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By HaleStewart January 21, 2015 11:15 am
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Looking At the World Bank's And IMF's Latest Global Economic Concerns

          Over the last several days, both the IMF and the World Bank have issued their global growth reports, both of which contained lowered projections.  The combination of these texts place into context the underlying reasons for the recent equity market and and commodity market sell-off, treasury market rally and overall concern regarding world economic performance.

          Let’s start with the World Bank’s report, which contained four concerns:

First is persistently weak global trade. Second is the possibility of financial market volatility as interest rates in major economies rise on varying timelines. Third is the extent to which low oil prices strain balance sheets in oil-producing countries. Fourth is the risk of a prolonged period of stagnation or deflation in the Euro Area or Japan.

I’ll take these in the order presented.

          Global trade has been dropping for two reasons, the first of which is the Chinese slowdown as shown in the following chart:

Before the recession, overall Chinese GDP growth was increasing, from about 8% to 12% just before the financial crash.  But after the recession, Chinese growth has been moving lower, now settling in the 7% range.  But just as importantly, the composition of internal growth has changed from an economy based on manufacturing and exports to one more centered on domestic consumption.  This has led to a drop in global trade, as China’s demand for raw materials like industrial metals has declined, which is highlighted in this chart from the WTO:

This is also a primary reason for the drop in commodity prices, especially industrial metals.

          There are two central banks that are close to raising interest rates: the US and the UK.  The net effect of this increase will be to pull money out of emerging markets (which were the net beneficiaries when the developed world dropped their rates) back to the larger, more stable economies.  This will create an economic double whammy on emerging economies who, in addition to seeing their overall trade drop as a result of the trade decline, will also lose foreign direct investment (FDI).  Not only will trade flows decline to emerging markets, but so will money flows.

          There are several countries that will experience hardship as a result of low oil prices.  Let’s start with Venezuela and Russia, who are both extremely dependent on oil prices for their governmental funds.  The drop in WTIC obviously places both in an extremely difficult position, increasing deficits and lowering overall domestic demand.  There are also several people who have argued that OPECs price moves are a deliberate attempt to hurt political rivals Iran and Russia.  However, regardless of the underlying reasons, low oil prices are clearly disruptive to several already hurting economies.

          When combined, the Japanese and EU economy are the about $1.6 billion larger than the US, which attests to their overall importance.  This makes the threat of prolonged period of stagnation in both an extremely negative development.  Adding to the potential problems is that Japan has an incredibly high debt load – over 200% of GDP.  But perhaps most troubling is that both are facing extreme difficulty in dealing with their stagnation.  Japan has been in a deflationary environment for over a decade, yet they have only recently developed the political will to overcome it.  And the ECB has been trying to overcome German austerity resistance for the better part of the last two years, despite mounting evidence of continent wide stagnation and an ever real possibility of actual deflation.          

          The IMF also talks about the issues related to emerging economies.  They also focus on two specific countries: China and Russia.

          China has been slowing their growth from 10%/per annual to about 7%, largely because their population growth is slowing a bit. This allows them to slow the rate of expansion without threatening political stability.  Also, underneath the surface, their middle class has been growing, which usually means the group will want to increase overall consumption of goods.  This explains why we’ve seen pork and cow prices increase in the country, and is also a partial explanation for the country’s increased oil appetite over the last ten years.  And, as their incomes have increased, so have their costs of production, making them less a manufacturing exporter.  While trade and trade growth are still important to the economy, they will be less so. 

          If Russia isn’t in a recession, they soon will be.  Their currency has crashed, forcing the central bank to increase interest rates to 17%.  This will undoubtedly lead to a recession.  Adding to their problems is that over half of their trade and federal revenue is derived from oil.  And, just to add one more problem, international sanctions imposed as a result of their invasion of Ukraine prevent Russian business from accessing international credit markets.  The total impact of these developments is the Russian economy is in deep trouble. 

          To a large extent, the contents of both reports have been priced into the markets.  Emerging markets and Russia have sold off, oil has cratered while the dollar and Chinese equities have rallied.  There has also been a large upward move in developed country debt, as investors seek safety in times of stress.  But regardless of these moves, the reports clearly explain these recent moves, making them important documents to read and digest.

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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