IF investors thought the past year has been full of surprises, wait till they see what’s in store next year. None of us should overestimate our capacity to forecast events and how they will drive financial markets. But, some things are becoming quite clear as we think about the coming year: The pessimists will point to geo-
political risks that can only worsen, how growth in the eurozone, Japan and China is under a cloud and how financial stresses are building. The optimists will talk up the strengthening US recovery, the likely turnarounds in large emerging economies such as India and Indonesia, and the exciting prospects that new technologies such as renewable energy and cloud computing, which are reaching take-off points, promise us.
Our take is towards the optimistic end, despite expecting some unpleasant surprises along the way.
Geopolitical risks — the messy evolution of a new world order
If one thing is clear about 2015, there will be no respite from politics troubling financial markets. Essentially, we are in the midst of the evolution of a new world order, which will be unsettling. As the US loses its dominance but fights back, as a rising China flexes its muscles, as once-powerful but somewhat diminished countries such as Russia and Japan try to reassert themselves and as regional powers such as India and Turkey push their agendas, it becomes more difficult to resolve political crises. There are two arenas in particular where troubles are likely:
Middle East instability likely to hurt global stability: The political structures created in the Middle East in the 1920s to 1940s by the UK and France, built around artificially created countries with boundaries that cut across tribal and religious identities, are being undermined by a multitude of groups, of which the notorious Islamic State is only one. That is why the civil wars in Syria, Iraq, Libya and Yemen are difficult to resolve and could well spill over into neighbouring countries. Worse, if successions to ailing monarchs in the Gulf region prove to be destabilising, things will get worse. This region, still the single most important source of oil for most of the world, is set to undergo highly unsettling regime changes.
Europe another potential source of market shocks: First, tensions between the Western powers and Russia over Ukraine’s unresolved civil war are showing signs of spreading to new hot spots such as Moldova and Georgia. Second, there are major elections which could upset the whole process of recovery from the eurozone’s sovereign debt crisis. Crisis-hit countries such as Spain and Portugal have elections at the end of the year, which could see the governments that have committed to austerity packages being turfed out by more radical parties which threaten to tear up the bailout agreements that have stabilised the eurozone. Even more threatening, Greece could see early elections as well, which would bring into power parties that reject the terms under which the country has avoided default. Finally, the general election in the UK in May could set in train events that lead to a referendum on its membership in the European Union, which could trouble global investors.
Fortunately, tensions in Asia over conflicting territorial claims in the East and South China Seas have eased of late. Although tensions in the Korean peninsula remain an issue, Asian political risks appear to be in abeyance, at least for now.
The global economy: Conflicting forces but net impact likely positive
On balance, we think that there are enough positive drivers in the world economy to offset the headwinds.
First, the economic upswing in the US will accelerate, although there could still be sharp swings from quarter to quarter. The latest data is very much aligned with this outlook, with lead indicators rising and new orders for both manufacturing and services running at strong levels. The only areas of concern are housing where there is a clear but patchy recovery and still-weak capital spending. But the many positive drivers coming together are likely to boost these lagging sectors. After all, small business optimism is at its strongest since February 2007; the labour market is surging, allowing wages to accelerate; a rebound in credit flows to firms is reducing the credit constraint on business expansion; and vehicle sales are at their best level in a decade, suggesting robust demand conditions. It also looks like political leaders are mindful to ensure that the political squabbling between the Obama Administration and its Republican Party opponents will not derail economic recovery.
Second, the fall in oil prices looks set to persist for a prolonged period, given the outlook for the supply-demand balance. This will boost global demand in many ways, first because it transfers income from oil exporters to those who are more likely to spend it. Moreover, by reducing costs of production, it boosts corporate profits, placing companies in a stronger position to hire and spend while the drop in inflation gives central banks more leeway to keep interest rates low.
Third, while emerging economies could face challenges next year, several large emerging economies are putting in place reforms that could transform their economies over the medium term. In India, Indonesia and Mexico, there are leaders who are boldly making unpopular reforms that will unleash their supply side energies and raise growth rates over time. More recently, the re-elected president of Brazil brought in reformist economic ministers who are likely to do the same for the country.
Fourth, several technologies are reaching take-off points which will spur investments and produce tangible improvements to consumers and businesses. Take two examples — solar power and cloud computing. The costs of solar power are falling, with predictions that it will soon become as cheap to produce solar-powered electricity as electricity from conventional fuels. That would be revolutionary, stimulating a big shift towards investments in the solar and other renewable energy space. Another area of a likely surge is cloud computing where regulatory inhibitions are gradually ebbing in the finance sector and more and more companies are switching to cloud-based services, leading to massive investments in the sector.
Where are the risks?
There certainly are headwinds as well but we believe that these can be contained. For instance, there are valid concerns about the eurozone and Japan, where recent data has been discouraging. However, in both cases, the Organisation for Economic Co-operation and Development composite lead indicators — which sums up forward-looking indicators to predict future economic growth — suggest low but positive growth in 2015 for both economies. In both cases, policymakers have demonstrated resolve to take strong, even radical, measures to protect economic growth.
The economic risks are actually higher in China where imbalances such as overcapacity in many industrial segments, a massive overhang of debt, a deflating real estate sector, difficult credit conditions for a private sector whose cashflows have been squeezed by narrowing profit margins, increasing deflationary pressures and the unwinding of speculative excesses are creating a drag on the economy. Here, too, the critical variable is the effectiveness of policy response. The central bank has started to loosen monetary policy more vigorously while fiscal spending is also being speeded up. These counter measures will probably suffice to avert a sharp slowdown but China is unlikely to avoid a period of slower growth coupled with episodic stresses for one or two years.
The implications for investors
The baseline scenario for the world economy sketched above carries important implications for financial markets:
First, the US Federal Reserve is more than likely to tighten monetary policy earlier and faster than markets expect. While this will precipitate outflows from emerging markets, the disruption to financial markets is unlikely to be as severe as in 2013. More aggressive monetary policies in the eurozone, China and Japan will add to global liquidity, but none of these countries has the same impact on global liquidity and interest rates as the US. Thus, the net effect should be to push long-term rates up in the US and in Asian countries, which directly or indirectly manage their currencies against the US dollar.
Second, while the consensus view of a strong US dollar and weak euro/yen in 2015 is difficult to argue against, the question for us is how Asian currencies will respond. We suspect that the Chinese renminbi will be allowed to weaken modestly, which would bring some downward pressures on Asian currencies.
Third, commodity prices are likely to continue weakening, though not as substantially as in 2014. The years of high prices since 2009 had encouraged huge investments in expanding mining capacity for base metals and oil/gas, for instance, which means big new sources of supply emerging just as demand is disappointing expectations. While the fall in oil prices may deter investment in new capacity, especially in higher cost oil such as shale or deepwater oil, it may take more than a year before the impact on new supplies is felt. Thus, barring a severe political shock in a major oil exporter, oil prices could remain at current low levels through most of 2015.
Fourth, can we have tightening US dollar liquidity, volatile currencies, rising long-term rates, weak commodity prices and episodic stresses in China without all this precipitating other financial risks? The Bank for International Settlements (BIS) recently warned about rising risks of financial stresses in emerging economies for similar reasons. The BIS has pointed to the sharp rise in US dollar loans to emerging economies, which has helped to fuel rapid debt accumulation among emerging economy companies. Many of these companies seem to have borrowed foreign currency loans to fund local currency operations, a recipe for financial unpleasantness if ever there was one.
In addition, rising rates are bound to undermine real estate sectors across the world, especially those such as in Singapore, which have run up excessively and where supply is rising rapidly relative to demand.
The bottom line
The coming year will bring major changes in the global environment. On balance, these changes will be positive for Asian countries — a rising US economy will boost demand while the risks can be managed in most part.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy
This article first appeared in The Edge Malaysia Weekly, on December 22 - 28, 2014.