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By HaleStewart April 3, 2015 12:57 pm
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International Economic Week In Review; Looking At the Global Problem Spots, Edition

     Earlier this week, I placed the US economy on “yellow alert” status, meaning that a large enough number of economic indicators are flashing warning signs to warrant caution.  The US, however, isn’t the only major country experiencing problems.  Below I highlight the issues faced by China, Brazil, Russia, Canada and Australia.    

     China: because of its meteoric rise to first world status over the last 25 years, placing China at the top of the list may seem counter-intuitive.  However, the low-hanging economic fruit is gone.  Fixed asset investment, industrial production and retail sales have been declining for the last three years.  Total debt/GDP has been estimated at an unsustainable 250%.  Thanks to a massive build-out in their industrial infrastructure, the country has an over-capacity problem.  Pollution has reached dangerous levels across large swaths of the region.  And real estate sales are contracting:

Only one conclusion exists to the previously laid-out facts: China has serious problems that are slowly coming to the surface.

     Brazil: as a child of the 1970s, I remember the term “stagflation” well.  Thanks to recent events in Brazil, analysts can use this term again.  Inflation increased from ~5.5% in early 2014 to over 7% in 2015:

The real’s drop from 2.2/dollar at the beginning of 2014 to its current level of 3.1 has made this situation worse.  To combat both problems, the central bank raised rates from 11.25% at the end of 2014 to their current level of 12.75%.  Higher rates led to economic contraction:

Finally, the government faces a major scandal involving the country’s state-owned oil company and members of the current administration.  The inter-twining of a tense political environment with an economic downturn places the country in a terrible bind.

     Russia: after Russia’s invasion of the Ukraine last year, the west imposed sanctions that cut Russian business off from western financing.  Oil’s drop in 4Q14 made matters worse.  Both events contributed to the ruble’s collapse.  In December, a surprise late-night rate hike to 17% which was intended to stop the sell-off created the impression policy makers were panicking.  And despite these policy actions, inflation has increased to 16.7% in the latest reading:

To date, Russian policy-makers have offered no meaningful solution to the situation, save for increasing Vodka production.

     Canada: As explained by Deputy Bank Governor Timothy Lane, oil’s price drop will be a net-negative for Canada :

The most immediate impact will be positive: a boost to consumers’ disposable incomes and spending. Lower oil prices will also benefit many sectors, such as manufacturing, by reducing production costs. Our latest Business Outlook Survey, which was published yesterday, showed that more firms than in previous surveys are anticipating declines in their input costs, thanks in good part to cheaper oil and cheaper commodities in general.

The positive effect on the world economy and the resulting stronger growth would also be positive for Canada. A buoyant global economy would increase Canada’s non-energy exports, boost confidence and lead to improved business investment.

However, these gains will be more than reversed over time as lower incomes in the oil patch and along the supply chain spill over to the rest of the economy. The decline in Canada’s terms of trade will also reduce the country’s wealth.

The lower prices, if they are expected to persist, will significantly discourage investment and exploration in the oil sector. As I mentioned earlier, we are already seeing signs of this.

Lower oil prices are also typically accompanied by a weaker Canadian dollar, and this time is no exception. The dollar’s depreciation by over 10 per cent against the U.S. dollar in the past six months will help cushion the economy from the impact of lower oil prices.

Despite the mitigating factors I enumerated, lower oil prices are likely, on the whole, to be bad for Canada. Estimating the magnitude of that overall impact requires carefully analyzing the interplay between the various effects as they work through the economy. That is what we are doing as we prepare next week’s forecast.

Central bank head Poloz echoed this sentiment in an interview with the Financial Times, calling the net impact of oil’s price drop “atrocious.”  In an economic pre-emptive strike, the bank cut rates 25 basis points at their latest meeting.  But this wasn’t enough to prevent the latest M/M GDP reading from decreasing .1%.  It appears the country’s problems are just beginning.

     Australia: although GDP growth has been over 2% for the last year, the Australian economy faces a major structural hurdle.  For the last 20 years, the country has exported an ever-increasing amount of raw materials to the Chinese manufacturing complex.  Therefore, the Chinese slowdown has been slowly seeping into the Australian economy.  Unemployment has increased over the last year to a little over 6%.  Equally important, non-manufacturing business investment has stalled while mining investment is starting to decrease:

This has led to below trend GDP growth, as noted in the latest RBA Minutes:

Members noted that a range of indicators suggested that Australian GDP growth continued at a below-trend pace in the December quarter and over the course of 2014. These indicators had suggested that growth of consumption, dwelling investment and public demand were likely to have increased, but that business investment was likely to have fallen further, largely reflecting further steep declines in mining investment. 

     As the above points illustrate, there is weakness across the globe.  While several journalistic sources have written about China’s problems with debt, real estate and general overcapacity for at least the last two years, they haven’t yet led to a cataclysmic meltdown.  But the high level of debt and especially the issues with real estate are certainly cause for major concern.  Brazil’s increasing inflation harkens back to the hyper-inflation days in the early 1990s, which explains why the central bank has opted to raise rates at the expense of growth.  Russia’s problems, although partially self-inflicted, don't show any sign of abating.  Canada’s issues should abate once oil rebounds.  Still, if oil remains at low levels for over a year, expect problems to increase.  Finally, Australia needs to change the under-lying structure of its economy from a resource export model to one more evenly balanced between sources of growth.  Like China, they are finding that process more difficult in practice than in theory.

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on the Bonddad Blog.  He is also a tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.   You can follow him on twitter at:@captivelawyer  








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