Friday, 2 January 2015

2015: Back to Realpolitik and back to growth

Well, well, well, it seems the Cold War era is back upon us. And I'm not just saying this as a consequence of a holiday season James Bond movie marathon that I watched. No, it's real, or to be more precise it's - Realpolitik! It seems that diplomats are setting the stage once again, and that the debate over Russia vs the West is likely to overtake the debate on the economy next year. Which is good on one hand as it implies that the economy is recovering so it's no longer the main focus of attention, but on the other hand it's bad since foreign policy standoffs only build uncertainty and are not good for economic recoveries. But overall the economy actually is expected to perform quite well next year (well, apart from Russia, but more on that below). Low oil prices will be the key in prompting a stronger recovery. The IMF links a 10% change in oil prices to roughly 0.2% change in global GDP. Prices that have fallen by 50% in the last 6 months are likely to be a significant boost to growth in 2015. The outlook, thus, is a positive one.


Since last year's predictions were quite precise, I am hoping that this year they be even better.

The first big issue is: will the central bankers raise interest rates next year? This is now becoming increasingly likely. The FED will be first to do so amid a stronger recovery in the US. In March last year, the FOMC has announced a rate rise to about 1% in 2015, and slightly below 2% in 2016. The market has had time to adapt to this announcement and has reacted rather well. As I've stated back in March when the rate increase was announced, this won't cause any commotion on the markets, even in the short run. The BoE may follow them in this decision, while the ECB probably won't. The ECB will however go into even stronger quantitative easing next year, still buying time for structural reforms. Draghi has announced this last month, and from what I've heard in my trip to the ECB in the beginning of December, they are convinced they are doing everything they can to help Eurozone via low interest rates and unconventional monetary policies. So obviously the ECB won't directly start the recovery in Europe, this is still left upon Europe's governments. The Bank of Japan also will not increase interest rates next year.

What about the recovery? Is next year the year? Well, yes and no. Yes, as Europe (Eurozone) will continue to grow at around 1% as it did this year, however this won't mean that a robust recovery has started. Unemployment will stay high (particularly in France and Italy), despite some members improving their unemployment situation (Spain, Greece, Ireland, Portugal). Inflation will stay low (the threat of deflation is becoming Europe's serious long run issue), budget deficits will be lower than this year, and we might even see some structural reforms implemented (however their distribution will certainly be skewed and limited to a few countries). So in Europe the year is expected to be a year of positive trends, but they still won't be felt by the majority of its citizens. I stand by what I wrote last year: the recovery is happening despite, not because of the policies enacted by the politicians. It is being led by global growth fundamentals (energy booms, international trade, low oil prices, etc.), not by reforms from within. This still makes Europe fragile and sensitive to any external shocks. Which are plentiful nowadays.

The "it" country in Europe in terms of growth this year will be Ireland (3.5%). The country with the worst performance will be either Cyprus or Croatia (both probably around 0%, perhaps even negative growth).

In the United States I predict around 3% growth for next year, driven by a resurgent Silicon Valley boom, and by low oil prices. It's hard to precisely predict how low oil prices will affect the country, since the US is the world's biggest producer, consumer and importer of oil. However in net terms the US spends much more than it produces (as I've said, it is also the largest importer), so low oil prices will certainly provide a net benefit for the US economy. It might, however, hurt a lot of newly formed shale gas producers and hence contract their exports (along with a stronger dollar). In terms of monetary policy, falling oil prices will certainly push inflation expectations down, but all in all I don't expect the Fed postponing the interest rate increase because of it. The opportunity cost of sending a signal of uncertainty is too high for the Fed to renege on its announcements. 

In political terms, the current standoff remains. The Republicans and the Democrats will start preparing their candidates for the 2016 primaries (due to begin in January), where it seems very likely that the Democrats' strongest nominee will be Hillary Clinton. As for the Republicans many names are being thrown in, so it's hard to predict who might emerge as a likely candidate at this point. By the end of the year we might get a more clear picture.

In Japan, the growth rate will be positive, although less than 1%. It still suffers from many of the same problems as it did in the past 20 years, and Abenomics has clearly failed as the remedy it was hoping to be. The rise in consumption tax has hurt them much more than expected. Japan doesn't have a problem with unemployment as Europe clearly has, but its fiscal balance and gross public debt are still huge issues. Japan is a very puzzling story, a scenario that is very likely to capture Europe in the next 5 to 10 years. It seems that nothing works to prompt Japanese growth. Any short-term macro policies aimed at boosting growth are counterbalanced by a problematic fiscal situation. Japan remains in its limbo state for another year. 

For Germany next year won't be a year with strong economic growth. It will be around the European average of 1%. Introducing the minimum wage should have a neutral net effect on growth (as for many the minimum wage will just replace the benefits they've been receiving so there's no expected increase in consumption). The biggest drag on growth will be a balanced budget. But the Germans are well aware what they are sacrificing for this. For an ageing country overburdened with debt, balancing the budget is a necessity to prevent long term problems. Germany is today preventing the possible collapse of tomorrow. That is the smart way to do it. If (when?) a new structural shock hits Europe, Germany is probably the only country that will be ready for it. Losing a few years of strong growth to see your debt drop down to below 60% of GDP in 3 years, is worth it. Particularly since Germany has strong structural fundamentals that enable its productive capacities to flourish and make sure it can always count on its exports. And finally, low oil prices will certainly help Germany  in the following year. 

In the UK, the general election is coming up. The main prediction is that the Conservatives will stay in power, and that UKIP will become a parliamentary party (they already have two MPs in Parliament, but these were defectors from the Conservatives; UKIP has yet to perform well in a national election - and they will in 2015). On what do I base this prediction? Well, look at the pools, Labour is on a downward trend - its lead over the Conservatives went down from an average 8-9 p.p. in 2013 to about 2-3 p.p. in 2014. Next year it's only going to get worse for Labour as the economy continues to recover and as immigration takes the stage as the main issue in Britain. The problem with the polls is how they translate into actual seats. Having a 15% support for UKIP doesn't imply they get 15% of seats in Parliament. In the first-past-the-post system, it's all about getting wins in constituencies. Although it's hard to imagine a coalition of Conservatives and UKIP, I predict that the Conservatives will enjoy a minority government, with UKIP (and what's left of the LibDems) giving them support to form the government. I don't think there will be a National government of Conservatives and Labour, as some tend to predict. Not in these elections at least.

As for the economy, it will continue on a stable growth trajectory with around 2.5% GDP growth, and more importantly with unemployment declining and the budget deficit decreasing. Housing prices will continue to rise in Britain, although perhaps not as much in London, at least in the super-prime property market.

International relations

In terms of global, foreign policy predictions, many battles wait upon us.

By the end of last year no one saw the annexation of Crimea coming. It was one of those fat tail events that just take everyone by surprise. Another similar event was the rise of ISIS (or ISIL), a radical Islamist rebel group based in Iraq and Syria. Although few could have predicted their ascend last year, the rise of Islamist radicalism was an inevitable consequence of foreign military interventions in Iraq and the Middle East, lasting for more than 10 years by now (after all, they started gaining strength back in 2006).

How will these two major threats to stability be overcome? First off, the fight against ISIS is highly unpredictable. Currently the emphasis is for the Iraqi and Syrian armies to fight them off. So far the US and the NATO are only providing support in terms of training and equipment (US special forces are already there assisting with air strikes). However if things escalate beyond control, I wouldn't be too surprised to see the US putting troops back on the ground and leading the fight against ISIS. In his final two years in office Obama has nothing to lose with such a decision. But again, this will only happen if the conflict escalates beyond control and ISIS starts gaining more power. 

As for Ukraine, in 2015 it is likely to remain in its current status quo. Putin, facing domestic pressure of a declining economy for the first time in his 14-year reign, won't risk new conflicts over Ukraine, but is very likely to increase nationalist and protectionist rhetoric back home, primarily to protect his strong position. It is this rhetoric that will dominate the scene next year. 

The biggest pressure for Putin will be the price of oil. For a very long time (actually for the full duration of Putin's reign) Russia has profited heavily from high energy prices. Not anymore, as next year the price of Brent oil will probably drop below $50 per barrel at one point and will remain low throughout the first half of the year. Putin has failed to use the accumulated wealth from oil and gas earnings to structurally change Russia's economy, and reduce its dependence on energy prices. Even worse Putin has used the accumulated wealth as a typical dictator - to empower his cronies (his winning coalition), thus strengthening his hold on power. That was and still is bad for Russia, as its people are now painfully realizing as the Ruble has plunged about 40% against the dollar.
Oil prices, 1946-2014. Source
The sanctions from the EU aren't helpful either, as the Ruble will continue to decline if things remain the same, pilling up pressure on Putin. This will imply one of the following scenarios: the Russian central bank defends the nominal exchange rate by selling its foreign reserves, which could provide to be extremely costly and can push the country into a real recession (recall the Bank of England trying to protect the pound back in 1992 when Soros imposed a 27bn loss upon them); or having the government defend the exchange rate by engaging into austerity policies, which is also likely to push Russia into a recession. Leaving things as they are and allowing the currency to float with limited sales of reserves (a strategy the Russian central bank is applying) will also hurt the country economically next year. Russia is facing a serious economic crisis, in many ways self-imposed - dependency on oil and gas, cronyism, and foreign policy interventions have finally caught up with Putin. History is repeating itself for Russia, only this time their position of power was short-lived. However Putin won't go down that easily. That's why I expect a resurgence of Realpolitik in foreign relations. 

In China growth will fall below 7%, slightly below expectations. Will next year be the bubble burst for China? Maybe, maybe not. As I've learned from last year's predictions, predicting exactly when will the Chinese bubble burst is an unrewarding task. After all, this too is a fat tail event, so its occurrence will surely be surprising. As for the slight pessimism over China's slowdown, it is due primarily based on reports on weak property sales, a decline in fixed investments and the manufacturing sector, and expected low inflation and lower consumer spending. However let's not forget that low oil prices will significantly benefit China as well. China is the second largest net importer of oil. 

In India after a gloomy year expect the growth rate to accelerate under new leadership of Narendra Modi. There are many reasons for optimism in India; low oil prices will ease the pressure on high inflation and the current account deficit (India imports 70% of its oil consumption). This will enable India's central bank to cut interest rates in order to help the government promote some structural changes to India's economy (the government has already started applying reforms focused on better governance, fiscal prudence and ease of doing business, with the labor reform announced next year, in addition to attracting new investments from China and Japan). All this will help its economy grow above 6% next year. 

As for the rest of the emerging markets? A strong dollar certainly doesn't help, neither does the announced increase in interest rates from the Fed. Low commodity prices and low oil prices will hit the commodity and oil exporters (particularly in Africa and South America). Bond yields are on the rise in most of the emerging markets, so I do expect another growth slowdown next year for the EMs. 

Altogether, it will be a year of positive growth rates, but not everyone will feel it, particularly in Europe. Low oil prices will drive most of the positive growth in the West (and in India and China), but not everyone will be happy because of it. The international stage has been set for muscle flexing, something Putin is very good at (both figuratively and literally). It won't last too long, but in my opinion it will dominate the debates in the following year. I do hope that I'm wrong this time.

Happy new 2015! 

No comments:

Post a Comment