Global Economic Outlook
The economic situation for retailers
The past year began with such promise and ended with such uncertainty. At the start of 2010, the world was relieved to have avoided a more grim economic result. The downturn of 2009 was the worst in decades, but it was not as bad as what might have happened. Government intervention to recapitalize banks, stimulate demand and flood the market with liquidity helped to avoid pandemonium. However, all of this was not sufficient to start a robust recovery -- at least not in the developed economies of North America, Europe and Japan. There, growth has been modest, and thankfully, inflation has been low. On the other hand, strong growth came to the emerging world and with it the risk of rising inflation. Hence, as 2011 begins, retailers worry about inadequate demand in rich countries and overheating in emerging countries. In addition, they now face concerns about exchange rate volatility, changing fiscal policy and the sustainability of recovery in some markets.
One problem is that imbalances continue to haunt the global economy. Interest rates in developed countries are unusually low, reflecting aggressive monetary policy and weak demand for credit. Thus, money is flowing out of these countries and into emerging markets with higher interest rates. Yet in those countries where growth is strong, the inflow of capital is putting upward pressure on currency values, thereby hurting export competitiveness. At the same time, rapid growth in emerging markets is creating new inflationary pressures, which have led some central banks to tighten monetary policy, thereby putting additional upward pressure on currencies. Now, many emerging governments are intervening in currency markets to hold down their currencies in order to improve export competitiveness – but this risks exacerbating inflation. Moreover, if every country tries to devalue its currency, no currency will decline in value, but all countries will increase their money supplies, thus generating inflation.
And so the global economy remains imbalanced. Countries that have traditionally relied on exports (such as China, Japan and Germany) and need to move toward domestic-led growth continue to depend heavily on exports. Countries that relied too heavily on their consumers (such as the United States and the U.K.) and need to export more now face competitive devaluations in their target export markets, thereby hurting their own export competitiveness. Failure to adjust to new realities will only delay the day of reckoning, yet making the necessary adjustments involves short-term pain.
Affluent countries that nearly experienced economic meltdown now face tattered financial markets. Credit fails to grow as consumers and businesses hoard cash and continue to deleverage. Debate rages over whether central banks and governments should respond by becoming more aggressive, but an aggressive stance risks continuation of global imbalances.
Overall, the outlook for 2011 is for strong global economic improvement, with the preponderance of growth taking place in emerging markets. In the developed world, however, growth is not expected to be exceptional. Let us examine the outlook in each major market and consider the potential impact on retailers and their suppliers.
The U.S. economy did not perform especially well in 2010, but 2011 looks to be more promising due to several factors. First, there is considerable pent-up consumer demand. In addition, consumer cash flow has markedly improved, so there ought to be a pickup in consumer spending. Second, the aggressive expansionary policy of the Federal Reserve, known as quantitative easing, is likely to push down real interest rates and, therefore, boost demand for credit. It could also lead to increased values for various financial assets. The result, it is hoped, will be a stimulus for consumer and business spending. Finally, although a high degree of structural unemployment remains, there are indications that job growth will pick up speed in 2011. This would boost consumer spending and help to reduce worrisome budget deficits at the federal and state levels.
Still, there are some negative factors that could restrain economic recovery. Slowing growth overseas could hamper export growth, which was strong throughout 2010. In addition, a tighter fiscal policy could have a negative impact on overall economic activity. Finally, continued private sector deleveraging in the wake of the financial crisis could hamper growth.
As for U.S. consumers, they appear to be operating within the realm of a “new normal.” After a near orgy of debt-financed spending over the past decade, greater sobriety is now in evidence. While good for individual households, this new frugality is not necessarily good for retailers. It is manifested in greater value orientation, more price sensitivity, less discretionary spending generally and less spending on big-ticket items in particular. In the past decade, much spending was fueled by the housing market; in the coming years, housing is likely to be constrained if not dormant. While low prices of homes boost affordability, for many households it means having mortgage debt in excess of the value of the home. This fact, applicable to about one-quarter of all U.S. mortgage holders, has a negative impact on spending and mobility.
For U.S. retailers, the reality of the new normal has meant substantial cost cutting, lean inventories and modest expansion. As a result, despite slow growth, many U.S. retailers have become well positioned for the coming year. Those with strong value propositions or clear differentiation are likely to do well. Still, there is probably more retail capacity than the country needs, and further consolidation is not out of the question.
We are also likely to see spending restraint in the realm of discretionary merchandise. Thus, retailers focused on home-related and other big-ticket items may face challenges. The bifurcation of U.S. retailing, so evident the past decade, is likely to accelerate. This means strength for highly price-oriented retailers and those focused on superior customer experience -- and trouble for those in between. Clearly the challenges in the U.S. market will stimulate some retailers to invest outside the United States.
Although Europe as a whole bounced back in 2010, a confluence of factors is likely to cause a slowdown in growth in 2011. More importantly from a retail perspective, most of Europe’s growth is coming from exports rather than consumer spending. In Germany, for example, which had strong export-driven economic growth in 2010, consumer spending remained relatively stagnant. On the other hand, the modest and declining unemployment rate in Germany bodes well for a modest pickup in consumer demand.
Notably, economic policy within Europe has been aimed at reducing budget deficits rather than stimulating growth. Most governments are currently engaged in fiscal contraction, which entails tax increases and spending reductions. The European Central Bank (ECB), unlike the United States and Japan, has not engaged in quantitative easing and remains focused on minimizing inflation. Finally, European credit markets remain troubled by continuing sovereign debt problems and bad bank assets. The result is that the only factors stimulating economic activity in Europe are the weak euro and strong growth in emerging markets, which have boosted exports. Meanwhile, consumer spending is going nowhere, and fiscal contraction is likely to have a negative impact in the year ahead.
The other interesting thing about Europe’s outlook is that the continent faces a two-track economic outlook. Germany, Sweden, The Netherlands and other northern countries are performing well, largely based on export strength. In contrast, the peripheral nations of the EU face the prospect of recession or slow growth, largely due to massive government austerity combined with troubled credit markets. In some cases, like Ireland and Spain, the outlook is hurt by the need for banks to repair their balance sheets following the collapse of a housing price bubble. In other cases (such as Greece), the problem is a history of government largesse combined with failure to boost productivity. In any event, the recent recession shocked Europe into confronting long-simmering problems.
All the turmoil in Europe last year caused considerable volatility for the value of the euro; it also caused concern about the sustainability of the euro project. The underlying problem was the imbalance within the Eurozone. Germany, with strong productivity growth and modest wage gains, reduced its unit labor costs and was able to boost its exports to the rest of Europe and the world. On the other hand, Greece, Spain and Portugal saw only modest productivity gains and declining competitiveness.
At the same time, being in the common currency area enabled these countries to borrow cheaply and accumulate excessive debt. In any other part of the world, this situation would have resulted in currency devaluation for Greece or Portugal. In this case, that cannot happen. Hence, there was a need for structural reform. Although the EU provided a large financial backstop for its wayward members, the reforms undertaken have not convinced the markets that problems have been solved. Consequently, Europe seems to muddle from one crisis to the next.
What happens next? The answer is that uncertainty remains. Some observers question whether the euro itself will survive, but the cost of ending the Eurozone would be catastrophic, especially for strong exporters like Germany. That is because an end to the Eurozone would lead to a significant appreciation in the value of a new deutschemark, resulting in competitiveness problems for Germany. Instead, a more likely scenario is for a new debate about how to make the eurozone work better. This could entail greater fiscal integration, more serious punishments for wayward countries and more predictable procedures for dealing with crises. As of this writing, a new procedure for dealing with troubled countries is in the works.
In the U.K., the government is engaged in a bold experiment in austerity, drastically cutting the budget deficit in order to boost market confidence. The goal is to make sure that Britain avoids the problems that some other European countries have had with sovereign debt. Critics say that such a policy will slow economic growth unnecessarily and create social unrest. Supporters point to more robust economic performance in 2010 than had been expected, even after announcement of the budget measures. They also point to strength in the private sector, which might help to offset the deleveraging of the public sector. For retailers, the rise in the value added tax (VAT) will surely have some negative impact on spending.
The good news in the United Kingdom is that, with low interest rates, the otherwise troubled housing sector has not been damaged as much as might have been expected. Unemployment is far lower than expected as well. But there are troubling headwinds for the consumer sector. These include a decline in real wages (the result of modest wage gains combined with higher inflation), an abnormally high level of consumer debt and debt service and substantially tightened consumer credit conditions. These factors, combined with government austerity, suggest that consumer demand in the coming year will be modest at best.
Japan’s economy began 2010 with unexpectedly strong growth. Unfortunately, by late 2010 the economy was decelerating, and the outlook for 2011 is not good. The problem is that the main source of growth has been exports, and with a strong and rising currency, Japan’s exports are becoming uncompetitive. Also, a slowdown in demand in many foreign markets has hurt the growth of Japan’s exports. The result is that, by the end of 2010, exports were no longer growing -- and neither was the economy. Slow growth combined with modest money supply growth led to deflation (falling prices), which tends to discourage consumer and business spending. In addition, deflation exacerbates the problems of debtors, thereby harming bank profitability and causing troubles in credit markets. Although the Bank of Japan has instituted a modest policy of quantitative easing, there is debate as to whether this is sufficient to create some inflation and boost the economy.
As for the Japanese consumer, there was a modest pickup in spending in 2010 due to temporary government incentives. The end of such incentives means no government stimulus for spending in 2011, barring a change in policy. In addition, business investment remains weak as companies demonstrate low confidence in future growth.
For Japan’s retailers, the expected business environment suggests weak sales growth and poor pricing power. It will not be surprising to see Japanese retailers continue to invest in global expansion.
There have been signs of a soft landing in China after fears that the economy would slow down too much. Last year the government began the process of tightening monetary policy in order to slow growth and defuse inflationary pressures. By initially pushing down equity prices in response, global financial market participants demonstrated concern that China might be headed for a hard landing -- that is, they were worried that government policy would be too blunt and that the economy would slow down excessively. The more gradual slowdown that China has experienced lately has been welcomed by global markets, though they have been alarmed by the rise in inflation. However, this rise is not surprising as the impact of a monetary tightening on inflation will likely take time. A reasonable expectation is that inflation will continue to rise before starting to decline sometime later in 2011.
One reason for global anxiety about the rate of deceleration in China is that the country has become an engine of growth for the world. Rising domestic demand in China leads to increased imports, thereby stimulating exports in other parts of the world, including the United States, Germany and many emerging commodity exporting countries. As domestic demand decelerates, there could be a negative impact on global output.
Still, the global economy will probably be better off if China undergoes a soft landing rather than a future crisis -- and China may be better off as well. History shows that China tends to face increased social unrest and wrenching economic change during periods of inflation. Clearly the Chinese authorities want to avoid such an occurrence.
One of the big issues in the global economy is the exchange rate between China and the United States. China has begun to gradually revalue its currency. This will be beneficial to China as it will act to suppress inflation and help the country shift away from export dependence and toward growth based more on consumer demand. Yet China’s revaluation has been gradual, lest the country cause serious dislocation for exporters. Finding the right balance between concerns over inflation and export competitiveness will be a challenge in the year ahead. At the same time, other Asian countries have been reluctant to allow their currencies to rise more rapidly for fear that their exports to China will become less competitive.
Finally, the United States’ aggressive monetary policy is pushing down the dollar and boosting the value of many emerging market currencies. For China, this means either further upward pressure on the renminbi or a greater cost to holding down the value of the renminbi. In any event, 2011 is likely to see continued controversy about currency values, with the risk that protectionism could rear its ugly head. Meanwhile, China and other Asian economies face the risk of greater inflation if they fail to allow currency appreciation. Although China is fighting inflation with higher interest rates, this has the perverse effect of boosting flows of hot money into China, thereby leading to money supply growth and potential inflation. Only revaluation would allow for slower money supply growth.
What does all of this mean for China’s retail market? The good news is that, through all the turmoil of the past two years, Chinese retail sales never skipped a beat. Growth has been steady and strong. This is likely to continue, especially as China gradually transitions away from export dependence. On the other hand, rising inflation, along with possible price controls by the government, could cause difficulties for retailers. Rising commodity prices also threaten margins. Finally, although China’s overall growth will decline somewhat in 2011, it is expected that growth in secondary cities and regions will remain strong. This is where a disproportionate share of retail investment is likely to take place.
India’s economy has been growing quite rapidly following the end of the global recession. Growth has been so strong, in fact, that inflation has started to rise to uncomfortable levels. As a result, India’s central bank began to tighten monetary policy last year, which should lead to a modest slowdown in growth in 2011.
A significant source of India’s economic growth in 2010 was exports: Industrial production rose rapidly to meet the rising external demand for India’s output. But due to rising interest rates (the result of monetary tightening), capital inflows accelerated, leading to an appreciation of the Indian rupee. This will likely have a negative impact on export growth in the near term and will contribute to the slowdown in India’s economy in 2011.
Longer term, exports are well positioned to play a major role in India’s growth. Although India has become well-known for its proclivity to export business services, this has been only a modest source of growth in recent years. It cannot play a large role in India’s future as India is not likely to produce sufficient numbers of skilled workers to meet the needs of this industry. Instead, manufacturing, especially for export purposes, can be a way to absorb large numbers of unskilled workers into the economy. India has already shown considerable manufacturing prowess. In addition, China’s shift toward higher wages and higher value added production means that an opening exists for India to produce low wage output.
India’s potential for industrial growth, combined with favorable demographics, bodes well for strong economic growth. It also bodes well for strong consumer spending growth, especially as the number of young consumers rises rapidly. Unfortunately for global retailers, India remains largely closed to foreign retail organizations due to restrictions on inbound investment. However, the current government favors liberalization and intends to push for an end to restrictions on foreign retailer investment. Meanwhile, large Indian conglomerates are rapidly expanding. India’s modern retailing sector as a share of the total industry has risen rapidly in the past few years and now accounts for roughly 15 percent of retail sales. This figure is likely to continue rising in the years ahead. As the retailing industry modernizes, the cost of distribution will fall, supplier organizations will have an incentive to invest in technology and consumers will gain access to cheaper and safer products. The cost of this, however, will be disruption to the lives of millions of small, independent retailers.
Brazil’s new president Dilma Rousseff is relatively lucky: The biggest short-term challenge she faces is one that many other world leaders would envy. That is, rather than trying to make the economy grow, she will have to prevent the economy from growing too fast. When Brazil experienced very rapid growth in the past (mainly in the 1950s and 1960s), such growth was usually accompanied by very high inflation, even hyperinflation. The recent strong growth, especially the blistering growth that took place in 2010, was unusual in that inflation remained very low by historic standards. Still, there is a general consensus that such rapid growth is considerably more than Brazil can sustain without creating serious bottlenecks that could ultimately lead to inflation.
On the positive side, Rousseff will benefit from a surge in tax revenue, the result of a strong economy, and the fiscal deficit is likely to decline from an already relatively low level. Engineering a slowdown in growth is not that difficult -- it entails a tightening of monetary policy that was already well under way by late 2010. In addition, a rise in the value of Brazil’s currency suggests that the rapid pace of Brazilian export growth will lessen somewhat in 2011. Nevertheless, that rise will also be the source of headaches for Brazil’s growing export sector.
For consumers, the outlook is very good: Brazil’s economy is expected to grow at a healthy pace over the next several years. In addition, the number of households moving from poverty into the middle class is expected to be significant. The growing market for lower middle income households will be a strong source of growth for the retailing industry. Modern food retailers will seek to attract these consumers through competitive pricing and modern merchandising.
The world of retailing looks most promising in emerging markets—especially those with strong growth prospects and good demographics. That means such disparate places as Turkey, Egypt, Indonesia, Colombia and South Africa. In each of these markets, it is expected that economic growth will be strong and that investment in modern retailing will be significant. Perhaps of most interest is the fact that global retailers are increasingly talking about Africa. This region, which failed to have significant growth for much of the last half century, is now experiencing good growth as a result of rising commodity prices and better governance. It will be interesting to see if the world’s leading players take the plunge into this last frontier of modern retailing.
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