Vol 11 (2014) - Issue 1

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The 2014 Narrative

The emergence of divergent monetary policies, sustained global growth and low inflation, and on-going structural changes will dominate the 2014 narrative.

Emergence of divergent monetary policies
Global central banks will remain pro-active next year, standing ready to buffer any negative shocks in the global economy. In particular, central banks outside the US are set to consider additional steps to buffer the potential shocks emerging from the US tapering. This is the case for the ECB and the Bank of Japan. The UK is likely to weather the impact without additional central bank action as further evidence of economic recovery emerges.
In the US, the long-awaited tapering process dominates. From a technical standpoint, the tapering is necessary as the Fed looks to avoid absorbing a rising share of assets (MBS and Treasuries). The Fed purchases Treasuries at a monthly pace of USD 45 bn a month (USD 540 bn a year) while the budget deficit is set to narrow to about USD 625 bn in fiscal year 2014. Fundamentals should also support tapering, as both data and the cycle improve.
From a financial market standpoint, the decision to taper is less clear and argues for a moderate approach. We have long held the view that the Fed provides the liquidity the private sector has failed to adequately supply in the aftermath of the Great Recession (Exhibit 1), given the dearth of safe assets. To use the relay analogy, it is as though there are too few liquidity-providing private sector entities to pick up the Fed’s liquidity baton. Until the ‘passing-of-the-baton’ takes place, interest rates will stay low. The Fed’s forward guidance will be increasingly important once tapering starts. The challenge for markets is to differentiate between pricing in tapering and pricing in an eventual rise in interest rates.

Sustained global growth
Global growth is set to firm to 3.5-3.8%, up from around 3% rate reached this year. It is predicated on the continuation of the cyclical growth rotation towards advanced economies, eventually helping global trade to recover. This in turn will have a second-round positive effect on emerging markets (EM) whose growth is dampened by structural change and capital outflows related to US tapering. The lead indicators, such as the most recent November purchasing managers’ (PMI) reports, are encouraging as they strongly suggest a rebound in global manufacturing activity (Exhibit 2).
US growth should accelerate from 2% (Q4 to Q4) this year to 2.6% next year (Exhibit 3), in response to a slight firming of consumer spending growth; acceleration in investment spending; and diminished fiscal drag. The consumer will remain cautious, inserting some vulnerability to our assumption. The healthy corporate balance sheets should trigger capex spending and contribute to the virtuous cycle of job creation, higher consumer confidence and consumer spending. Corporate profits should grow at mid-to-high single digits and profit margins should remain at multi-decade highs as long as there is slack in the labour markets and in spite of the projected higher corporate spend. The fiscal drag shaved off 1.5ppt this year and should be less severe next year (0.5ppt), in the absence of tax increases.
The Euro area should benefit from a smaller fiscal drag as well, and continued strengthening of demand for exports. The region has emerged from recession and the lead indicators suggest gradual recovery in domestic demand. Consumer spending growth has turned positive but the very weak labour markets represent a major headwind. Regional disparities will remain. One of the major adjustments took place in the external sector. The current account balance has swung from a 1.9% deficit-to-GDP ratio in Q3:2008 to a 2.4% surplus-to-GDP ratio in Q3:2013, reflecting a contraction in imports in a first phase, followed by a firming of export growth in a second phase. Competitiveness has been restored in some of the periphery countries thanks to the massive wage devaluation. These adjustments are headwinds to growth, which will remain very weak next year. We project 1% growth in 2014, following the 0.4% contraction this year (Exhibit 3).