% of the world economy. Many of them are expanding robustly enough. Emerging Asia, for instance, is in much better shape than it was before the collapse of the baht in 1997 triggered the Asia financial crisis. Back then, emerging Asia was full of foreign debt, had unsupportable fixed exchange rates and was dogged by wonky financial and property sectors. Today, even as currencies drop from India to Korea, emerging Asian countries have sounder financial systems, freer exchange rates, tame inflation, current-account surpluses, large forex holdings and sturdier government finances. While these neighbours face losing export sales to China and currencies are falling accordingly, it’s more the emerging world outside east Asia that’s a bigger problem; namely, much of Latin America, the oil exporters, Russia, South Africa and Turkey. Still, considering emerging countries as a group, when you allow for their young and growing populations and expanding middle classes driving consumption, their resources, pro-business governments (to generalise), infrastructure needs and low labour costs, the IMF’s forecast of 4.2% growth for 2015 (including China) looks reasonable. So too does 7.5% growth for India, which is 2.7% of the world economy and which expanded 7% in the 12 months to June.

China, as 13% of the world economy, deserves separate analysis. No one denies that China confronts challenges as it shifts from an investment- and export-led economic model to one driven by consumption. Its overriding task during this transition is to ensure that aggregate demand stays high enough to avoid a recession. Authorities have vast ability to do just that. Interest rates are well above zero (the one-year lending rate is at 4.6% even after five cuts since November), public debt at only 50% of GDP allows for fiscal stimulus and China boasts the world’s largest forex hoard of US$3.7 trillion. On top of that, Beijing’s autocratic nature will prove an asset in an emergency for it can enforce unorthodox remedies without worrying about the due process that can snarl democracies. The political reality is that Beijing will succumb to short-term growth fixes to keep unemployment low enough to ensure social and political stability, even if that sets up bigger problems later. China’s new wealthy need little encouragement to spend and the world’s highest wages growth is another reason why retail sales are expanding more than 10%. Thus, few would forecast China’s growth to drop below 4% in the coming 12 months. Most predict Chinese growth to be about 6%.

Modern woes

Admittedly, slabs of the advanced world are struggling. The eurozone, which covers 17% of the world’s economy (to outsize China), is yet to regain its pre-crisis size. So it can be classed as in a depression. But the deflation-prone euro area is eking out growth (0.4% expansion in the second quarter) as low interest rates, falling commodity prices, an improving labour market and higher wages are aiding consumer demand. The Greek saga is a threat, for sure. But what Athens’ recent near-default and near-exit from the euro showed is that the Balkan country’s troubles appear to do little immediate economic damage to neighbours. The political damage tied to austerity and joblessness in Greece and elsewhere is spreading. But it will take a few more years to cause vast economic ructions – by, say, if Marine Le Pen were elected French president and fulfilled her pledge to pull France out of the euro and EU. Even if eurozone growth is pegged at 1% to 1.5% for the next 12 months, that’s better than nothing. Japan, for all its radical fiscal and monetary stimulus, might offer closer to nothing. Japan has zero inflation and its economy shrank 0.4% in the June quarter because consumption and investment are spluttering while China’s slowing is curbing exports. But Japan these days is only 5.9% of the world economy. The IMF estimates Japan will eke out about 1% growth in the next 12 months.

Luckily for the world, the rest of the advanced world is thriving, especially the US, which grew at a vibrant 3.7% annualised pace in the June quarter. Retail sales are buoyant, consumer confidence is touching eight-year highs and the jobless rate is at a seven-year low of 5.1%. Housing is humming. Business investment is climbing and the government is injecting stimulus. Exports play a relatively minor role in driving US growth (at just 13% of GDP compared with 50% for Germany) so the country is insulated from miseries abroad. While wages are stagnant, productivity sluggish and there is some hidden unemployment, at least Washington is unlikely to host soon a destabilising showdown over raising the country’s debt limit, which is due to be lifted again this year. All said, consumer spending is expected to help the US maintain its 3% annual pace of growth into 2016 and beyond. Advanced economies less the US, the eurozone and Japan amount to 23% of the global economy. The IMF predicts 2.2% growth this year for advanced economies overall. That appears a reasonable outlook for countries including Switzerland and the UK, for most of them will benefit from lower commodity prices – even if they are not so good for Australia (1.9% of world GDP) and Canada,

All up, economist might be prudent to trim their global growth forecasts for the next 12 months. But they shouldn’t go too much below the 3.3% the IMF in July forecast for 2015 or the 3.8% it predicted for 2016. The body was well aware when it made those projections that the commodities bubble had exploded.[8]

 

Country and regional percentages of world output come from the World Bank’s database and measure gross domestic product for 2014.http://databank.worldbank.org/data/download/GDP.pdf. IMF growth forecasts are estimates taken from the World Economic Outlook – July 2015, Table 1 (Overview of the World Economic Outlook projections) on page 4 that give estimates for 2015 and 2016 rather than the upcoming 12 months. Other financial information comes from Bloomberg unless stated otherwise.


[1] Reserve Bank of Australia. Commodity price index. In SDR terms, the index rose from 24.4 in January 2004 to a peak of 162.2 in May 2011 before falling to 60.0 in July 2015. http://www.rba.gov.au/statistics/frequency/commodity-prices/2015/icp-0715.html. By way of comparison, the Bloomberg Commodity Index shows an increase of 140% from 1999 to 2011 and a 52% tumble since then.

[2] Prices movements for aluminium, nickel and zinc are based on the London Metal Exchange’s three-month rolling forward contract. The price for copper is the LME’s cash spot price. Oil is based on West Texas Intermediate price. Iron ore is based on the spot China price.

[3] Bloomberg News. “China will respond too late to avoid a recession, Citigroup says.” 28 August 2015.http://www.bloomberg.com/news/articles/2015-08-27/china-will-respond-too-late-to-avoid-recession-citigroup-says

[4] World Bank database. Gross domestic product by country and other categories for 2014. http://databank.worldbank.org/data/download/GDP.pdf

[5] GDP on a purchasing power parity basis makes allowances for the different costs of goods and services in different countries.

[6] IMF. Box 1.1 “Global business cycle” in World Economic Outlook – April 2009. “Crisis and recovery”. Pages 11 to 14. http://www.imf.org/external/pubs/ft/weo/2009/01/pdf/text.pdf

[7] IMF. World Economic Outlook database. http://www.imf.org/external/pubs/ft/weo/2015/01/weodata/index.aspx

[8] IMF. World Economic Outlook Update release. “Slower growth in emerging markets, a gradual pickup in advanced economies.” 9 July 2015. http://www.imf.org/external/pubs/ft/weo/2015/update/02/pdf/0715.pdf