'Old world' markets come around again

Global growth is expected to generate its fastest growth since 2010 this financial year lead by the 'old world' economies like the US, the UK and to a lesser extent Japan. Europe is out of intensive care but will likely remain in the recovery ward while the outlook for China and other emerging markets is for lower but stable growth.

For the US, it makes sense that given it was the first to enter the quantitative easing (QE) process it will be the first to exit. Rising house prices and higher equity returns has lifted the wealth of households, providing a solid base on which consumer spending can grow. Household net wealth has now risen to $77.7 trillion, above its pre-crisis peak of $70.7 trillion. US manufacturing is experiencing somewhat of a renaissance with new technologies and the rise of shale gas lowering the cost of production. Interestingly, the US is expected to surpass Russia and Saudi Arabia in 2015 as the world’s top oil producer, and will be close to energy self-sufficiency within the next two decades.

A milder drag from fiscal policy is expected in 2014/15 given the Bipartisan Budget Act negotiated in December last year defers $US64 billion in spending cuts previously scheduled for 2014 and 2015. This will be offset by still accommodative monetary policy. Even with the Fed's tapering of QE, 2014 will still be the second most accommodative year for monetary policy in US history.

Little Britain is once again becoming Great Britain. The labour market is improving faster than expected underpinning robust consumer spending. The surge in house prices in the UK has led the Bank of England to pull back on its own version of QE, the Funding-for-Lending Scheme. House prices in England increased for a 5th consecutive quarter in March to be up 9.2% over the past year. The two headwinds the economy will face this financial year are fiscal tightening and a weakening external account. Not helping on this score is the strength of the UK pound, which is expected to strengthen further as markets move to price in expectations of higher interest rates in 2015.

The healing process is underway in Europe with the economy emerging from recession after 7 consecutive quarters of negative growth. Ireland was the first of the 5 EU nations (others are Greece, Cyprus, Portugal and Spain) to emerge from its bailout program after 3 years of support. Its investment grade rating has been restored by Moody’s as a result. Portugal will become the second country to exit with an announcement imminent. A real issue for Europe this year is the risk of deflation. Currently, inflation is running at just 0.5% yoy. The spectre of deflation is raising the probability that the ECB may have to conduct its own form of quantitative easing at some point in the near future.

In Japan Prime Minister Abe's determination to revive confidence to spur economic growth will drive Japanese equities higher. The Nikkei was the best performing major equity market last year. Abe's decision to double the monetary base within two years will continue to weigh on the yen and boost the international competitiveness, and hence earnings, of corporates. Consumers will need to grapple with the hike in sales tax from 5% to 8% that took effect in April.

China's transition away from being a producer to being a consumer will continue. While the rise in wages is undermining its manufacturing cost competitiveness, it is supporting the rise of the Chinese consumer. China’s average manufacturing wages are now more than three times higher than Indonesia and Vietnam. Labour costs have increased by 20% in the past three years.

The key issue for China is its addiction to easy credit. Credit is now 200% of GDP and growing at 20% annually. For an economy that is growing at around 7-7.5%, this is unsustainable. As a way of correcting the imbalance, the Chinese authorities are pushing forward with their urbanisation plans – urban populations consume more than rural populations. The expectation is that another 250 million people will be urbanised in the next 10-15 years.

The outlook for other emerging markets is more mixed. For some, including those in the North Asia region like South Korea and Taiwan, the cycle is more closely tied to the US technology sector and have healthier current account balances. Inflation is not a problem in the vast majority of economies at present, but that can quickly change if currencies weaken significantly in response the further tapering by the US Federal Reserve.

The key issue for emerging markets is political risk. Elections are expected in all of the “fragile five” economies (Brazil, Indonesia, India, Turkey and South Africa) this financial year which will likely cause some, albeit temporary, volatility. Tensions between Russia and the West are likely to remain heightened, leaving Russia most likely in recession within the next 18 months.

For Australia, the outlook is for growth to be below trend as the hole left by the decline in mining activity is only partially filled with housing, exports and a recovery in consumer spending. The persistent strength in the Aussie dollar is offsetting the work done by the Reserve Bank to ease financial conditions. We continue to see the Australian dollar as overvalued and expect it to reverse in the near to medium term in line with weaker commodity prices and a stronger US dollar.

Fiscal policy is expected to be on the contractionary side for several years to come as the Government works to reduce the debt levels built up over the past few years. Leading indicators of labour market conditions point to an improvement by calendar year end which should provide support to consumer confidence. Job vacancies have been on an upward trend now for the past nine months. A recovery in global growth prospects, and stable growth in China, will continue to underpin the boom in exports. With inflation pressures contained, it is likely that interest rates will remain on hold for at least the remainder of 2014.

While 2014/15 is going to be the year in which old world economies rise again, it will also be a year of transitions. More countries will be in some kind of transition this year than at any other time in recent history. For Australia it will be about moving from mining to non-mining lead growth; for the US it will be about moving away from the use of unconventional monetary policy; for China it will be about the move away from investment, toward consumer-led growth; for Japan from deflation to inflation and for Europe from crisis to stability.

Each transition carries its own level of risks and probability of success. Market focus and attention will shift from one to the other of these transitions at different points in time, creating volatility at each turn. In this environment, risk management becomes just as important as return management.

About Tracey McNaughton

Tracey McNaughton CFA is head of investment strategy and executive director of the global investment solutions team at UBS Global Asset Management. In this role she has responsibility for Australian economic and investment research and is a member of the Australian Investment Committee. Tracey was previously Senior Investment Specialist at Colonial First State Global Asset Management, and prior to that worked in the UK for Baillie Gifford as a fixed income portfolio manager and as a senior economist at BT Financial Group.