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Economic Update: Sustained Global Expansion

February 2014

Richard B. Hoey

Chief Economist, BNY Mellon and Dreyfus

Chief Economist Richard Hoey presents his February 2014 Economic Update

Despite recent concerns about financial risks in China and stresses in some other emerging countries, we continue to expect stronger global economic growth in 2014, with global real GDP growth likely to accelerate by one-half to three-quarters of one percent above the sluggish pace near 3% in 2012 and 2013. This acceleration should be led by developed countries, reflecting monetary stimulus and a reduction of the fiscal drag and deleveraging drag in many countries. For the U.S., we continue to expect three years of 3% growth in 2014, 2015 and 2016.

There is a clear difference between China and many other emerging market countries. China's financial system is domestically-oriented. After years of current account surpluses, it is an international creditor with large international reserves. It uses capital controls to limit inflows and outflows. In that context, domestic economic and financial policy matter much more for China than do sentiment swings among foreign investors. While some other countries in North Asia also have limited sensitivity to foreign investment flows, many emerging market countries have substantial current account deficits and depend on foreign investors for external finance. This is in sharp contrast to China's domestically-dominated financial system.

For many years, Chinese economic expansion has been supported by strong exports and strong investment financed by a high consumer savings rate and financial repression in the form of low real interest rates paid to consumers and charged to corporate borrowers. In the process, the skill set of the Chinese workforce has been strengthened, a key factor in strong economic growth. More recently, the consequences of weak capital discipline in the allocation of lending and investment have become more of a concern. Some observers anticipate a "hard landing" in the Chinese economy.

We believe that forced liquidation of bad debts is not inevitable, but rather would be a policy choice in the Chinese context. We doubt that they will choose it. We believe that the Chinese government has the financial strength to absorb a substantial portion of the legacy bad debts over a period of years and to tolerate a gradual recognition of legacy bad debts in the private sector over an extended period of time. The result should be an orderly deceleration of Chinese economic growth. We expect about 7.5% real GDP growth this year.

After running current account surpluses for many years, the external balance sheet of China is quite strong. It is a net international creditor, not a net international debtor. Chinese debt is largely owed to domestic Chinese lenders in an economy with a very high savings rate. The government of China has the power to decide who will absorb the losses from bad debts in vulnerable portions of the Chinese financial system and when that will occur. Given the recent example of a global financial crisis which triggered the great recession, we expect that China will choose to dampen the risk of a major financial crisis even at the cost of having the Chinese government absorb a substantial portion of the losses on legacy bad debt over the course of time. At the same time, we expect that the government will modify financial rules in order to slow the creation of new bad debt. This should contribute to an orderly slowing in economic growth in the coming years.

With demographics slowing the growth rate of the Chinese workforce, eroding competitiveness due to strong wage inflation and a need to slow domestic credit creation, the trend growth rate is shifting downward in China. However, we expect an orderly deceleration rather than a hard landing.

We expect a well-behaved pattern for oil prices and other energy prices even as global economic growth accelerates due in part to an orderly deceleration of Chinese economic growth. We regard most commodity prices, including energy prices, as the "effects" of shifts in global supply and demand. Because spending on energy is such a large portion of global spending, we believe that energy prices are also "causal" for economic growth. Weak or roughly flat world energy prices, especially when they are due to strong supply growth more than to cyclical weakness in demand, can help support global economic expansion. Moderate energy prices benefit real income growth and may help motivate the continuation of easy monetary policy in many countries.

From a long-term perspective, the emerging market share of global GDP should continue to shift higher over time. The Brookings Institution estimated, in its report on "The Emerging Middle Class in Developing Countries," that between 2009 and 2030, the share of the global middle class population would shift down from 18% to 7% in North America, shift down from 36% to 14% in broader Europe and shift up from 28% to 66% in Asia. The details are hard to forecast reliably, but the probability that the emerging country share of global GDP will continue to trend higher is very high. It is also likely that the emerging country share of global profits will trend higher over time, especially if corporate governance improves and government interference in the private sector trends down.

The condition of many emerging countries is much stronger than it was almost two decades ago at the onset of the Asian financial crisis. Emerging country sovereign credit ratings have been rising even as developed country sovereign credit ratings have been falling. Many countries have shifted to more flexible exchange rate regimes. A higher proportion of sovereign borrowing is done in domestic currencies rather than in foreign currencies. International reserves have increased substantially for many emerging countries.

Nonetheless, what explains the sharp sell-off in emerging country assets in the last several quarters? In part it can be attributed to anticipation of future increases in U.S. interest rates. We believe that QE3 temporarily pushed down both long-term Treasury bond yields and volatility, thus motivating excessive speculation in emerging country currencies, debt and equities. That speculation was largely unwound by the announcement in mid-2013 that quantitative easing would be tapered. However, it is important to note that throughout the developing world, nominal policy interest rates are still near zero, real policy interest rates are still low and often negative and sovereign bond yields are still low in nominal and real terms.

Many emerging countries are sensitive to the Chinese business cycle, which has had a different pattern than the developed country business cycle. The Chinese business cycle is out of step with the developed economy business cycle due largely to the hangover from the credit boom engineered by China after the global recession to mitigate the spillover to China from the global recession. This had implications for emerging countries which are major exporters to China. For them, demand growth in the early phases of the global economic recovery was better than in the developed countries. However, the eventual hangover of the subsequent deceleration in China's growth rate has been a more recent source of weakness, especially among commodity exporters, even as developed country growth has begun to accelerate. We expect that the combination of faster growth in the developed world and continued expansion in China should help generate sustained expansion in most emerging countries as long as a rising trend of U.S. bond yields is gradual, not dramatic. That is what we anticipate.

Some emerging countries which experienced sharp currency declines have had a temporary upsurge in inflationary pressure. We believe that, over the next year, the resulting tightening of monetary policy in these vulnerable emerging countries should succeed both in improving their current accounts and in calming inflationary pressures. We believe that the most crucial differentiator among the emerging countries over the next several years is likely to be the level and trend in medium-term policy credibility. This should help determine the supply of foreign capital to individual emerging countries.

Our expectations for monetary policy in major countries are unchanged. The basic policy adopted by the Federal Reserve when Janet Yellen was Vice-Chair has been continued now that she is Chair. We expect that quantitative easing will continue to be tapered at $10 billion per meeting, with a high "hurdle" for any decision to pause the taper. The basic adjustment from Fed-manipulated Treasury bond yields to free-market Treasury bond yields largely occurred at the time of Chairman Bernanke's "taper talk" in May and June of 2013. We expect 10-year Treasury bond yields to drift persistently higher at about a 50-basis-points-a-year pace in 2014, 2015 and 2016, before a bond yield spike to 5% in 2017 or 2018, following the November 2016 elections. Short-term interest rates should start to rise in the second half of 2015. Additional easing from the Bank of Japan is likely to be needed later this year. Forward guidance has been modified at the Bank of England and made more flexible at the Fed, as unemployment rates fell faster than anticipated and central banks wished to retain their easy monetary policy anyway. We expect a slight easing move from the ECB soon.

The outlook for the U.S. economy is one of the keys to the global economic outlook. We believe that there was a transition in mid-2013 from four years of about 2% growth to a new cyclical trend of three or more years of about 3% growth. In recent weeks, however, economic reports have weakened significantly. We believe that weakness has two causes, both temporary. One was the weather and the other was a slowing in inventory accumulation. With weak growth in non-agricultural payrolls in the last two months, it is relevant to ask whether a substantial downshift in demand for labor has begun. We don't think so. Contrary evidence includes (1) estimates of faster payroll growth by ADP, (2) strong growth in household survey employment in recent months, (3) an improvement in job availability surveys by the Conference Board, (4) a rise in the employment intentions surveyed by the National Federation of Independent Business, and (5) a rise in the employment indicator in the non-manufacturing ISM. While survey data have their weaknesses, they are likely to be less vulnerable to weather impacts than other economic variables.

We believe that there are two different kinds of inventory adjustment. One occurs when final demand drops sharply and businesses are slow to adjust production, generating substantial cyclical weakness. A milder version is when the pace of inventory accumulation surges powerfully and then slows to a more sustainable pace. We believe that the U.S. economy is undergoing the latter, milder inventory slowdown. While the fourth quarter 2013 real GDP growth should be revised downward and the first quarter 2014 growth rate may be weak, we continue to expect real GDP growth in the U.S. of about 3% in 2014, continuing at roughly the same pace in 2015 and 2016.

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