The World Economy: Why forward-looking markets may soon start to anticipate a difficult 2015
GLOBAL growth picked up in 2013, ending the year at a solid pace. This strength should carry over into early 2014, but momentum is likely to wane. The global economy may be entering the late stage of the cycle, characterised by rising capacity constraints, increased inflationary pressure and tightening liquidity.
Monetary trends predicted recent economic improvement. A year ago, global inflation-adjusted money supply growth was strong and higher than output expansion. This signalled that prospects were brightening and there was excess liquidity available to boost markets. Global industrial production grew by 5 per cent annualised in the six months to November 2013, up from 1 per cent a year earlier. Equities, of course, have performed strongly.
Monetary signals are now less favourable. While still respectable, global real money growth has declined since spring 2013. As economies strengthen, it has fallen beneath output expansion. This suggests that momentum is close to a peak, while markets no longer enjoy a liquidity tailwind.
Most forecasters and investors expect current strength to be sustained. The IMF recently raised its 2014 growth projections for the US and Japan. According to Merrill Lynch, three-quarters of global fund managers judge the economy to be in the early or middle part of the cycle, implying that the upswing has several more years to run. This view is questionable.
First, the cycle looks mature by historical standards. Global industrial output has risen by 30 per cent since February 2009 and is 12 per cent above its prior peak. The upswing has lasted 58 months versus an average duration of 78 months for the previous four trough-to-peak output rises. If this cycle were to match the average, another recession would begin in 2015.
Secondly, stronger growth is running into supply-side constraints. In the US, the Institute for Supply Management business survey indicates that the economy-wide operating rate is above average – at odds with claims that there is still a large negative output gap. Firms globally are finding it difficult to recruit skilled labour: skill shortages are at their most acute since 2007, at the end of the last cycle, according to the world business survey conducted by Germany’s Ifo Institute.
Thirdly, there are signs that inflationary pressure is reviving in response to capacity tightening. Global inflation was broadly stable in 2013, with falls in strong currency areas – in particular, the Eurozone – offset by rises in Japan and elsewhere. Business price expectations in the Ifo world survey rose notably in late 2013, to their strongest since spring 2011. Commodity prices have firmed recently.
Central banks are trying to extend the cycle by promising to defer official interest rate increases until after inflation rises. Liquidity conditions, however, tighten endogenously at the end of a cycle, as stronger activity and price gains push up longer-term yields and cause the gap between real money and output expansion to close. This process is underway. Central banks usually lag market-driven liquidity tightening, often magnifying its effect at the wrong time.
Rather than loose policy, the best hope of extending the cycle is a surge in business investment that boosts supply capacity and defers higher inflation. Capital spending intentions have firmed but are not sisimongnalling a major shift towards expansion. Continued business reluctance to increase capacity, ironically, probably partly reflects additional uncertainty created by central banks’ “monetary activism”.
2013 was a better year for financial markets than main street. The reverse may be true in 2014, as forward-looking markets begin to anticipate more difficult economic conditions in 2015.
Simon Ward is chief economist at Henderson Global Investors.