Last week, the International Monetary Fund (IMF) released its twice-a-year World Economic Outlook (WEO). The report is released in April and October. This is the first edition for 2007. IMF has pencilled in a global GDP growth forecast of 4.9% for the world economy in 2007 and 2008. These are strong numbers and are well above the trend growth rate of around 3.5-4% for the global economy.
Further, WEO states that some of the downside risks to global growth have diminished in the six months since the release of its last report. Two upside risks have been further upgraded—the strength of domestic demand in Europe and the growth in emerging economies. In assessing the prospects for emerging markets, one turns to the outlook for the US economy as it still remains the case that the world catches a cold when the US sneezes (WEO, page 148). WEO feels that the evidence is not clear-cut that the US economy is “going to sneeze” (likely to face a recession). It might well be a mid-cycle slowdown. WEO presents charts of indicators whose behaviour in the last few quarters closely resembles their behaviour in mid-cycle slowdowns in the past rather than during recessions. The interesting exception is the behaviour of investment spending, which has weakened well past normal mid-cycle slowdowns. The hope of the Federal Reserve—one that is shared by IMF—is that investment spending will pick up, now that the industry appears to have worked out its inventory problems. The jury is out on that.
Imagine the double-blow attack on US growth if this investment spending pick-up fails to materialize, and if the problems of delayed or defaulted mortgage payments by US home-borrowers lead to a drop in the prices of homes, and compounds trouble for many mortgage lenders. www.lenderimplode.com suggests that more than 56 lenders have either shut down or greatly wound down their lending business. This number was in the range of 30s in March. Real-estate lending by US commercial banks tumbled in March, for the first time ever in many years. IMF would perhaps agree that the spill-over from a slowdown in the US, arising out of contraction in investments and rising woes in the housing sector, would be significantly negative for the rest of the world. What it contends is that a problem in the housing sector alone need not cause a US recession and, even if it does, it need not have a big impact on the rest of the world.
This is certainly arguable. Housing does not have huge import content. Hence, diffusion of the impact from US housing via trade linkages would be almost non-existent. But the counter-argument is that the problem in US housing involves the financial sector since low-quality mortgages have been securitized and sold to all types of institutions globally. Therefore, the financial spill-over could be greater than in the past.
Second, IMF argues that the spill-over also depends on how the US dollar itself behaves. For example, in the US recession in 2001, the dollar actually strengthened and Brazil, with its large short-term external debt denominated in US dollars, experienced a crisis in 2002. Now, the dollar is weakening. Most currencies, with the exception of the yen, are strengthening. That must be good news. But thanks to low interest rates in the US almost up to the end of 2005, most emerging economies have already reduced their external debt and, hence, a weakening dollar won’t be of much help. But the weakness of the dollar would mean that emerging economies cannot rely on weak currencies to export their way out of trouble as they might have done in 2001-02. Therefore, yours truly is of the opinion that IMF sounds more sanguine than circumstances warrant.
However, if the IMF assessment turns out to be correct in the coming months—that the US economy will face no more than a mild mid-cycle slowdown before growth reaccelerates—then it is very good news for emerging market assets. Investors could send more cash to emerging economies as slow US growth and a weakening US dollar render US dollar assets unattractive and foreign assets more attractive. It is evident in the way emerging currencies have risen in the last several weeks and in the further swelling of international reserves among emerging country central banks. If the trend continues, overvalued assets will be in bubble territory by year-end.
Bubbles need only a small needle prick to burst. That could be economic, financial or geopolitical. India’s neighbour to the West and North is entering turbulent times and the echoes would be felt here. Even if global economic conditions turn out to be benign, prudent investors would, at regular intervals, reduce the riskiness of their portfolio as the year wears on.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer (Singapore) Ltd. These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org