RECENT weeks have seen the International Monetary Fund and the World Bank downgrading their forecasts for global economic growth. In its monetary policy statement, the Federal Reserve Bank of the US also expressed caution about the economy, cutting its forecast for US GDP growth. The consensus among many learned commentators seems to agree with these downbeat expectations.

Getting the economic trajectory right is crucial for ensuring that the right monetary policy decisions are made, so these forecasts do matter. For example, the US Fed has justified its dovish stance towards monetary policy normalisation on the back of these downgraded forecasts and what they mean for unemployment and inflation. Global investors’ risk appetites have grown on the expectation that weak growth will keep monetary conditions loose so as to keep boosting valuations. If growth turns out to be faster than expected, there will be a disorderly recalibration of expectations of monetary policy: Risk appetites will fall, capital will exit emerging market assets, and currencies will weaken in much of Asia.

We believe that global growth will turn out to be stronger than expected for two reasons. First, the drags on economic activity early this year are dissipating and being replaced by stronger growth drivers. Second, the underlying processes in the global economy are becoming more supportive of economic growth. This means a high risk of disruption in financial markets but we believe that most Asian countries will gain more from the global up-cycle than lose from the likely financial market turbulence.

Growth drivers turning more positive

Growth slowed in the early part of this year because of a number of one-off factors which are diminishing or reversing completely. First, the bad weather and labour strikes at ports in the US west coast are over, taking away a considerable negative. Second, the initial impact of falling oil prices was negative for growth because oil producers wasted no time in slashing capital spending and employment, while the winners from lower oil prices preferred to wait to ensure that lower oil prices were here to stay before celebrating with a surge in spending.

Sure enough, economic data in recent weeks shows that these one-offs have reversed and that a decent pickup in economic vibrancy across the world is unfolding:

• The US economy, in particular, is gathering momentum. The Conference Board lead indicator is pointing to a modest acceleration in growth. Confidence among small and medium-sized businesses, which are the economy’s biggest source of labour demand, is at its strongest level this year, prompting increased hiring and capital spending plans. Consumer confidence is returning after the weakness in the beginning of the year, boosted by rising wages and growing job security because of falling unemployment. The housing sector is a source of growth as well, with strength in home sales and housing starts and as home builders’ confidence levels return to post-crisis highs.  

• The eurozone is also growing faster than expected. The latest purchasing manager index for June shows the region’s manufacturing and services sectors at a 49-month high. Passenger car sales are growing strongly, attesting to rising consumer confidence, and unemployment is edging down. Fears earlier in the year that the eurozone would fall into a deflationary trap have eased following signs that prices were beginning to stabilise.  

• Japan’s economy is turning around, overcoming the hit to growth from last year’s increase in the sales tax: Economic growth in the first quarter was strong with corporate capital spending accelerating. The more recent strength in core capital goods orders suggests that capital spending will continue to support growth. The spring wage negotiations point to a further rise in wages, which will support consumer spending.

The strong momentum in the developed economies of the US, Europe and Japan means that about half of world GDP is now accelerating. Since these three giant economies are well-integrated, growth in one spills over into another, reinforcing each other’s prospects.

The less favourable news has been in large emerging economies such as China, Russia, Brazil, Turkey and South Africa, where the headwinds remain daunting. But these countries account for only about 20% of world output. Moreover, India and other emerging economies are doing well, so the overall global economy is in increasingly good shape.

Underlying processes in the world economy largely support growth

If we look beyond the data at the underlying processes driving the world economy, this positive interpretation of global prospects becomes more convincing.

First, the sharp fall in oil prices and in commodity prices in general will boost growth more forcefully over the next few months. The World Bank estimates that a sharp fall in oil prices of the magnitude we have seen and which is caused by supply factors will boost global growth by around 0.7 to 0.8 percentage points over the medium term.

What about the negative impact on commodity producers? Remember that there are far more businesses and consumers who use commodities than there are commodity producers. Also, remember that the winners from high commodity prices in developing countries like Indonesia are usually large corporations, such as the big mining companies, not the average citizen. So, the losses to commodity producers are more than offset by the gains to businesses that produce manufactured goods, and to consumers. The fall in energy costs and costs of most raw materials, including base metals and rubber, supports growth in two ways: (a) reduced production costs will boost profitability and so incentivise manufacturers to raise output and employment; and (b) as lower production costs are passed on to consumers, they will raise demand as well.  

Second, liquidity conditions remain supportive of growth in most parts of the world. Despite the recent rise in bond yields in the US and Europe, yields remain low in historical terms. Combined with the rise in equity valuations over the past year, the overall cost of capital has actually fallen, just as improving economic prospects are raising potential returns on investment. This is a strong argument for investment, which has been disappointing so far, to recover. With so many new technologies reaching takeoff points — 3D printing, robotics, social-mobility-analytics-cloud computing and bio-medical advances, huge new investment opportunities are opening up as well. This week’s data showing core capital goods demand turning around in the US is encouraging, though we will need a few more months of data to be sure.

Third, the recovery in the US and other developed economies has been disappointing so far in that it has not generated as strong a recovery in Asian exports of manufactured goods as expected. However, we believe that the global recovery is entering a new and more import-intensive phase. If investment spending does recover more strongly, as argued above, then demand for components of capital goods that Asians produce will rise. Moreover, the lagged impact of a stronger US dollar will also kick in, boosting Asian exports.  

What about the risks?

There are certainly several areas where things could potentially go wrong.

First, China: Although data in the last two weeks shows that China’s economy is beginning to stabilise, there are many troubling signs that make us wonder whether this stabilisation is for real. For instance, while purchasing manager indices have edged up, the fact that hiring has been slashed, capital spending is weak and loan demand is at multi-year lows raises the question of how sustainable the stabilisation can be if businesses do not have enough faith in the future to add jobs and capacity. Equity markets have soared, driven by liquidity, a worrying rise in margin debt and the comfortable assumption that policymakers will take care of any risks. It will be sensible to expect that China will experience some stresses in the coming months, even if policy support does contain the worst scenarios.

Second, if US growth does pick up well ahead of expectations as we believe, US monetary policy will have to tighten a lot more quickly than markets currently expect. As we saw in the May 2013 “taper tantrums”, abrupt changes to a complacent market consensus can cause a lot of disruption in financial markets, especially for emerging market economies. It is probably inevitable that emerging markets become stressed in the strong growth scenario that we foresee. At this point, it is markets such as Brazil, Turkey and South Africa that look particularly vulnerable given the challenges they face.

Conclusion: what is the bottom line for our region?

In short, overall global demand will pick up but risks related to China and monetary tightening could worsen.

Asian markets will face risks but we suspect they will be less than in the 2013 taper tantrum:

• India’s fundamentals have improved hugely — greater political confidence, a current account deficit that has virtually disappeared, sharply lower inflation, a strong rupee and a rising economic cycle.

• Indonesia has also seen some improvement but not as much as India — inflation is actually higher today than in May 2013, and while the current account deficit has come down below 2% of GDP, Bank Indonesia estimates that it is likely to rise again soon. Moreover, Indonesia’s rupiah has been volatile as well, unlike the Indian rupee which has remained remarkably resilient in the face of the recent financial turbulence.

• Malaysia’s economic fundamentals are reasonably good — a credible central bank, a strong current account surplus, relatively low inflation, an improving fiscal position and rising private investment. As one of the world’s most open economies, it will be one of the biggest winners from the expected recovery in global demand. However, the ringgit has been hurt as a result of the controversy over government-backed entities such as 1Malaysia Development Bhd and the subsequent increase in political temperatures.

• Singapore’s robust financial position and super-strong external accounts will allow it to weather any renewed instability in financial markets, while its manufacturing sector will gain from rising export demand. However, its real estate sector is already deflating, so the prospect of rising US interest rates will cause domestic rates to rise and reinforce the real estate correction.

• The Philippines and Vietnam are likely to be resilient — their economies are growing nicely, and external accounts are in relatively good shape.

Overall, we believe that the risks can be mitigated: The underlying momentum in the world economy should be strong enough to offset the risks.

Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy

This article first appeared in Forum, The Edge Malaysia Weekly, on June 29 - July 5 , 2015.

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