Global Economic Outlook
Each time it appears that the global economy is about to accelerate, something happens to throw a wrench into the wheels of growth. In the past year, that wrench has been the crisis in the Eurozone. With much of Europe in recession, European demand for imported goods has declined, thereby having a negative impact on many of the world’s leading economies. It is often forgotten that the EU remains the world’s largest economy -- indeed, larger than the United States and of great importance to global commerce.
In the past year we have seen the economies of the United States, China, Japan, India and Brazil decelerate as the long arm of the European crisis has reached across the globe. Moreover, the slowdown in these critical economies influenced economic performance in their neighborhoods. For example, many economies in East Asia have been negatively influenced by the slowdown in China.
Observers who speak of the end of globalization are wrong, as are those who believe that the fate of emerging economies is no longer tied to that of developed economies. Thus, what happens in Europe in the coming year will likely have a significant impact on the rest of the world.
Likewise, what happens in the United States and China will also be of great importance. Barring a fiscal convulsion, the U.S. economy is likely to accelerate in the coming year, which will have a modest positive impact on global growth. China has avoided a hard landing through a combination of monetary and fiscal stimulus, and stronger growth is likely in 2013. In both economies, however, structural changes are underway that will influence the path of the global economy.
As of this writing, much of Western Europe is in recession. This results from several factors. First, nearly every country on the continent is cutting its fiscal deficit through tax increases and spending reductions, which has a negative impact on economic activity. Second, the fear that the Eurozone will fail has led to a perception of currency risk within the Eurozone. This means that lenders require a risk premium in order to provide credit in countries perceived as being at risk, including Spain, Portugal, Italy and Greece. The result is a decline in credit market activity in these countries. Third, the EU has compelled banks to recapitalize through reductions in lending and the sale of assets. Again, the impact is to discourage private credit market activity. Finally, the huge uncertainty about the economic future of Europe has led businesses to curtail capital spending.
Meanwhile, negotiations continue on the best path forward for the Eurozone. There is general agreement that failure would entail huge and unacceptable costs in the form of a severe economic downturn. Thus, the Eurozone must be fixed but how? The consensus view is that the Eurozone requires three forms of integration to succeed. First, there needs to be a banking union with a central authority to supervise and recapitalize banks. Negotiations have been underway among EU members to achieve this goal, and EU leadership hopes to achieve a banking union in 2013.
Second, some mechanism will be needed to assure sovereign debt repayment that is not overly onerous for member countries. Currently, efforts at fiscal consolidation are backfiring in that they are suppressing economic activity, thus leading to reduced tax revenue and still large fiscal deficits. If Eurozone debt could be consolidated, shared or replaced by Eurobonds, repayment would be far easier – especially if a dedicated stream of revenue could be secured to fund debt servicing. However, opponents fear that without a central authority with the power to enforce fiscal probity, such debt consolidation would be a bottomless pit.
Finally, some form of fiscal and political union will probably be needed, making the Eurozone more like a single national entity rather than simply a fragmented monetary union. The problem is that such a move is politically difficult and would likely take decades to evolve. Yet Europe has a few years at most to achieve this goal before the whole enterprise unravels.
What is the alternative? For the time being, it would be to simply muddle along from one crisis to another, with slow economic growth and continued economic uncertainty. Yet such a situation cannot last indefinitely. Failure to grow could ultimately lead voters to reject political parties that favor the continuation of the Eurozone. In the long run, failure is the only real alternative to further integration. What would failure entail?
The collapse of the Eurozone would likely begin with a sovereign default. This would lead to the exit of the defaulting country from the Eurozone and its inability to tap ECB funding or other forms of external finance. A severe recession would ensue. Such an event would have a contagious and negative impact on financial markets, possibly leading to the exhaustion of existing bailout facilities as other countries find it difficult to tap into capital markets. If, at that point, the EU failed to quickly integrate, it is likely that other sovereign defaults would take place. This would probably lead to a seizing of credit markets, the printing of new currencies, an increase in inflation and a sharp drop in economic activity across Europe. Moreover, a deeper recession in Europe would surely have a significant negative impact on the global economy. After all, the modest recession in which Europe now finds itself has already slowed economic growth in such important economies as the United States and China.
It bears noting that there are some positive things happening in Europe today. First, the value of the euro has fallen significantly in the past few years, leading to increased competitiveness on the part of European exports. In addition, wage restraints combined with productivity improvements in Southern Europe have helped to restore some of the lost competitiveness that was at the heart of the crisis in the first place.
Second, the European Central Bank has promised to undertake unlimited purchases of sovereign debt from countries that submit to conditional bailouts from Europe’s new bailout facility. Just the existence of this promise, which has not yet been implemented, has been sufficient to significantly lower sovereign bond yields for countries like Spain and Italy. The ECB program has drastically reduced the risk of imminent failure, thereby buying time for Europe to engage in longer-term solutions.
Nevertheless, many problems remain. As of this writing, there is concern about Spain’s ability to roll over existing debts and fund troubled banks and regional governments. One such government, Catalonia, now threatens to secede from Spain if it doesn’t obtain a better fiscal deal from the central government. Meanwhile, Greece has obtained the latest tranche of bailout money after promising to reform labor markets. But many observers doubt the deal is sustainable and believe that, ultimately, Greece will require significant forgiveness from sovereign holders of its debt.
By late 2012, China’s economy appeared to be turning the corner following a rough year of decelerating growth. The main problem was exports, with Europe as the main culprit. By mid-2012, exports to the EU were down 12.7 percent from a year earlier. Chinese imports were down as well, partly due to declining commodity prices, but also reflecting weakening demand in China. Industrial production was up a relatively modest amount in 2012. This meant that China’s economy became weaker than had been expected. The worry was that the much-anticipated soft landing would turn into a hard landing, which now appears unlikely.
Meanwhile, the weakness in the industrial sector had a negative impact on investment into China. Investors moved money out of China, perhaps as a result of declining profitability of Chinese companies and pessimism about the Chinese economy.
One effect of the weakening industrial sector is a decline in Chinese company profitability. Corporate revenue continues to increase, but export-oriented companies are struggling to maintain sales by cutting prices. The result is weak profitability.
To deal with the slowdown in economic activity, the government has taken a variety of actions. The central bank has cut the benchmark interest rate and has reduced banks’ required reserves, thereby boosting bank lending. In addition, the government has increased public investment in infrastructure. The result of these measures has been positive. Bank lending has increased, although not as much as had been hoped. The rise in credit market activity is very likely due to the recent cuts in interest rates and the reduction in banks’ required reserves. Indeed, the broad money supply has accelerated as well. The question now is whether the government will choose to take further actions aimed at stimulating the economy. With a change of leadership in late 2012, major decisions may be put on hold until the new leaders have time to assess the situation.
Longer term, China faces some serious challenges:
• First, too much of China’s economic activity has taken the form of investment in fixed assets like factories, shopping centers, apartment complexes, office buildings and highways. This accounts for 48 percent of GDP. Much investment has had negative returns, resulting in large losses for state-run banks. Such investment fails to boost growth and represents a serious imbalance in the economy. Normal, sustainable growth will come from shifting resources away from investment and toward consumer spending. To accomplish this goal, China will have to privatize state-run banks and companies, liberalize credit markets, allow more currency appreciation and further increases in labor compensation and provide a greater safety net in order to discourage high saving.
• Second, China’s demographics are changing rapidly. Labor force growth is slowing, which will result in slower economic growth. It will also create a shortage of labor, thus boosting wages – indeed, this is already happening. The result is that China’s vast pool of cheap labor is dwindling, and along with it the cost advantage for global manufacturers. In fact, the wage differential with Mexico for manufacturing workers has nearly disappeared. Consequently, many manufacturers are shifting export-oriented production out of China and into countries like Mexico and Vietnam.
• Third, China’s next phase of growth will require better human capital, more efficient capital markets and freer flow of information. These attributes will require economic and political reforms that will challenge the perks of China’s elite. As such, it will be politically difficult.
As of early December, negotiations were under way to avoid the so-called “fiscal cliff” which involves large automatic tax increases and spending cuts. If the United States was to go over that cliff, a recession would almost surely ensue. Most analysts expect that the cliff will be avoided and that a longer-term budget deal will be reached in early 2013. It is expected that such a deal will entail some revenue increases and some spending reductions, phased in over several years, with the goal of stabilizing the U.S. debt-to-GDP ratio over time. Assuming this scenario plays out, here is how the U.S. economy is likely to perform in 2013.
The economy will probably grow a bit faster than it did in 2012. By late 2012, it was apparent that U.S. consumer spending and the housing market were showing signs of modest improvement. Consumers have experienced several positive factors lately. Among these are a substantially reduced level of debt and debt service payments, thereby significantly improving consumer cash flow; increased wealth through good performance of the equity market; accelerating employment growth and steady, if very modest, income growth; and, finally, much increased confidence as measured by the leading indices of consumer confidence. All of this conspired to create modest growth of consumer spending, especially on automobiles. In addition, the housing market has gone from severe negative influence on economic growth to modest positive influence. Activity in the housing market has turned around, although it remains far below the levels reached during the last economic expansion. Home prices have risen, construction has accelerated and turnover among new and existing homes has increased – all creating the conditions for more spending on things related to the home.
Of course, 2012 saw significant negative factors as well. The recession in Europe led to a decline in U.S. exports to Europe and, consequently, to a sharp slowdown in the growth of industrial output. Moreover, concerns about Europe and uncertainty about its future caused U.S. companies to cut back on capital spending. The result was a slowdown in the growth of economic activity in mid-2012 and, indeed, renewed fears of a double-dip recession. Yet it appears as of this writing that the economy is doing better, despite the headwinds from Europe. Exports not directed at Europe are performing well, the result of a weak dollar and improved competitiveness on the part of U.S. manufacturers. Moreover, with increasing supply and reduced prices of natural gas, U.S. energy-intensive companies are becoming even more competitive.
Assuming that the U.S. fiscal cliff is avoided, and assuming that the Eurozone does not collapse and does not experience a severe economic downturn, then it seems likely that 2013 will be a moderately good year for the U.S. economy. Growth should pick up, inflation should remain subdued and the policy environment might even be less rancorous following the surprisingly decisive nature of the November elections. But what can retailers and their suppliers expect longer term from the U.S. economic environment?
First, the growth in 2012 came largely from consumers rather than exporters. This is not how the recovery began in 2009 and is certainly not what one should expect going forward. Consumer spending remains an unusually -- and probably unsustainably -- high share of GDP following the debt-fueled boom of the last decade. Now, as consumers continue to deleverage and banks continue their effort to restore healthy balance sheets, it seems unlikely that consumer spending can again grow as fast as it did in recent years. Rather, consumer spending is likely to decline as a share of GDP while exports and business investment boost their share. The stage is already set. U.S. manufacturers are already more competitive due to a declining dollar, declining relative energy prices, improved labor and productivity. Moreover, U.S. companies that sell or distribute consumer goods and services now recognize that their future growth depends on going global. They are increasingly focused on emerging markets due to the expectation that these markets will account for a disproportionate share of global growth in the coming decade.
Second, much has been written about the continued skewing of income distribution in the United States. It continues apace, and higher taxes on the wealthy will do little to offset this trend. The causes are many, but an imbalance in the labor market between the skills demanded and those supplied is the principal culprit. A shortage of skilled labor is boosting compensation for the highly educated while a surplus of unskilled workers is suppressing compensation for everyone else. The result is hugely important for retailers and their suppliers. We are already witnessing a bifurcation of the consumer market, with upper-end sellers focused on offering clearly differentiated, high-quality goods in the context of a superior customer experience while other sellers focus on offering the lowest price.
Finally, a very positive aspect to the U.S. outlook concerns energy. Due to a massive increase in production of natural gas and oil through new technologies, the United States is expected to become the world’s largest producer of hydrocarbons by the end of the decade and a net exporter of energy. This will have several implications. First, low energy prices will boost U.S. manufacturing competitiveness. Second, there will be a sizable improvement in the trade balance. Third, investment in energy will boost employment significantly. Finally, the switch from coal to natural gas will significantly reduce carbon emissions.
Japan’s economy has been mostly sluggish for some time, despite the increased government spending on reconstruction following the earthquake and tsunami of 2011. Although there have been periodic bursts of economic activity like the 5.5 percent growth rate in the first quarter of 2012, growth has mostly been disappointing. In addition, compensation continues to decline, with total wages to workers in Japan in mid-2012 only marginally higher than in 1991. This means, of course, that unit labor costs are declining, thereby improving the competitiveness of Japanese products, but that is largely offset by the negative impact of a highly valued yen. On the other hand, declining wages contribute to declining purchasing power and stagnant consumer spending. It also contributes to deflation, which remains a serious problem in Japan.
To combat deflation, the Bank of Japan has set a formal inflation target of 1 percent. Yet prices continue to decline despite a more aggressive monetary policy. For the past year, the Bank of Japan has engaged in quantitative easing, whereby the Bank purchases assets like government bonds in order to inject liquidity into the economy. The idea is to boost the money supply, thereby creating some inflation. Other goals include keeping market interest rates low and putting downward pressure on the value of the yen. However, the policy has yet to result in any inflation. This raises a question as to whether the amount of quantitative easing is sufficient.
Meanwhile, many indicators suggest that the health of the Japanese economy is not improving. The well-known Tankan survey, which measures confidence among manufacturers, declined throughout much of 2012. In addition, exports declined, industrial production fell and purchasing managers’ indices for both manufacturing and services were down.
At a time when the Japanese economy hardly needs bad news, the political dispute between Japan and China over a group of islands is having a real impact on the economy. Japan’s major automotive company sales in China have fallen sharply. While the vehicles are mostly assembled in China, many of their parts are made in Japan. Consequently, if this dispute results in a sustained decline in Chinese demand for Japanese products, it could have real consequences for Japan’s already troubled industrial sector.
For retailers, the economic situation in Japan suggests continued weak sales growth and declining prices. Even if there are changes in economic policy, it will take time for them to work their way through to consumer behavior. Therefore, retailers should not expect much strength of demand in 2013. Longer term, Japan faces challenging demographics, a continued strong yen, continued deflation or low inflation and a lack of economic reforms that would improve the efficiency of the distribution system. Thus, retailers in Japan are likely to seek growth outside of the home market. Still, Japan remains a very affluent society. For global retailers looking to tap into fat wallets, Japan will remain an attractive if slow-growing market.
The slowdown in the global economy has taken a toll on many, but not all, emerging markets.
In Brazil, the slowdown in exports to Europe and China, combined with the lagged effect of monetary policy tightening, led to a substantial slowdown in growth in 2011 and 2012. To combat this, Brazil’s central bank began a process of aggressive interest rate cuts starting in late 2011 and continuing through the autumn of 2012. In all, the benchmark interest rate was cut by more than 500 basis points, resulting in the lowest rate ever recorded. In addition, the government began a process of fiscal stimulus in 2012 that entailed tax cuts and spending increases. The result is expected to be a pickup in growth in 2013. The only problem is that this stimulatory policy was implemented even as inflation remained higher than desired. Therefore, in November, the central bank decided to stabilize interest rates and wait for inflation to decelerate before implementing further stimulus. In addition, the radical reduction in the benchmark rate helped to keep the currency from rising too far, thus reducing the risk that manufactured exports would become less competitive. As for Brazil’s consumer market, it remains reasonably healthy. The biggest risk comes from a relatively high level of consumer debt.
In India, growth declined in 2012 as well. Yet unlike in Brazil, India’s central bank has remained focused on inflation, even at the cost of delaying economic recovery. Much to the chagrin of the government and many businesses, the central bank has kept the benchmark interest rate relatively high, awaiting a drop in inflation. Meanwhile, the economy suffered in 2012 from the impact of a global slowdown as well as the effect of weak business confidence. To restore confidence and set the stage for faster growth in the future, the government proposed a series of major reforms aimed at boosting productivity. Among these was liberalization of foreign investment in retailing. As of this writing, it is not clear whether the government will be successful in implementing its reform agenda. Elections must take place no later than 2014, and they may help to clarify the direction of policy.
In Russia, the economy continues to grow modestly, but high inflation led the central bank to raise interest rates. External weakness has been offset by strong domestic demand, but higher interest rates may hurt domestically driven growth – especially business investment and interest sensitive consumer spending. In addition, government incentives for consumer spending have expired as the government seeks to reduce its deficit. Thus the outlook for economic growth is modest at best.
Despite the weakness in the BRIC economies, some parts of the world have managed to grow strongly. These include the Andean countries of South America, much of sub-Saharan Africa and some countries in Southeast Asia, including Indonesia and the Philippines. As the global economy ultimately recovers, these regions stand to benefit. Moreover, they are immensely attractive to the world’s top retailers. This is because they are likely to experience strong growth, have limited modern retailing and are likely to see an expansion of the middle class which drives modern retail.