Monday, 28 December 2015

Hits and misses: Evaluating last year's predictions

This is becoming a sort of a post-Christmas tradition on the blog - each year in the weak after Christmas I offer a wrap up of the year by evaluating my last year's predictions. Once again, I have to say, it was a good year in terms of what I got right (I managed to even beat my own predictions from 2014: 85% compared to last year's 75%), but there were a few events that went under my radar (the Greece situation triggered by Syriza's victory, and the refugee crisis). 

The title of last year's predictions was: "2015: Back to Realpolitik and back to growth". My main prediction was that most economies in the West would return to having steady rates of economic growth (which came true), and that debates over the economy will be overshadowed by the return of realpolitik and muscle-flexing between Russia and the West. I've also stated that "low oil prices will be the key in prompting a stronger recovery", which they were, and I managed to exclude Russia from that prediction in that low oil prices, coupled with sanctions, would hurt their economy even further. Russia will end 2015 with negative growth (the first three quarters were negative), but it was Russia in particular where the debate over the declining economy due to low oil prices and a stumbling ruble was overtaken by its military conquests in foreign lands (Ukraine and Syria). 

All in all, I offered quite a positive economic outlook, but a grim political one. I could say that this came true, however the political outlook was grim for reasons I failed to predict. 

Let's give it a run around topic by topic:

The Hits:

1. "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." 

Yes! Prediction achieved in the very last minute! Two weeks ago the Fed raised interest rates from 0.25 to 0.5% for the first time since 2008. Furthermore they've announced the rates to continue rising throughout 2016 as well. Since investors saw this coming, the announcement hasn't unsettled markets so much (as I anticipated), but it did add strength to the dollar and it did cause problems for the emerging markets (and will continue to do so). 

1.1. I was also right in saying that the ECB and the BoJ will not increase rates this year.

2. "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."

A spot on prediction, growth rates were indeed around 1% (current prediction is 1.5% but this may go down in Q4), where despite a good two opening quarters, the third was a bit of a disappointment of only 0.3% growth. Unemployment unfortunately stayed high (again, particularly in France and Italy, but it started to decrease in Spain, Ireland, Portugal and even Greece, so the average is slightly lower than last year 11.6% to 11%), inflation low (around 0%), while budget deficits on average did decrease (from 3% to 2.5%, EU average), but not as a consequence of structural reforms. Finally, the last prediction is also unfortunately true - currently it's still a jobless growth in Europe. 

2.1. "The "it" country in Europe in terms of growth this year will be Ireland (3.5%)." 

Ireland was definitively the "it" country, but its growth for 2015 will probably be even bigger than what I've predicted. The current forecast is around an impressive 6%! This will surely continue into 2016 as well. Kudos to Ireland for engaging a truly robust recovery, with unemployment, debt to GDP, and the budget deficit all going down, and exports going up. And all that with inflation around 0% (i.e. without a monetary stimulus; or in other words - borderline deflation did not hurt their recovery). 

3. Regarding the political situation in the US, I stated Hilary will be the Democrat's strongest nominee (kind of a no-brainer), but that it was too close to call for the Republicans. Good prediction as well, since Trump (and Carson?) came out of nowhere! 

4. "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. ... 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." 

Unfortunately, this too came true. Japan was stuck with around 0.5% GDP growth, and with Abe's economic policy still unable to kick-start the economy.

4. "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... The biggest drag on growth will be a balanced budget. But the Germans are well aware what they are sacrificing for this. ... And finally, low oil prices will certainly help Germany in the following year."

Growth was around the European average, estimated at 1.7%. Overall, Germany's fiscal prudence did cause a drag on growth, but this was all expected and planned. 

5. UK: "The main prediction is that the Conservatives will stay in power, and that UKIP will become a parliamentary party...I don't think there will be a National government of Conservatives and Labour, as some tend to predict." 

Got that one right, and I made the prediction in the beginning of the year when none of the pundits got it right and when many were in fact talking about a grand coalition between Labor and Conservatives. I sought my bragging rights back in June.

5.1. "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."

GDP growth was predicted to be exactly 2.5% for this year, both unemployment (from 6.1% to 5.4%) and the deficit (5.7% to 4.4%) went down, while housing prices continued to go up (this market is turning into quite a bubble). 

6. 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." 

Quite accurate. Ukraine remained in its status quo, Crimea is still annexed, there are no new conflicts, while Putin did very well to protect his position back home. 

7. Russia: "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." 

Linked with the previous issue, and with the overall prediction regarding how low oil prices will adversely affect Russia, it did face a serious economic crisis, but Putin came up with an anticipated response: building up his military power and showcasing it abroad. 

8. "In China growth will fall below 7%, slightly below expectations ...  based on reports on weak property sales, a decline in fixed investments and the manufacturing sector, and expected low inflation and lower consumer spending."

This has finally happened as well, China is experiencing a slowdown in growth. Despite the worries from the Chinese government, this is still a more than decent performance from China, and was actually expected (one cannot grow indefinitely at double-digit levels).   

9. "IIndia 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 ... All this will help its economy grow above 6% next year." 

All this has happened, low oil prices have eased the pressure and helped fuel higher growth, to which the central bank responded by cutting interest rates. Economic growth will probably be around 7% this year, outpacing China for the first time in decades.

10. "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." 

So true, the emerging markets have fallen behind the developed world in economic performance. Considering that they've failed to achieve convergence in living standards this is even more worrying for them. A strong dollar coupled with low commodity prices depressed them further, and even caused havoc in some countries (like Venezuela and Argentina). 

11. Oil prices: "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."

Indeed it did. The price continued to be low throughout the year (currently at $37). However the biggest impact wasn't so much on Russia as it was on the emerging markets, particularly Venezuela (the decline in oil prices struck a huge blow to their socialist model which was severely punished at the polls).

The Misses: 

1. "In the United States I predict around 3% growth for next year, driven by a resurgent Silicon Valley boom, and by low oil prices. ... 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)."  

The growth rate was strong, but it will most likely fall a bit short of the 3% target. Current estimates have it around 2.5% (close to last year's 2.4%). The decline in oil prices has however failed to pick up consumption as anticipated, while some oil companies have slashed investments as a consequence. I did state that it was difficult to predict how precisely the low oil prices will affect the US economy, since it is, at the same time, the largest producer, consumer and importer of oil, but I did state that it will entail a net benefit for the economy. This is still left to be seen, but to be fair, I will place this entire prediction under the miss category, as the factors which I thought would be key in prompting US economic growth failed to do so. 

2. "The country with the worst performance will be either Cyprus or Croatia (both probably around 0%, perhaps even negative growth)."

Argh! I never seem to get this one right! Someone always surprises me. I was way too bearish on Croatia and Cyprus, while Greece went completely below my radar. I simply did't see Syriza coming. More on that below.

3. "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..."

Even though I got the general prediction on the UK elections correct, I was wrong about the scope of victory for the Conservatives and I slightly overestimated UKIP's influence. It turned out that the Conservatives didn't need any coalition partner and that they've done it all on their own. To be fair I also failed to predict that the SNP will take so many seats away from Labour. 

4. "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." 

Ok, this one was a so-so prediction. I hedged by saying that "if things escalate beyond control" (vague as this may sound) the US would put troops on the ground. From today's point of view it looks like another superpower will beat them to it - Russia is increasing its military presence in the Middle East, and I would be surprised to see them lead the charge in 2016. But more on that in the next post. 

Under the radar:

1. Syriza and Greece. The story that occupied the first half of the year. And just by the end of 2014 I was thinking Greece is finally going to be OK. Not very high economic growth, but definitely a positive outlook, and then the elections happens, Syriza wins (single-handedly), and it all falls down the drain. To do a quick recap see here, here or here. I was actually correct on Greece many times before. It still serves to be one of my most precise predictions, when back in October 2011, I predicted exactly the scenario that would occur a few years from then, following a terrible response strategy from EU's policymakers. On Greece I have had a stellar forecasting record, which is why I was particularly unsettled as it went under my radar by the end of last year. I won't make that mistake again in 2016. 

2. The refugee crisis. And Europe closing its borders. 
No one saw it coming. At least not in the scope that it occurred, where in 2015 alone almost a million migrants have entered the EU by sea. In 2014 it was nowhere near this much. 

3. Corbyn and Trump? Fair enough, but literally NO ONE saw these two emerging. Not even themselves by the end of last year. Surely. For 2014 I was right in predicting that anti-establishment extremist parties will dominate the May EU elections, but I never thought that the extremists will start dominating within party lines. It still doesn't have to end well for either of them, but the trend is certainly interesting, and will be closely monitored. 

All in all, it was a messy year. With hopes that 2016 will be better (predictions coming up in the next post), I wish all my readers a happy new year!

Thursday, 17 December 2015

Graph of the year: The Fed increases interest rates!

It has happened. The Fed has raised short-term interest rates for the first time since the start of the financial crisis in 2008. And immediately they've doubled it! The rate went up from 0.25% to 0.5%, with a pledge to be gradually increased further in the years to come. In Janet Yellen's own words: "This marks and end to an extraordinary seven year period." 

Source: The Economist
An increase of interest rates in theory implies several things. Central banks increase interest rates when they want to curb the expansion of the economy, or in other words to prevent its overheating. A quarter of a basis point increase hardly means the US economy is overheating, but in the wake of the liquidity trap during the crisis and the recovery, and particularly Fed's September 2012 announcement that it will purchase mortgage securities as long as it takes until the labor market "improves", this move is viewed as a careful and gradual "return to normal". More importantly, the signal this move sent throughout the world's markets is immense. 

First of all, it confirms that the US has fully recovered from the crisis and is now embarking on a steady growth trajectory with unemployment declining consistently for the past 5 years. Even my favorite labor market indicator, the civilian employment-population ratio has improved - it is slowly but steadily rising for the past year and a half. It is still, however, a good 4 basis points below its pre-crisis peak. As I've emphasized a number of times before, this is obviously a new normal for the US (Europe as well - see here and here), as those 4 p.p. of people who lost their jobs during the crisis will probably never return to the labor market. 

Second, the signal it sends to markets worldwide is both encouraging and worrying at the same time. In the US an increase of interest rates should imply higher savings since credit is now becoming a bit more expensive (bad for debtors, good for creditors), and more importantly a stronger dollar (higher domestic interest rates appreciate the currency). It should also put a downward pressure on asset prices, as it did but by a small margin. Since the move was well expected throughout the year the domestic markets adjusted easily well before the announcement. The same is true of the dollar - it went up against most currencies today, but this is nothing new. It has been rising steadily against the euro for the past year and a half. By now the USD/EUR exchange rate is likely to actually reach its parity! It's good to hold dollars right now. Especially if you live in the Euro Area. 

The dollar growing stronger will inevitably hurt emerging markets. In a 6-year period when US interest rates were at their historic lows, the dollar was gaining strength, primarily because the demand for dollar was increasing. Now as the Fed keeps increasing interest rates (and it surely will already in March 2016), the dollar will only grow stronger. How strong depends on which currency we're comparing it to. Against the euro? Very likely. Against the Rubble? Almost certainly. Against many of the emerging markets' currencies? Also, almost certainly. 

Why is this such a big problem for emerging markets? First and foremost since most of their debt is denominated in dollars. The stronger the dollar, the more expensive it is for them to repay their debt. This has all happened once before in the 90-ies, particularly in Latin America. Back then it was called the "original sin" - having dollar-denominated debt backed by local-currency revenues. The weaker your domestic currency (for example because of the lack of demand for newly-printed domestic currency), or the stronger the dollar (or whichever foreign currency the country has borrowed in), the worse it becomes for the country to pay off its debts. In today's slow-paced global recovery, most emerging markets (and most developed economies) are already overburdened with debt. They have trouble meeting payments as it is. A strong dollar coupled with higher interest rates (read: higher borrowing costs) will only make things worse. Believe it or not, the past 6 years were good times for taking on new debt (restructuring it - meaning replacing old expensive debt with new, cheaper one). Now the real troubles will start, particularly as the emerging markets are expecting slower growth next year. 

Finally, regarding domestic inflation, the move is welcomed according to most critics. The Fed has announced that this move is the first step to ensure that inflation is contained in the time to come. Throughout the past 6-7 years inflation in the US has been really low, borderline deflation. This is why many inflation doves have claimed that the Fed need not increase interest rates as long as there is no real threat of inflation. However, inflation hawks were saying this is a matter of time, due to the huge amount of money pushed into the US economy over the crisis and recovery period (M1 money stock went from $1,400bn to over $3000bn over only 6 years). The problem is that most of this money has stayed out of the real economy - it has been primarily used to clear banks' balance sheets. Even private sector companies were hoarding cash. But most importantly the real reason why all this money-pumping hasn't resulted in high inflation, neither in the US or in Europe, was because the velocity of money was low. See further explanation here. Anyway, it's a good thing for the Fed to react already to the potential of a price increase. As soon as the velocity of money picks up, there will be an increased pressure on prices. The Fed was smart to anticipate this. 

Source: The Economist
NOTE: The FT has a fantastic, easy-to-understand, coverage of what happens when interest rates rise. I recommend to everyone to take a look.

Sunday, 13 December 2015

Adios Chavismo y Kirchnerismo

Over the past month we witnessed two major political changes in the South American continent. Venezuela and Argentina have ousted their long-lasting socialist parties and have turned center-right. The scope of this change is even greater considering the fact that two dominant Latin American political economy ideologies were punished at the polls: Chavism and Kirchnerism.

However, to be honest, the defining figures behind these political and economic ideologies weren't themselves punished by the voters. Chavez died, his successor Maduro still remains in power, but it was the Socialist party that lost the parliamentary elections (by a landslide), while Cristina Kirchner had to step down after serving two consecutive terms in office - it was her chosen successor that lost the November Presidential run-off. The Venezuelan elections can still however result in a blow to Maduro since the opposition gained a two-third majority in Parliament, meaning they can change the constitution limiting the President's power or call a referendum on Maduro's leadership if he blocks the opposition's amnesty law (a lot of opposition leaders are - surprise, surprise - in prison). In fact prior to these elections it was said they represented a pre-referendum for Maduro. With a turnout as high as 75% this was indeed a huge blow to Chavismo, but not yet its final demise. 

Economic voting: incumbents punished due to a declining economy

Either way these two events could mark an end to an era, not only in these two countries, but possibly in South America in general. What happened at the elections was actually a very simple case of economic voting - both the Argentine and the Venezuelan economy were in dismal states after a decade and a half-long socialist experiment. 

In Venezuela inflation in 2015 was over 150% (projected to go over 200% in 2016), GDP fell by 10% with a further 6% projected decline in 2016, and with unemployment soaring at 18%. Price and currency controls were imposed causing shortages of basic goods (food and medication) not to mention huge queues in supermarkets (the price controls are primarily responsible for such high inflation rates). The percentage of people living in poverty is a whopping 73% (up from 23% only a few years ago), while the health system has completely collapsed. It's easy to see why this happened. Venezuela's socialist "Bolivarian revolution" agenda was based almost exclusively on its vast oil reserves. The revenues from oil were used to fund social welfare programs as well as buying power and influence abroad. As oil prices have fallen dramatically over the past year and a half, the government simply couldn't afford all of its expenditures. While poverty was declining and living standards improving during Chavez's reign, all this was funded thanks to high oil prices and large government revenues. The socialist mindset has reached an impasse once more - they ran out of money. Naturally the economy collapsed. 

Source: The Economist
In Argentina, the situation was only slightly better, although there too the economy was crumbling. After another default on its debt in July 2014, and following a slump in commodity and oil prices, their foreign currency reserves have been drained, making it even more difficult in attracting foreign investment. The fact that Kirchner nationalized the biggest domestic oil company YFP taking it away from the Spanish Repsol, in addition to nationalizing the airline company, the railway system and the largest pension fund, didn't help either. Furthermore, similar to its like-minded socialist leaders in Venezuela, the government persistently misreported the key statistics about the economy. 

Inflation is also high, officially estimated at 14%, but with independent domestic economists calculating it to be around 25%. It too is a consequence of capital, currency and price controls, and it too is denting domestic purchasing power and living standards. Arguably one of the most devastating economic decisions by Kirchner was to implement the so called "supply law". Under this absurd piece of legislation the Argentine government has prohibited companies to set prices too high, thereby generating "too much" profit, or producing "too little", thus successfully constraining them from both ends and literary pushing them into bankruptcy. Of course the concepts of "too high" or "too little" are not defined, as long as the "extraprofits" can be detained. Nothing embodies Kirchnerism more than this move - after nationalizing all the biggest industries, the small and medium-sized businesses were also contained by a typical central planning agenda. Couple this with other laws that undermined legal contracts and basic property rights, not to mention Kirchner's capture of the justice system, it's also easy to see why things went so wrong in Argentina. 

Source: The Economist
Limited access orders 

Underneath their populist surface both Chavism and Kirchnerism were nothing more than rules of Robin-Hood-like, extractive elites which have designed and perpetuated a system of cronyism, corruption and personalization of power and key institutions. They are an almost perfect depiction of the North, Wallis and Weingast (2009) limited access order (LAO). Let me remind the readers of what LAO implies: "an institutional framework in which well-organized ruling elites manipulate the economy by generating privileges based on the personalization of governing institutions. They define such societies as natural states, or the more precise limited access orders, in which intrapersonal relationships between the powerful and the political elites serve as the base of all political and economic outcomes. The elites are then successful in preventing the development of the civil society and ensure a long-run constellation of existing political relationships."

Or in the framework of Acemoglu and Robinson (2012) this is a typical example of an extractive political order, which necessarily designs economic institutions to be extractive as well. It can also be extended to fall under the iron law of oligarchy, since the pattern of governance of these countries resembles their former autocratic regimes, the very same ones they fought against. But just like under any extractive political system, there is a limit to its growth and expansion. In both cases it was the natural resources (oil in Venezuela and land in Argentina) that held the elites in power, allowing them a chance to expand their socialist agenda when prices were high and money was pouring. 

Many dictators in the world depend on the availability of resources. If they have no resources to exploit then they form alliances with global superpowers (US, EU, Russia, China) and depend on their foreign aid. In some cases the dictators are ruthless to everyone and take all the money for themselves. This is a shortsighted strategy as it often leads to the leader being deposed and, well, murdered (Gadaffi, Caucescu, Saddam, etc.). In other cases they are more socially sensitive and only kill and imprison those who directly oppose them, while giving huge populist concessions to their voters. This strategy, only seemingly better, is also misguided as it places a too high emphasis on the country's natural resources. When prices start to fall, it's good as over for the dictator. This is why Putin's biggest challenge thus far was the rapid decline in oil prices that began last year, which evidently hurt Russia's economy. However Putin was clever enough not to put all of his eggs in one basket, plus he faced different circumstances. Kirchner and Maduro on the other hand, they didn't even have that choice. 

As for their legacy, it will be extremely hard for the opposition to fix the dismal state of their economies. Even more so as expectations are certainly riding very high from the voters. This is why one shouldn't exclude the scenario of Kircherism and Chavismo returning to the big stage after a few years. Hopefully this won't happen as the voters have learned their lesson. But in politics, just like in economics, it's never that simple.