Perspectives 2016: The world looks to China

This year draws to a close on an unusually uncertain note regarding the health of the global economy. In its World Economic Outlook for October, the International Monetary Fund (IMF) says that “a return to robust and synchronised global expansion remains elusive”.

It projects moderate global growth for 2015 at 3.1 percent, a 0.3 percentage point lower than 2014, and rising slightly to 3.6 percent in 2016.

Leading the way out of the global recession, the US has shown slower than expected growth this year, despite a strong second quarter. Its economy is forecast to grow by 2.6 percent in 2015 and 2.8 percent next year, contrasting with the euro-zone which is projected to grow 1.5 percent and 1.6 percent, respectively. The UK sits between the two with its economy projected to grow 2.5 percent this year and 2.2 percent in 2016.

Among the factors contributing to the mixed picture is the continued slowdown in Chinese growth, which the IMF projects will be 6.8 percent this year and 6.3 percent next; persistent fears of a renewed recession in Europe; depressed commodity prices with falling Chinese demand and oil tumbling close to $40 a barrel in mid-November; currency fluctuations in developing markets; and volatile stock markets across developed and emerging markets, notably China.

Of the investors surveyed by Private Equity International, 17.6 percent ranked a slowdown in Chinese economic growth as their number one macro-economic concern. It was second only to extreme valuations as a concern, and more important than cheap debt pushing up prices. The fate of the euro-zone was sixth, with only 5.8 percent ranking it as their top priority.

China’s transition from an export-orientated economy to a consumer driven one continues to ripple across the global economy in several directions, sometimes creating waves. The financial markets in particular have been sensitive to news from China, evidenced by western equity markets being rattled by the plunges in their Shanghai counterpart.

Robert Keiser, vice-president, global market intelligence at S&P Capital IQ, says the US stock market reacted negatively in August at the publication of “soft economic data” on Chinese retail and auto production figures. In contrast, geopolitical tensions on the edge of Europe were ignored.

Specific issues concerning investors in China’s immediate neighbourhood include uncertainty over which segment of Chinese manufacturing will feel the most impact of new government policies and what will follow recent initiatives such as a tax cut on cars, says Suvir Varma, partner at Bain & Company’s Southeast Asia practice. There is also the question as to whether Chinese consumers can keep increasing their spending.

The impact of a China slowdown on commodity prices also has a psychological dimension, says Capital Economics’ chief European economist Julian Jessop. “The negative effects are coming through faster than the positives relating to consumer spending. Falls in commodity prices are positive in the long term but in the short term it is undermining sentiment,” he says.

With commodity prices and inflationary pressures in mind, the market is watching for further Chinese interest rate cuts following the People’s Bank of China reduction in October of its one-year benchmark rate to 4.35 percent. “If you have China central bank stimulus it could affect US rates and bring about an unfavourable deal making environment in 2016 and 2017,” Keiser says.

In the US, at least in the short term, interest rate uncertainty seems to have abated as the economy continues its recovery. After years of speculation about a possible US interest rate hike, one is viewed as inevitable at the next Federal Reserve meeting in December. It is a welcome sign that the economy, six years on from recession, is normalising.

Paradoxically, the market perceived the Fed’s decision in September not to begin to raise rates from almost zero as a sign of its lack of confidence in the global economy, says Jessop.

With the recession fading into memory and strong labour data in October reporting unemployment stable at 5 percent, the Fed gave the final “green light” to raise rates, Keiser notes. Over the short term, the debt market has already priced in a rise and future increases are expected to be gradual.

“The Fed will be careful with subsequent interest rate rises. It’s in a tricky place. They said they’d normalise interest rates by year-end and now it’s up to them to do so,” Keiser says.

Low funding costs mean it continues to be “a very fertile environment for M&A and private equity” he adds. The resulting high market valuations were rated by 41.1 percent of limited partners PEI surveyed as their primary macro-economic concern.

The US and the euro-zone continue to be on divergent macroeconomic paths, with hints from the European Central Bank, that like its Japanese counterpart, it is planning to cut interest rates, with further roll-on effects of a strengthening dollar.

Jessop holds the view that European rates will remain low “for years” noting that the continent has yet to obtain the growth, rising wages and price pressure that the US enjoys. Such a financial environment conti-nues to favour private equity. “In Europe and Asia, they are still in a sweet spot where the economies are in recovery, which is good for corporate profits but not yet recovered strongly enough to push up wages and costs,” Jessop says, speaking generally.

Within the euro-zone, it is political tensions rather than external geopolitical issues that are contributing to uncertainty, including the political friction sparked by the inflow of migrants from the Middle East and Africa and the rise of anti-austerity parties across Europe.

The UK’s referendum on EU membership expected next year is a further source of instability, Jessop says. A stronger recovery in the UK, tighter labour markets and a pick-up in wage and price pressures set its economy apart from the rest of Europe. The Bank of England is expected to follow the Fed and raise interest rates next year.
For emerging and developing markets, the picture too is mixed.

The IMF predicts that 2015 will mark the fifth year in a row of declining growth, which “reflects a combination of factors: weaker growth in oil exporters; a slowdown in China, as the pattern of growth becomes less reliant on investment; and a weaker outlook for exporters of other commodities, including in Latin America, following price declines”.

However, Brazil and Russia appear to be moving out of recession, and India continues to grow. Investors’ concerns there focus on whether reforms can really take hold to drive up Indian growth, says Varma.

So these markets too will look to China, particularly those who export commodities or compete to produce consumer goods, concerned about any further currency depreciations. Much in terms of the direction of global economic growth in the year ahead will depend on decision making in Beijing.