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By HaleStewart September 19, 2014 12:26 pm
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International Economic Week in Review: OECD and IMF Issue Warnings

     This week, both the IMF and OECD issued policy papers that lowered growth projections for the advanced economies and argued that downward risk possibilities had increased.  The issuance of both these documents provides a good opportunity to take stock of the economic position of the major NCM (non-currency manipulated countries) countries as well as highlighting the problems they are facing as outlined in these two reports.

     EU: The EU is easily the economy most at risk.  If the region is not already in the beginnings of a deflationary spiral it’s very close.  Unemployment is high, growth is non-existent and the possibility of further economic stutters has increased thanks to the situation in the Ukraine.  Topping that off is the ECBs latest stimulus attempt fell far short of expectations. 

     UK: in contrast to the EU is the UK, which is the best performing major OECD economy.  Unemployment is dropping, overall growth is strong and inflation is contained.  The only major problem the country is facing is weak wage growth, which should begin to increase with the continued drop in unemployment.

     US: right behind the UK is the US.  Unemployment is dropping (although overall labor utilization is still weak) inflation is contained, the budget gap is closing and growth rebounded in the 2Q14 from the 1Q14.  Recent ISM reports for both manufacturing and service sectors have pointed to solid 2H14 growth prospects.  The general consensus is for the Fed to start raising rates sometime in the 1H15.

     Canada: The Canadian economy continues to expand at a moderate but consistent pace, with an average annualized growth rate of 2.4% for the last six quarters.  The annual inflation rate is a little above 2%.  Exports have been increasing at a good rate since the beginning of the year.  Unemployment, however, has been around 7% for the better part of a year.

     Japan: Abenomics is running into strong headwinds.  Although inflation is rising, the pace of the increase has been slowing.  The export boost that was projected as a result of a drop in the yen’s value didn’t materialize because most Japanese companies have moved their production offshore.  A sales tax increase in the Spring sent GDP growth down over 7% in the 2Q.  Industrial production has been declining since the first of the year.  And although unemployment is very low, wages have not been increasing. 

     Australia: Although it’s too early to raise warning flags, the recent unemployment numbers may be pointing to some problems.  The unemployment rate increased to 6.4% two months ago and then dipped to 6.1% in the latest reading.  However, many analysts considered this drop highly suspect and likely to be revised higher.  In addition, the RBA is hemmed in from lowering rates by a potential housing bubble.  And the needed shift in business investment from one that focuses on natural resources to one that is more diverse is not materializing due to weak domestic demand.

          Let’s now turn to the risks seen by these two reports:

Geopolitical tensions with Ukraine and Russia heightened through August and may increase further as the effect of additional sanctions is felt. In addition to being a drag on economic growth for the region and beyond, further unrest could also trigger large spillovers on activity in other parts of the world, through a renewed bout of increased risk aversion in global financial markets, higher public spending or revenue losses, or disruptions to commodity markets, trade, and finance due to intensification of sanctions and countersanctions.

We’re already seeing some of this play out, as seen in the charts for both the Russian and emerging Euripean market ETFs:

Commodity prices, however,  remain low, but that that could change, especially if the Middle East situation continues to worsen.  And, as Russia is the largest energy provider to Europe, it has the ability to squeeze the EU economically in the event of a cold winter.  And this is occurring in the economic region (the EU) that is already very close to an outright recession.

Risks to activity from low inflation remain relevant for the euro area and, to a lesser extent, Japan.

Japan has been in a deflationary spiral for the better part of two decades.  The EU is either at the beginning of a spiral or is very close, as noted by this chart from the OECD report:

As the recovery proceeds, there are risks related to the normalization of the U.S. (and U.K.) monetary policy. The U.S. labor market has been strengthening more rapidly than forecast and inflation has begun to rise (though it remains well below the Fed’s longer-term objective of 2 percent), increasing the probability that monetary policy will need to be tightened faster than previously envisaged or the risk of monetary surprises or sudden shifts in expectations about the path of policy normalization. Against the backdrop of increased financial market optimism—reflected in the compression of risk spreads and volatility indicators—such surprises could trigger abrupt financial market corrections.

This happened in the 3Q13 and 4Q13 and was referred to as a “taper tantrum.”  Emerging market currencies dropped due to the capital flight, leading some of these countries to increase rates.  India and Brazil are prime examples.  We’ve already seen some emerging market selloff in the last few weeks:

In the medium term, the risk of secular stagnation (a prolonged period of low growth and weak demand) in the major advanced economies, especially the euro area and Japan, cannot be ruled out.

This is very real risk in the EU.  Growth is non-existent and inflation is low.  There is no sign that governments are willing to do anything (read stimulus spending) to increase demand.  And Japan has been experiencing this for nearly two decades.  And while Abenomics has increased inflation, the need to begin dealing with the massive deficit through tax increases may stall the economy.

There is also the long-term ramifications of low employment and wage growth.  This was highlighted several weeks ago in an OECD jobs report.  The OECD revised outlook contained this chart that added to the evidence of weak employment growth globally:

The OECD employment/population ratio is very low nearly 5 years after the end of the recession.  As a result, wage growth is very weak.

And finally, there is also the sub-pace of global trade, highlighted in the OECD report:

Weak trade is the direct result of weak demand.

     Both of these organizations have highlighted several very important risks to the global economy.  Investors and traders would do well to keep them at the forefront.

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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