The global economy has improved modestly while the near-term risk of recession has subsided in most of the world’s major economies:
- China remains in the late cycle, though the risk of slipping into a growth recession* subsided as economic activity regained momentum.
- Germany and much of the rest of Europe solidified their recovery, reducing the risk of recession.
- Japan’s mid-cycle expansion has held strong amid supportive monetary and fiscal policies.
- The U.S. remains firmly in a mid-cycle expansion with low recession risk, despite recent fiscal uncertainties.
The following is a more detailed look at developments in major areas of the economy.
China’s economic activity has continued to pick up, further diminishing the likelihood of a recession. Since Chinese policymakers stepped back from their efforts in June to rein in shadow lending, a renewed emphasis on growth in both credit and infrastructure has stabilized the economy. Total social financing—a measure of aggregate private lending by banks and other financial intermediaries—rose rapidly in the third quarter, with new credit created during that time approximately equivalent to 30% of the gross domestic product (GDP).1 Amid this free-flowing credit, the perception of banks’ lending attitudes reached new all-time highs. However, overall business conditions remain weak and have not responded as strongly to the surge in credit as in the past (see chart, right). Fixed asset investment has increased, boosted by new infrastructure projects and an upturn in the property sector.2 Industrial activity has become more broad-based as production growth has swelled demand not only for goods associated with the infrastructure build-out (e.g., cement, steel products, etc.) but also for inputs to the manufacturing process.3 The purchasing managers index (PMI) indicated expansion in manufacturing activity; the outlook remains positive for the manufacturing sector as new orders mount while inventories are drawn down. New export orders increased for the first time in six months, as stabilized global growth lifted Chinese manufacturing activity.4
Although the Chinese economy has improved on a cyclical basis, it continues to display late-cycle characteristics such as rising credit intensity (higher credit growth is required to boost economic output), weak corporate profitability, and excess capacity in real estate and other areas. The lack of a substantial economic acceleration in the face of significant credit expansion suggests that these funds are being deployed toward relatively unproductive assets (such as real estate) or to roll over existing debt. China’s economy has clearly stabilized amid renewed credit growth and infrastructure spending, but potential medium-term risks remain.
Deep dive into China's imbalances
To better understand the rapid increase in credit in China, we conducted a study of 29 countries and found that only six have attained house-price and credit imbalances as large as or larger than those in China currently. To measure the magnitude of imbalances we looked at credit-to-GDP ratios and inflationadjusted house prices to calculate how far above trend they had become. The other examples of large imbalances included the U.S. before 2007 and Japan before 1997; all eventually ended in banking crises that led to substantial economic and financial losses.
China is an unusual case, but its very large imbalances will have to unwind somehow. Of the few comparable circumstances in the past, the Japanese example could, perhaps, be the most likely model. As in Japan during the 1980s, China’s banking sector is a key element of a system designed to deliver investment-led economic growth by channeling surplus household savings to the industrial sector. After Japan’s housing peaked in 1990, this system took a long time to collapse during a protracted “lost decade.” Japanese banks continued to roll over non-performing loans to keep the system afloat, but economic stagnation eventually led to a full-fledged financial crisis in 1997. Although China is less financially open, its very large imbalances cannot continue indefinitely, and mediumterm risks may include slower economic growth and eventual financial instability.
Given the concerns about the sustainability of China’s creditfueled economic expansion, it is important to understand how globally significant a downturn in the second-largest economy could be. The systemic importance of China can be seen in its 10% share of global trade flows (the sum of exports and imports), which is comparable to the U.S. share of 12% (see chart, right). A substantial weakening in China’s demand for imports due to an economic downturn could greatly affect many nations, including direct exporters to China (such as several other Asian countries), as well as commodity producers in Latin America and the Middle East. Even though China represents only 3% of global finance (the sum of foreign assets and liabilities), in the aggregate its well-being has tremendous significance for its trade and financial partners.
China’s systemic risk can further be measured by the importance of its partners for the rest of the world economy. The 10 countries with the most significant direct trade and financial links to China have varying degrees of global systemic importance, but in aggregate these 10 countries represent approximately 25% of global trade, and 32% of global finance (see chart, right). Although cyclical stabilization and government policies may avert a growth recession in the near future (see Typical Business Cycle chart, at the end of the article), these Chinese economic imbalances bear close attention because a downturn in China would likely have significant global repercussions.
Germany remains in early-cycle recovery, and the eurozone more broadly has experienced a modest economic improvement, as evidenced by greater financial stability in the region’s periphery and improved manufacturing activity. The eurozone manufacturing PMI has shown expansionary activity for four months in a row, after a two-year contraction.5 Unit labor costs have declined in Italy and Spain, helping improve competitiveness and demand within Europe. Higher trade within the eurozone has added stability by blunting the impact of a strengthening euro and a potential deceleration in demand from emerging markets. The region’s peripheral economies have also benefited from lower fiscal drag and more stable borrowing costs.
Growth is modestly accelerating across the eurozone and sentiment continues to improve. However, deflationary risks remain amid stubbornly high unemployment, as the eurozone headline CPI fell to 1.1%—its lowest level since 2010.6 Overall credit conditions remain tight with some signs of easing, but credit availability may shrink if regulators’ stringent stress tests require certain banks to raise additional capital. Political brinkmanship subsided after Italy’s Prime Minister Enrico Letta won a vote of confidence in setting up a coalition government, while a German coalition government appears likely to form before year-end. Conditions in Europe continue to strengthen as economic recovery in the major economies becomes entrenched, political uncertainty subsides, and sentiment improves.
Japan: Reforms needed
Japan’s mid-cycle expansion continues to benefit from supportive monetary and fiscal policies. Employment dynamics and the manufacturing inventory cycle have both exhibited positive trends, while recent surveys of business owners indicated ongoing improvement in overall business conditions.7 Furthermore, consumer credit demand continued to improve, consumption growth ticked higher in September, and bank lending standards remained accommodative.8 Core CPI rose to 0.0% in August, the first nonnegative report since 2008, representing progress for the central bank’s anti-deflation objective and potentially some tightening in labor market conditions (see chart, right). However, there remains scant evidence of real wage growth so far. Negatively, Japan’s trade deficit has widened, amid slow global growth and elevated costs for transportation and electricity, which have pressured exports despite a weakening yen.
The government faces challenges in implementing the “third arrow” of Abenomics, which includes structural reforms to promote growth. The planned increase in the consumption value-added tax (VAT) from 5% to 8% in April of 2014 is intended to help narrow the budget deficit. We expect Japanese consumers to pull forward some spending prior to the VAT hike, providing a potential boost in consumption in the coming months. However, higher taxes may eventually discourage discretionary consumption and create disinflationary pressures—which occurred following Japan’s VAT increase in 1997, when core inflation last surpassed 2% before subsequently falling (see chart, above right). While the near-term economic outlook remains solid, meaningful structural reforms will be needed to support sustainable medium-term growth.
United States: Some risks
The government shutdown has restricted the recent flow of economic data on the U.S. economy. The country entered the shutdown solidly in mid-cycle, with modestly positive job growth, strong corporate profitability, and a constructive credit backdrop. However, private-sector data released after the shutdown began suggests that activity has likely softened. Specifically, the regional Federal Reserve manufacturing surveys and consumer confidence both weakened relative to pre-shutdown levels (see chart, right). The government resumption may provide a lift to real activity in the weeks ahead, though with the possibility of another shutdown and a recurring debt-ceiling debate, uncertainty in Washington may continue to weigh on consumer and business confidence into early next year. The U.S. is still in a mid-cycle expansion, but downside risks to the near-term outlook remain amid potential government disruption.
Global: Pick up continues
The global economy continues to experience modest improvement, led by cyclical upturns in developed economies. Leading indicators rose in nearly 80% of the world’s largest developed economies over the past six months, while also rising in approximately half the largest emerging economies.9 The broad-based revival in global manufacturing has been spearheaded by advanced economies, with almost 90% of developed countries experiencing expansion in their September manufacturing PMIs, versus 70% of emerging economies.10 Global growth remains slow, but with increasing momentum.
The economic performance of developed economies outside of Germany, Japan, and the U.S. has continued to be largely positive. The United Kingdom (U.K.) is in an early-cycle recovery, driven by an improvement in housing demand and eurozone exports. U.K. companies have started to expand payrolls, encouragingly via full-time hires.11 Canada is in a more mature mid-cycle expansion phase than the U.S., with poorer housing dynamics and slowing crude oil production growth.12 However, over the past four months, Canadian leading economic indicators have improved at the fastest pace since the end of the recession, suggesting the country’s economic expansion could accelerate in the near term.13 Australia is the relative laggard of the group, as deteriorating economic growth in China and other Asian emerging markets has reduced the demand for Australian mineral goods.14 However, stabilization in China has mitigated some of the risks that Australia may experience its first recession in 20 years.
Emerging economies other than China generally remain in late-cycle expansion phases. Stagflationary conditions have persisted for many economies with current account deficits—such as Brazil, India, Indonesia, Turkey, and South Africa—due to weaker currencies, higher borrowing costs, and persistent inflation pressures since late spring. However, global inflationary pressures have eased somewhat with the decline in commodity prices, and the Fed’s postponement of quantitative easing provided financial relief to currency values and bond yields in most countries. The pick-up in the global economy continues, led by better cyclical dynamics in developed countries.
Summary and outlook: Good for stocks, especially European
With the global economy maintaining a slow, steady rate of growth, the backdrop has improved over the past few months. Developed economies generally remain in more favorable phases of the business cycle. As China’s late-cycle economic expansion has shown signs of incremental improvement, other emerging markets have stabilized somewhat, though the outlook is not uniform.
Global asset prices have responded well to the mid-October resolution of the U.S. debt ceiling debate and the end of the government shutdown. Following decisions by central banks in the U.S. and China to remain extraordinarily accommodative, markets have shown confidence that monetary support will continue amid tepid global growth and modest inflationary pressures. A number of policy risks still exist, most notably the new U.S. fiscal deadlines to find agreement on both government operations and the debt ceiling, again, early next year. Nevertheless, the overall investment climate remains relatively benign.
In an environment of gradual improvement in the business cycle, more economically sensitive assets, such as equities, will likely continue to benefit. Early-cycle dynamics and relatively attractive valuations provide fundamental support for European equities in particular. Loose global monetary conditions, slow growth, and weak inflation have helped bond yields stabilize after their steep rise in the second quarter, providing a more balanced and selective outlook for fixed income.