Look at the news headlines from the last few weeks and you might think that the global recovery is over. From the collapsing oil price to the emerging market slowdown, euro area deflation and geopolitical risk, there's plenty to worry about. The most timely global activity data, the Purchasing Managers' Indices, suggest that the pace of global activity slowed in the fourth quarter of last year. And in a classic sign of nervousness, investors have been dumping equities and buying government bonds.
So given these signals, why do we think that 2015 will be a year of reasonable growth, with global activity accelerating?
This is a big subject and this week's Monday Briefing is, therefore, longer than usual. Before we examine what could go wrong we look at the three key reasons for our optimism: cheap money, cheap oil and a resurgent US economy.
First, cheap money. Interest rates in the Western world are rock bottom and credit is cheap and plentiful. Central banks have responded to lower inflation and growth jitters by signalling that credit will stay cheap for longer. The European Central Bank is likely, finally, to undertake Quantitative Easing. Despite strong growth in the US and UK, the US Federal Reserve and the Bank of England have backed away from early rises in interest rates. Markets are assuming interest rates will stay lower for longer and this is pushing down the cost of borrowing for corporates and consumers. 30-year mortgage rates, the benchmark measure of housing finance for the US, have fallen from 4.9% to 4.1% in the last 18 months. Cheaper credit will provide a boost to global activity in 2015.
Second, cheap oil – and other commodities. Financial markets worry that plunging oil prices are the canary in the cage signalling a downturn in global growth. Yet the International Energy Agency reports that global oil demand has risen, not fallen, last year and that demand growth will accelerate in 2015. We think increasing supply, caused by OPEC's insistence on maintaining output in the face of sharply higher US oil production, has been the primary driver of lower oil prices, not weaker demand. Over the last year, the oil price has fallen 53%, natural gas prices 30%, copper prices 17% and agricultural prices by 4%. These declines are feeding into lower bills – and rising spending power - for Western consumers. Falling commodity prices have hit growth in commodity-producing nations, including Russia and Saudi Arabia. But they boost activity in the world's commodity-consuming economies such as North America, Europe, Japan and China, which are bigger and more economically significant than the producers. So, lower commodity prices are positive for global growth. The International Monetary Fund thinks that a falling oil price alone will add 0.3-0.7% to global GDP growth in 2015. With global growth running around the 3.5% mark, that represents a pretty sizeable boost to activity.
Third, the resurgent US economy. The US has decoupled from lacklustre growth in the euro area and Japan. US growth accelerated through 2014 and job growth last year was the highest in 15 years. The upswing in real earnings growth underway since last summer is set to continue as lower commodity prices feed through to lower prices in the shops. US households are upbeat; cheaper credit and rising real incomes should mean that 2015 is a year of accelerating consumer spending and good growth in housing. Agreed, a key measure of US business sentiment, the Purchasing Managers' Index, has softened. But with US firms cash rich, banks keen to lend and firms more bullish about investment than at any time in 25 years, we expect to see good growth in business activity and a quickening pace of US GDP in 2015.
That's the good news, but what about the risks? We consider these under three headings: a euro area crisis, a hard landing for China and geopolitics.
The euro area's weak recovery is threatened by deflation and the risk of Greece giving up on austerity and leaving the monetary union. The European Central Bank gives every indication that it is preparing to respond to euro area weakness with Quantitative Easing. We see a high likelihood of the ECB undertaking aggressive QE, possibly later this month, with the aim of awing markets and convincing observers of the Bank's determination to resist deflation. Credit demand among consumers and corporates has, perhaps surprisingly, already picked up in the euro area and we think (though many don't) that QE should help bolster it and asset prices. The good news is that the plight of the euro area consumer seems to be improving. Unemployment has fallen in the last year, thanks to improvements in Germany and the so-called periphery of Spain, Greece and so on. Consumer confidence is at above-average levels. Coupled with the boost to spending power from low inflation, consumer spending is likely to edge up in 2015.
QE should help ensure the euro area maintains weak growth, around the 1.0% mark, this year, but the risks are things turn out weaker. QE could, of course, prove inadequate or may not work at all (QE seems to have contributed to America's and the UK's recoveries, but its effects in Japan have been more mixed).
In Greece the anti-austerity party, Syriza, is ahead in the polls and could gain power in the 25th January elections. Germany's Chancellor, Angela Merkel, has made it clear that if Greece gives up on austerity then it will have to leave the euro area. A Greek exit is a real risk, but one with less disastrous consequences than the breakup crisis of 2012-13, because this is confined to Greece. Unlike in 2012, the ECB is able to lend at-risk governments support by buying their bonds, a move that should help stop Greece's woes spreading to other indebted countries. But that still leaves a non-trivial risk of a damaging Greek exit that may linger and could crystallise.
China's growth is proceeding at what, by the standards of virtually any other country, is a blistering pace. The Chinese government is engineering a shift in activity away from exports and investment towards consumer spending. The concern is that together with a shrinking of the working age population and rising labour costs, this rebalancing could result in a continued slowdown in Chinese growth. Last year's growth, of around 7.4%, is likely to have been the slowest in 25 years; this year economists expect Chinese growth to slow to the 7.0% mark. Together with weak or virtually no growth in Russia, and much weaker growth in Brazil, one might have thought this would mean a slowing of emerging market activity this year. But activity is generally expected to pick up in India, Africa and Central and Eastern Europe; as a result, the IMF expects overall emerging market activity to accelerate this year.
China's massive credit boom after the financial crisis is another cause of worry for economists. Chinese private sector debt has risen 70% since 2008 and now amounts to almost twice its GDP. This boom has resulted in a housing bubble which, when burst, could seriously damage the Chinese banking system. Attempts at controlling the flow of credit to the economy and cooling house prices have had some success. Prices fell for the third straight month in November, down 3.7% from a year ago.
For the moment, Chinese policymakers seem to be in control of these adjustments but watch out for sharp falls in house prices or a slowdown in consumption which could mark a hard landing in China.
Finally, geopolitical risks in the Middle East, Ukraine and Russia could affect global growth by influencing energy prices. In addition, there is a reasonable chance of sovereign defaults by Ukraine and Russia which could further affect growth in those economies and in Eastern Europe. If materialised, the effects of these shocks are likely to be short-term and will displace global activity from one point in time to another. External political and geopolitical shocks rarely fundamentally change the direction of other economies.
In sum, growth rates will, as always, be de-synchronised across countries but the big story is likely to be of decent global growth in 2015. Financial markets exhibit a recency bias and can exaggerate the real economy implications of latest news and transient factors. To us, the fundamentals of easy money, falling commodity prices and good US growth suggest a brighter outlook than markets seem to fear at the moment.
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