Stephansen, kathleen

Global Growth Outlook A tale of two countries: the US and China

Kathleen Stephansen AIG Chief Economist

October 10, 2013

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Global Macroeconomic Outlook 1) Mixed global growth dynamics, coupled with pro-cyclical fiscal policies, are major challenges for monetary policies.

2) The global macroeconomic outlook remains constrained by on-going deleveraging or other forms of structural reforms. Regionally, it is a tale of two countries, the US and China, against which additional dynamics, such as the recovery of Euro area growth and Japan and the slowdown in emerging market growth, are being played out.

• The US is emerging from a lengthy period of private-sector de-leveraging, but still exhibits mixed cyclical dynamics.

• China’s post-stimulus slowdown unveils structural problems that the government is set to correct. This is a headwind for the emerging cyclical recovery.

• Since 2011, Euro area peripheral growth was driven down by the simultaneous deleveraging of the public and private sectors. This is headwind for the emerging cyclical recovery.

•Japan is responding well to “Abenomics” but the recent strengthening of the Yen is a risk. .

Sources: Haver Analytics

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US: Waiting for the monetary policy regime shift brings back market volatility Interest rates have increased since the beginning of May in anticipation of a three-step regime change: • First, the tapering of asset purchases • Second, the end of QE in mid-2014 • Third, the exit from the zero-interest rate regime in late-2015 2. Raised importance in the forward guidance: The economy is not strong enough to normalize interest rates. We expect the first rate hike to occur mid-tolate 2015.

1. Investors have adjusted their views on the economy  Real rates rise; Investors seek more protection given the heightened policy uncertainty  Term Risk rises, pushing up long-term nominal yields

Effective Fed Funds rate (%)

10YR US Treasury & Breakeven

Fed Funds 2.9

10YR Treasury (LHS)

US Breakeven 10 Year (RHS) 2.85

2.8 2.6

2.65

2.5 2.3

2.45

2.2 2.0

2.25

1.9 1.7

2.05

1.6 1.4

1.85

4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00

2015.Q3 Fed increases rate to 0.25

Sources: Bloomberg;

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US: Was the Fed right not to taper?

1) Yes, as: • The data have been mixed • Lingering effects of the financial crisis • Current fiscal situation is messy

2) No, as: • The Fed’s credibility has been undermined and the forward-guidance message blurred • It complicates the timing of the end of QE

The Fed still plays a large role in the supply of market liquidity: Credit Market Lending (All sectors, SAAR, Bil.$)

Sources: Federal Reserve; Haver Analytics

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US Structural Dynamics Household deleveraging has run its course, but public deleveraging has started. Sequestrations shaved 1.5ppt off GDP growth this year. Less severe fiscal dynamics should be anticipated for next year, nonetheless remaining a factor that keeps overall growth on a moderate path.

All Sectors: Liabilities (SAAR, Bil.$)

Net Lending or Net Borrowing [-], NIPAs (SAAR, Bil.$)

Sources: Federal Reserve; Haver Analytics;

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US Cyclical Outlook: Moderate Growth The end of private sector de-leveraging should pave the way for a pick-up in private demand. U.S. real GDP growth has been lackluster, but signs of an acceleration have emerged with some ebbing of the fiscal drag. And inflation remains well below target.

Moderate growth: Real GDP (% change Annual Rate, SAAR Bil.chn.2009$) 6.0 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 -3.0

But Inflation Still Below Target 3.0% 2.5%

QE2

QE3

2.0% 1.5% 1.0% 0.5%

PCE: Chain Price Index (SA, 2009=100) YoY % Change PCE less Food & Energy: Chain Price Index (SA, 2009=100) YoY % Change Sources: Haver Analytics; MacroAdvisors and AGE estimates.

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US Labor Market slowly on the mend  Steady improvement in employment picture, with the economy adding slightly below 200K jobs per month for the first six months of the year and the unemployment rate down.  However, the momentum in payrolls has slowed to 148K-jobs-a-month in the last three months, and weakness remains by other measures, such as growth in hours worked, which trails 2012 levels

Unemployment Rate

Nonfarm Payroll Employment

Civilian Unemployment Rate: 16 yr + (SA, %) Linear (Civilian Unemployment Rate: 16 yr + (SA, %) )

Change in Total Nonfarm Employment ('000) $350 10.5 10.0

$300

9.5

$250 9.0 Avg Sep-12 to Jul-13: 192

8.5

$200 Avg Mar-12 to Aug-12: 141

$150

8.0 7.5 7.0

$100

Q2-2015: 6.5%

6.5

$50

6.0

Sources: Haver Analytics;

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US Cautious Consumer In spite of the recoveries in wealth and disposable income growth, the consumer remains cautious: Real PCE spending remains below historical trends. Consumer spending on durable goods (autos) is the driver.

Households Net Worth as % of Disposable Income

Real Disposable Income, Y/Y% Change

Real PCE Total, Y/Y% Change

Real PCE Durable Goods, Y/Y% Change

Sources: Haver Analytics

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US Steady Housing Recovery The recovery in housing is gaining momentum. The sector now contributes 0.3ppt to real growth, as housing starts recover. Sales have turned and the inventory overhang has declined, with foreclosures being down. House prices reached double-digit year-on-year growth.

Both the back-up in mortgage rates and the still timid trend in mortgage originations are worth watching.

The sector is set to contribute 0.5ppt to real growth, with the recovery in starts continuing over the next few years. But the sector is likely to be different and contribution to growth smaller than in pre-crisis years. Historically, the share of residential investment averaged 5-6% of GDP and contributed as much as 1-1.5ppt to real GDP growth. Following the crisis, its share to GDP dropped to 2-3% and contributed negatively to growth, by as much as 1ppt in 2008.

Housing Prices, Y/Y% Change

3.00%

Housing Starts (thousand units)

FHFA House Price Index: Purchase Only, United States (NSA, Jan-91=100) % Change - Period to Period FHFA House Price Index, YoY% 2013 S&P/Case-Shiller Home Price Index: Composite 20 (NSA, Jan-00=100) % Change - Period to Period S&P/Case-Shiller Home Price Index, Period to Period (2013)

2.00%

Projections

1.00% 0.00% -1.00% -2.00% -3.00% -4.00%

Sources: Haver Analytics; Macroeconomic Advisers estimates

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Investment spending Investment spending on equipment followed a typical cycle: the sector contributed to the recovery immediately following the Great Recession and has been on more moderate trend since then, reflecting the tension between strong corporate balance sheets and the replacement cycle, on the one hand, and a cautious consumer, on the other. High frequency indicators suggest a firming in trend going forward.

Capital Goods Orders ex. defense aircraft and profit margins CORE CAP GOOD ORDERS (3 MONTHS AVARAGE YOY%, LHS)

20.0%

ISM New Orders

NONFIN CORP PROFIT MARGIN (%, RHS)

15.0% 14.0%

10.0%

13.0% 12.0%

0.0%

11.0% 10.0%

-10.0%

9.0% 8.0%

-20.0%

7.0% 6.0%

-30.0%

Sources: Haver Analytics

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China: Soft Landing •

China’s economic growth has decelerated from 14.9% in Q2-2007 to 7.5% in Q2-2013 for both cyclical and structural reasons.

•

The slowdown is complex. The cyclically induced policy stimulus implemented during the global recession exacerbated the structural problems in the economy, as it led to an overleveraged corporate sector and a low capacity utilization rate, especially in some of the heavy industries. This has made it important and urgent for the economy to structurally rebalance from investment-driven to consumption-based.

•

The new leadership has pledged to advance structural reforms in order to facilitate the transition.

•

The transition could be slow but China will more likely avoid a hard landing and maintain a growth rate around an average of 7.0% in the next five years, with the help of: •The government’s growth stabilization efforts •Cyclical recovery in the advanced economies •Tight labor market, rapid income growth and strong household balance sheets •Urbanization trend •System innovation and structural reforms

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Cyclical challenge: The post stimulus slowdown  The Chinese economy decelerated dramatically in response to the reversal of fiscal stimulus and credit constraint.  Except for 2010, global trade growth has not recovered to the pre-crisis rate, which limited the expansion of China’s external sectors Emerging Markets Growth Rates 2007 Growth Rate China

8.54%

3.84%

Vietnam

Colombia

Non-Japan Asia ex.

China, 11.1

8.26%

4.82% 6.90%

4.00%

Indonesia

S Africa Turkey Mexico

3.18% 2.0%

4.0%

Japan UK 5.6 2.8 Canada 1.8

Developed Economies

30.0% 20.0% 10.0%

4.67%

0.0%

3.24% 3.50%

UAE

Euro Area 13.2

40.0%

5.50%

2.41%

U.S 18.6

World: Intl Trade in Goods & Services (SA, 2005 US$) % Change - Year to Year China Exports of goods and services, Nominal (YoY%)

6.10%

2.50%

LatAm 8.7

Global trade and China’s exports

6.35% 6.01% 1.48%

EEMEA 8.6

China 15.6

8.46%

5.03%

Emerging Markets

Developing Economies

9.67%

5.65%

Russia

0.0%

14.20%

7.51%

India

Brazil

Shares of World GDP (2012, PPP*)

2012 Growth Rate

-10.0%

4.37% 6.0%

-20.0% 8.0%

10.0%

Sources: AGE; Haver Analytics; Oxford Economics .

12.0%

14.0%

16.0%

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Structural Challenge: Rapid credit growth has highlighted the need to deleverage  An overleveraged corporate sector is the by-product of the policy stimulus implemented to buffer the impact of the global recession.  In the first half of 2013, GDP growth no longer responds to strong credit growth, as both productivity gains and demand growth have lagged behind credit expansion.  China’s growth path in the next a few years will greatly depend on how the deleveraging process unfolds.  The overcapacity problem in China has led to deflation in specific industries, initially the result of booming economic growth in recent decades, and then of the 2008 4 trillion Renminbi stimulus.19 industries have been ordered to cut production capacity in July.

Credit mostly flew to corporate sectors & local government China: Gross Domestic Product (NSA, 2000.Yuan) % Change - Year to Year (RHS)

TSF/GDP %

350% 14.0% 300%

Debt Ratio: Leverage is highly concentrated in a few sectors

12.0%

Liabilities/Assets (2012 numbers) Smelting and Pressing of Ferrous Metals

67%

Prod/Supply of Elect/Heating Power

66%

10.0%

250%

Waste Resources, Recovery/Proc

66%

8.0%

200%

6.0%

Petroleum, Coking/Nuclear Fuels Proc

65%

150% 4.0% 100%

Smelting/Pressing of NonFerrous Metal

63%

2.0% 0.0%

50%

Median

55% 50%

55%

60%

65%

70%

*Total social financing (TSF) is a measure of overall liquidity, which captures a variety of informal funding channels in addition to traditional bank loans.

Sources: AGE; Haver Analytics; .

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Leadership pledge for structural reforms The cyclical and structural challenges have prompted China’s Premier Li Keqiang to adopt a new policy framework, consisting of: 1) 2) 3)

Deleveraging (mainly in corporate sectors) No large stimulus  Focus more on the long term impact on the economy Structural reforms  Set up Shanghai free trade zones; others are still under discussion Trade, shipping and financial industry will benefit Policy innovation on management, tax and regulation  Liberalize financial markets Interest rate Exchange rate Convertibility of Renminbi capital account  Promote small businesses  Changes in the system of household registration  Facilitating rural land transfer  Tax reform  Deregulation in the service industry  Removal of price control on some utilities  Loosening of one-child policy, as early as the end of this year = A New Growth Model: Consumer-based economy

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The New Growth Model: Domestic consumption is source of support China Growth Forecast: average of 7.0% for the next 5 years 16.0

Sectors as % of GDP Consumption

China: GDP Index (YoY % Change)

Fixed Investment

Moving towards consumption driven growth in next 5 years

49

14.0 44

12.0 10.0

39

8.0 34

6.0 4.0

29

2.0 24

0.0

Global Comparison: China is much lower than BRIC and other EMs 80% 70%

Consumption/GDP (%, 2012) 66.06%

65.85%

66.99%

60%

66.63% 59.80%

59.53% 53.15%

50% 38.51%

40% 30% 20% 10% 0% Brazil

Source: AIG Global Economics; Haver Analytics

India

Russia

S. Africa

Mexico

Poland

Turkey

China

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Soft Landing in the Transition to the New Growth Model

1.

Growth stabilization efforts by the government

2.

Cyclical recovery in advanced economies and global trade

3.

Consumer sector strength

4.

Tight labor market and robust income growth

5.

Stabilizing manufacturing sector

6.

Rising housing price driven by urbanization

7.

Potential monetary easing and financial liberalization

8.

Local government debt still manageable

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(1) Growth Stabilization Efforts by the Government •

Premier Li Keqiang stated that China’s macroeconomic policy should: •focus on stabilizing growth and employment while containing inflation •continue to use fiscal and monetary tools to cushion the slowdown, •not rely on aggressive expansionary policies to restore previous rates of growth.

•

Announced growth stabilization policies would help China achieve its growth target of 7.5% this year.

•Urbanization, rebuilding shanty towns •Infrastructure spending, developing railroad in the west •Tax reduction for small businesses

•

More details of structural reforms and innovations are expected at the key economic policy meeting in November this year.

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2) Rebound in Trade; 3) steady Consumption; 4) strong Wage growth; 5) stabilization in the Manufacturing sector 2. Recovery in global growth and trade flows will help China’s external sector World: Intl Trade in Goods & Services (SA, 2005 US$) % Change - Year to Year China Exports of goods and services, Nominal (YoY%)

3. Steady growth for Wholesale & Retail Sales: Grow steadily China: Wholesale and Retail: Automobiles (NSA, Yuan) % Change - Year to Year China: Wholesale and Retail (NSA, Yuan) % Change - Year to Year

40.0%

120%

30.0%

100%

20.0%

Due to government stimulus

80%

10.0%

60%

0.0% 40% -10.0% 20%

-20.0%

0%

4. As wages: Rapid income growth helped to raise purchasing power China: Wages {Nominal}: All Units (Yuan) % Change - Year to Year

5. Manufacturing PMI: Regaining strength

Real wages, % Change (YoY%)

20.0 70.0

18.0

China: PMI: Manufacturing (SA, 50+=Expansion) China: PMI: Manufacturing New Orders (SA, 50+=Expansion) Boom-Bust line CRB Commedities Index (RHS)

500

65.0

450

60.0

400

14.0

55.0

350

12.0

50.0

300

45.0

250

40.0

200

35.0

150

30.0

100

16.0

10.0 8.0 6.0

Sources: AGE; Haver Analytics; Oxford Economics .

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6) Housing driven by urbanization; 7) room for monetary easing; 8) Local government debt still manageable 6. House prices are still rising

7. Room for monetary easing if need be

China: Average House Price in 100 cities (NSA, Yuan/Sq.Meter)

China: Prime Lending Rate (AVG, % per annum) 8.0

10,400 10,200

7.5

10,000

7.0

9,800 9,600

6.5

9,400

6.0

9,200

5.5

9,000

5.0

8,800 8,600

Still room for the government to lower

4.5

8,400

4.0

8,200

Urban vs. Rural population: Urban population is expected to continue in the next few years China: Population: 2012 (% of Total)

8. General Government Debt is low compared to other countries

China: Population: 2015 (% of Total) 250

General government debt/GDP (%, 2012 numbers)

239.8

200

Rural 47%

Urban 53%

Rural 39%

Urban 61%

General government debt = Central + Local

150 90.7

100

88.6

81.9

65.8

60.0

58.6

50 9.3

Total population: 1,354,040,000

Total population: 1,387,790,000

Sources: AGE; Haver Analytics; Credit Suisse .

0 Japan

U.K

U.S

Germany

India

China*

Brazil

Russia

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China: Key Macro Risks •

Deleveraging and excess capacity cuts in the heavy industrial sectors will be the dominant theme in the short run, which will put downward pressure on growth.

•

Risk in the housing market is not evenly distributed. Over-supply problem exists in some tier 3&4 cities, but the percentage is still small.

In the long term, house prices will be supported by the urbanization trend, strong household balance sheets, robust income growth, lack of property tax, low real interest rates, etc.

•

Local government debt has risen rapidly since 2009. Currently general government debt is estimated at around 60 percent of GDP. We believe the situation is still manageable and a systematic crisis is highly unlikely.

•

As the economy slows down with the government’s effort to slow credit growth, the banking sector’s non-performing loans are expected to rise.

•

The shadow banking system focuses on weaker borrowers and is characterized by asset-liability mismatches. The extent of the risk is unknown as the sector is non-transparent.

•

Delays in tough structural reforms could jeopardize China’s economic transition and raise the hard landing risk down the road.

20

Euro Area: End of Recession The euro area’s second recession since 2008 ended in 2Q2013 and forward looking data point toward timid recovery in H2:13. Peripheral sovereign yields have already priced in a lot of good news and we see limited upside going forward.

• Since Summer 2012 the ECB has affirmed its commitment to ensuring the irreversibility of the euro.

• The narrowing and anchoring of peripheral sovereign spreads during periods of crisis flare underscore the ECB’s market credibility.

• The biggest risks of a crisis flare-up arise from waning popular support for the necessary adjustment processes and continuous burden sharing.

• In 1Q2014, banking system asset reviews and pending recapitalization decisions, should cause a back-up in peripheral spreads.

Capital Goods Orders ex. defense aircraft and profit margins Euro Area Real GDP q/q change in % 1.5%

Sovereign 10-year yields 6.50

Italy & Spain 10YR Yield

6.00

1.0%

5.50

0.5% 0.0%

5.00

-0.5% -1.0%

4.50

-1.5%

4.00

-2.0% -2.5%

3.50

-3.0%

Italy 10YR

Sources: Haver Analytics; Bloomberg

Spain 10YR

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Japan – Macro Fundamentals  PM Abe’s ruling coalition is pressing for economic reforms. The most important developments are the three arrows of “Abenomics”: – Monetary revolution. On April 4th, the Bank of Japan (BoJ) called for an end to deflation and announced a plan to double Japan’s monetary base within two years in order to achieve the inflation target of 2 percent.

– Fiscal stimulus package worth ¥10.3 trillion ($116 billion).

– Set of reforms announced on June 5th fell short of market expectations as key issues on labor market, health care, agriculture and broader business deregulation were missing.  On Oct 1st, Abe announced the sales tax rise to 8% from the current 5%, effective April 2014.

Offsetting stimulus measures, such as tax breaks for companies making capital investments and wage increases, will total around ¥5 trillion.  The economy has responded positively to Abe’s aggressive stimulus plan: GDP growth reached an annualized rate of 4.1% and 3.8% in the first two quarters of 2013, respectively. We look for growth to average 2% this year and 1.7% in 2014. Core CPI rose 0.8% in August, showing the aggressive monetary and fiscal policy has probably broken the deflationary cycle.  Risks: Japan’s long term debt sustainability remains a focus. The yen has slightly strengthened recently, as the Federal Reserve delayed its tapering plan, the debt ceiling issue still needs to be addressed and the budget remains unsolved. But, in order for Japan to succeed in defeating deflation, the export sector has to continue to record strong growth, which requires the yen to remain weak or to depreciate even further.

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Conclusion: Near-term global growth is set be steady but on a weaker trajectory than prior to the financial crisis, with a regional rotation towards advanced economies. This should help global trade and emerging market growth to recover. Medium-term, emerging markets are likely to grow 3.0 – 3.5% faster annually than advanced economies thanks to change in the growth model.

Manufacturing Purchasing Managers Index

Global growth (Y/Y %change) 6.0

5.0 Avg 2000-2007: 3.9%

Avg 2010-2017E: 3.8%

4.0

3.0

Growth / Contraction Level (=50)

2.0

1.0

0.0

Global Real GDP (PPP) YoY%

GDP Growth Spreads between Emerging Markets and Advanced Economies (%) 6.00

U.S. and Emerging Markets Consumption Share of World Consumption

5.00

40%

4.00

35%

3.00

30%

2.00

25%

1.00

20% 15% Emerging Markets less Advanced Economies

U.S.

Sources: Bloomberg; Haver Analytics; Oxford Analytics; Credit Suisse

Emerging Markets

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