Economic Outlook for 2014

Dear friends, following are some of the important economic themes for this 2014.

As always we welcome any feedback, I have mode detailed information about each of the topic discussed below but I have summarised the content to fulfil the purpose of this blog which is meant to be informative but not the place where to analyse in depth each subject. If anybody is interested in additional information please connect with me directly using the contact form at www.affinitasconsulting.ae or info@affinitasconsulting.ae.

Overview

We recommend a cautious investment approach to 2014. While at the turning of the year many media outlets run big optimistic titles for 2014 we remain instead very prudent and skeptical about the health of the global economy. We see several reasons for weakness especially in the equity sector. Clearly, as always even weaknesses or a downturn uncover opportunities for successful money making but we leave those strategies to the people in the field and we would rather concentrate the following analysis on long term trends likely to affect economic growth instead.

The tapering of the US QE exercise is bound to have ripple effects globally, especially across the emerging market economies.

We reckon the US economy is not as healthy as mainstream media believes and we expect the Feds to evaluate tapering sometimes after Summer when additional signs of weaknesses are going to appear. Now that the elections in Germany are over and done with, and the upcoming banking stress test from the ECB looming we expect the Eurozone to create some waves again. Spain and Italy are bound to catch the spotlight: the first because of weaker than expected banking system and the latter because we expect the government to be challenged in the coming months.

Bottom line: it may be time to cash out on the equity gains accrued over the last few months and wait for bargains during the volatility that is bound to take place due to the tightening moves of the next few months. Some institutional investors or asset allocators may look into specific infrastructure projects which have demonstrated a low correlation with equity markets oscillations.

Investors or asset allocators may also explore and evaluate financial instruments that have as objective the isolation of the interest rate differentials.

A STRONGER DOLLAR

The tapering program announced by the Federal Reserve is going to be one of the key elements behind a likely appreciation of the USD against the other G10 currencies.

I believe we will see an even appreciation of the currency throughout 2014. While portfolio flows in 2013 definitely favoured Europe we believe that strong equity valuation discounts eliminated any chance for further growth hinderances. 

In addition US Banks are decreasing their exposure against foreign borrowers and we see this as a clear sign that the USD is no longer used as a funding currency but rather as a destination for investment.

With specific regard to the USD/EUR rate we simply believe that in spite of the PR coming from the EU there are significant unresolved problems in the Eurozone that are bound to flare again at any time (more below on this topic - EU problems all over again).

We are forecasting the following key rate: 1.20 $/EUR 

USD Investment Destination (Graph)

PRESSURE ON CORPORATE PROFITS

This topic is directly linked to a phenomenon that many economists have been discussing for more than a decade: the decoupling of productivity and wage growth, the so called Jaw of the Snake.

The decoupling between productivity and wage started to appear around the beginning of the 80s, we believe that the spread of the personal computer and the adoption of information technology greatly favoured this trend. 

Fundamentally: since 1990 German labor productivity increased by 25% with no appreciable difference in wage growth; in the US labour productivity has increased to-date 85% versus only 35% of the hourly wage. In a study published in 2012 & 2013 by the International Labour Organisation we learned that the share of labor as part of the gross national income has declined since 1975 by more than 10% across the 16 high-income economies.

This allows for a redistribution of the national income away from labor and in favour of capital owners.

ILO (International Labour Organisation) research goes therefore at the core of the problem: the decline in the labor share of the national income hinders aggregate demand; that is because the consumption propensity from labour income is much higher than the propensity to consume out of capital income.

We therefore believe that pressure on corporate profit will come directly from the spreading income inequality that is accelerating in many of the G10 economies. In fact, lower aggregate demand lowers government tax collection, and further hinders the ability and willingness of companies to invest.

Adjusted Labor Income Shares (Graphs)

Increasing Income Inequality (Graph)

EU PROBLEMS ALL OVER AGAIN

While the marketing machine hails the Banking Accord of 2013 we believe that its positive effects will take very long time to take effect, and during this time a lot can and will happen. Be aware that the resolution fund part of the accord will not reach its target till 2026! 

Throughout 2014 there are going to be several junctures testing the solidity of the union and especially its banking system. We expect the upcoming banking stress test by the ECB to be one of such tests. It is likely that the test is going to uncover the requirement for additional capital especially in Spain, Greece and Italy. The stress test is promised to be more stringent than the previous one, especially since the previous one proved to be inconclusive since after passing it with flying colors the Spanish Bankia, the Cyprus Laiki and the Franco-Belgium Dexia went belly up just months later.

We also believe that the Spanish economy hasn’t sufficiently deleveraged, especially in its real estate sector.

The figure below shows that notwithstanding the collapse of property prices, Spanish mortgage debt has adjusted by only half the magnitude of the US adjustment. 

Any alarm in the banking sector would have repercussion on the valuation of the sovereign debt. The vast amount of Spanish government debt is in fact held internally by domestic banks.

IMF projections give the Spain structural deficit as one of the worst globally over the next five years. It is likely that additional fiscal tightening is going to be required in the upcoming future to meet the required targets.

We remain quite pessimistic in the future of the Euro zone in spite of the victory speeches of some of its leaders. 

Since the local governments are going to be forced to fund their own bank bailouts till the European fund gets up-to-speed we expect a continuing shortage of credit. With a chronic shortage of credit given to the private sector we expect growth to remain weak or non existent for most of the EU countries and deflationary forces will remain at play during the entire year.

Reality will seep through in 2014 and equity returns should start to be driven by corporate earnings instead than Quantitative Easing operations by the central bank. 

It is clear that Eurozone leaders have addressed some of the issues on hand and made significant steps forward, especially steps that have been blessed by the German leadership. Nevertheless these steps remain insufficient to resolve the disparity between the different countries in the zone and time may be running out before additional shocks are going to rock the system.

Reverse globalisation

Global trade hasn’t recovered to the same levels prior of the 2008 crisis and its growth remains below trend since 2011. Further note that additional data leads us to believe that there is an underlying trend of re-shoring currently in place.

The Manufacturing Advisory Services survey show that among 500 UK small and medium size companies interviewed a significant percentage of them was in the process of reshoring or thinking about it.

15% of the manufacturing business in the South East was already reshoring and an additional 25% of the companies was considering reshoring activities over the following 12 months.

Shipping Remains Subdued (Graph)

Similar trends are not exclusive to the UK manufacturing industries but also in the USA where industrial reshoring has been a key theme of 2013. In the USA the trend is predicated on the falling energy prices (“fracking revolution). 

Over the next decade as labor cost rise in China and other Asian exporters we predict this trend to gain pace.

Shipping Indexes (Graph)

Reasons for Re-Shoring (UK)

DEBT SERVICE BURDENS

As the monetary stimulus keeps on being retracted the lid that was put on government bond yields is going to be lifted little by little. It is therefore normal that interest rates sooner or later are expected to be raised.

Our point is that as this happens we expect service burdens for household to rise and therefore depress consumption expenditures.

Debt Servicing Costs

We indicate few countries that are likely to hit particular consumption degradation at the rising of interest rates: Canada, Netherlands and Sweden. These countries experienced a fair amount of household leverage during the last 10 years with no sign of decrease since 2008.

A study from the Canadian Chartered Accountants found that 29% of the respondents would struggle to keep up with payments if interest rate rose by 2% and further 29% would consider challenging more than 3%.

Canada, the USA and Sweden have a high proportion of non mortgage variable debt outstanding that is used for consumption. As monetary policy keeps on tightening over the course of 2014 investors are best to avoid any consumer centric type of equities.

Interest Rate Vulnerability (Graph)

Please contact the Affinitas Consulting team (www.affinitasconsulting.ae) for any additional query or information.

World Economic Forum, competitiveness report. A BRIC and GCC perspective.

This year report has confirmed global trends that we clearly discussed in this blog a few times before.

While this report doesn't provide enough predictive detail for the long period provides an interesting historical insight for the progress made by countries in relationship to 12 variables selected to identify "competitiveness". 

The Gulf Countries make interesting progress in the rankings and offer interesting opportunities for investors that are looking to establish a presence in the emerging markets.

The data further substantiate one fact that I tend to emphasize consistently: the progress of the Gulf countries with regards to infrastructure, goods market and financial markets efficiency tend to further strengthen their position as effective gateways INTO emerging markets economies like African and Indo-China. In fact it is more and more common that companies set up their headquarters in the GCC to then reach out to Indo-China taking advantage of favorable tax laws as well as infrastructure.

In more details some of the highlights of the report for what it concerns emerging markets.

Please note that the rankings are based upon 12 competitive pillars and weighted against 3 different phases of development.

Briefly below about the 3 different development phases and further at the end of the posting the list of all 12 development pillars.

Phase 1: the economy is "factor driven" and countries compete mainly on on their factor endowments: unskilled labor and natural resource.

Phase 2: the economy is moving towards an "efficiency-driven" stage of development whereby production processes are improved. As a country improves and becomes more competitive productivity will increase and wages will rise. At this point,competitiveness is increasingly driven by higher education and training (pillar 5), efficient goods markets (pillar 6), well-functioning labor markets (pillar 7), developed financial markets (pillar 8), the ability to harness the benefits of existing technologies (pillar 9), and a large domestic or foreign market (pillar 10)

Phase 3: Finally, as countries move into the innovation-driven stage, wages will have risen by so much that they are able to sustain those higher wages and the associated standard of living only if their businesses are able to compete with new and unique products. At this stage, companies must compete by producing new and differ- ent goods using the most sophisticated production processes (pillar 11) and through innovation (pillar 12).

List of countries/economies at each stage of development:

One final note before continuing with our analysis: the future development of a country cannot be predicted using this report. This is more of a comprehensive ranking of how well countries have done in the past. We remain convinced that countries in the emerging markets will in the long run consistently outperform the growth of the G7++ group due to the underlying demographic trends, although it will take decades to see some of these countries at the top of this report.

Out of the traditional BRIC lot Russia is the only country out of the emerging economies that we believe will NOT keep up with the long term economic development due to its very unfavorable demographic. 

Further, high competition doesn't equal great opportunities: depending on the business nature, the most business opportunities often remain in areas that developing fast but are not completely regulated. 

So how do the traditional emerging markets fair this year?

Let's take a look at the typical BRIC (Brazil, Russia, India & China) group before going any further.

Brazil: 58th position, down 2 positions from previous survey. The position remains fairly stable with a slight improvement from the previous year. The progress that was made over the last decade has definitely contributed to the country's ability to rebound from the crisis in a sound manner: while the country's GDP slightly contracted in 2009, in 2010 the GDP is expected to grow at an annual healthy rate of 5.5%. In spite of the positives the outlooked remains partially mixed. The pros of: market size, well developed financial market and relatively well functioning higher education are matched by a weak saving rate, high interest rate and a high rate of public sector indebtedness. Goods and labor markets reveal some important rigidity and the quality of institutions remains poor with limited trust into politicians and the rule of law.

Russia: 63th position, same as last year. After the significant slide of the previous year, Russia maintains its position. While infrastructure, health, education and technology improves significantly other components of the index suffer. The major area of concern highlighted in the report are market competitiveness and efficiency of the goods markets. Competition is hindered by inefficient anti monopoly laws and restrictions on trade and foreign ownership. One of the main issue highlighted further in the report remains the weak institutions that translate in weak property rights (126th rank) and weak corporate governance standards (119th rank).

India: 51st position, fell two positions from last year. India's competitive advantage often remains its large market side as well as good development in the financial markets sector (17th rank) and business sophistication (44th rank) and innovation (39th). Unfortunately the country missed the development mark on few of the basic competitiveness drivers: health & primary education (104th rank). Life expectancy remains 10 years less than in China and Brazil. Another significant issue is also its infrastructure that is in need of an upgrade (86th rank), especially with respect to quality of roads, ports, and electricity supply. 

China: 27th place, up two positions from previous year. As you can see from the previous analysis this is the only BRIC country that improves this position this year.

While most of the pillars have remained stable from last year the two point climb in the ranking is almost all due to its better assessment of its financial markets (up 24 places to 57th tank). This is the result of easier access to credit and financing via equity markets, banks and venture capital. ICT is another traditional area of development for China, although the country has moved major steps forward the overall ICT penetration remains underperforming as compared to other economies (78th rank).

Let's now take a look at the Gulf Countries. All countries moved up in the ranking with the exception of the UAE that lost a couple of places due to the crisis that has engulfed mostly its real estate industry and forced the Dubai World conglomerate to restructure its debt.

Qatar: 17th place, moved five place up from last year. This country stays at the top among all GCC countries reaffirming its leadership in the region as the fastest developing country in the world. Its competitiveness rests on a strong combination of factors among which: low corruption, stable macroeconomic environment, high-quality institutional framework and efficient goods markets. It obviously helps that the country sits on the largest liquified gas reserves that have fueled much of the development effectively leaving the country completely untouched by the global economic crises.

United Arab Emirates: 25th rank, looses two places from last year. This is the only economy in the region that looses positions from the previous year given the negative impact of the economic crises over the Dubai emirate especially. The country remains a leader for its infrastructure (3rd rank overall), the high penetration of new technologies (14th rank) and the highly efficient goods markets (6th rank). The issue have appeared in the stability of the private institutions such as Dubai World that have raised the issue of the long term development sustainability of the country.

Bahrain: 37th rank, one place up from last year. The position remains stable and further outlines the country ability to provide a stable microeconomic performance (10th rank) and an excellent goods market efficiency (9th rank). Particularly good is also the ranking with regards to the financial market development (20th rank), although the country is obviously penalized by its market size (98th rank) and its ability to innovate (59th).

Saudi Arabia: 21st rank, seven places up from last year. The country has been consistently climbing the ladder over the past few years. In particular: the changes to the institutional framework and a stronger corporate governance have favorably impacted its position. Further, the government has enacted a massive stimulus package focused on improving the infrastructure on the country. While the stimulus package has deteriorated the macroeconomic stability of the country moving into a 'deficit' position the infrastructure project are going to benefit it for long time to come.

In spite of the long list of positives the country still faces significant challenges in critical areas such as health and education where it doesn't meet the standards of other countries at the similar level.

Oman: 34th rank, up 7 places from previous year. The country has made great progress with regards to its institutions (16th rank), overall macroeconomic environment (3rd rank) and goods market efficiency (25th rank). It completely lags, as compared to some of countries in similar overall ranking, for health and primary education (99th rank), higher education and training (63rd rank) and technological readiness (59th rank). The country is also further penalized by its market size only 73rd in the overall rankings. 

About the methodology and the 12 pillars.

From the report (page 17 of 515):

Since 2005, the World Economic Forum has based its competitiveness analysis on the Global Competitiveness Index (GCI), a highly comprehensive index for measuring national competitiveness, which captures the micro- economic and macroeconomic foundations of national competitiveness.2

We define competitiveness as the set of institutions, policies, and factors that determine the level of productivity of a country. The level of productivity, in turn, sets the sus- tainable level of prosperity that can be earned by an economy. In other words, more competitive economies tend to be able to produce higher levels of income for their citizens.The productivity level also determines the rates of return obtained by investments (physical, human, and technological) in an economy. Because the rates of return are the fundamental drivers of the growth rates of the economy, a more competitive econ- omy is one that is likely to grow faster in the medium to long run.

The concept of competitiveness thus involves static and dynamic components: although the productivity of a country clearly determines its ability to sustain a high level of income, it is also one of the central determinants of the returns to investment, which is one of the key factors explaining an economy’s growth potential.

12 pillars of competitiveness:

1. Institutions

2. Infrastructure

3. Macro economic environment

4. Health & primary education

5. Higher education and training

6. Goods market efficiency

7. Labor market efficiency

8. Financial market development

9. Technological readiness

10. Market size

11. Innovation

To download the original World Economic Forum report please follow this link: 

2010 World Economic Forum Competitiveness Report