Insights 2016

Bipin Rai: Preparing for the new economic reality

Since the financial crisis, the state of the global economy and markets has been at the forefront of the minds of politicians, business leaders and bankers. That’s not surprising given the extraordinary circumstances with which we are presented today.

Global growth remains patchy with the outlook uncertain at best. Interest rates in developed markets remain extremely low, and in some cases negative, due to weak internal demand in several economies and also due to central banks stimulating the economies in unconventional ways. Indeed, the introduction of central banks as buyers of risky financial assets has driven risk premiums to decline far beyond what many would regard as ‘fair’.

In our view, the above circumstances are symptoms of several shocks that have permeated the global economy over the past several years. First, the global demand shock, which has been catalyzed by the ongoing environment in China. Concern about the state of the Chinese economy, and the corresponding slowdown in import/export activity, has had a meaningful impact on business investment and trade globally.

Second, tighter monetary policy in the United States has led to concerns about increased market volatility and its effects on emerging markets considering the amount of USD denominated debt that is held in developing economies. Third, excess savings and lack of business and consumer spending in the Eurozone and Japan have led both economies to deal with disinflationary pressures.

Finally, lower commodity prices have hurt the fiscal position of exporters while the pass through in benefits to importers has been delayed by several factors.

Taken with idiosyncratic issues within each country, the above themes are expected to persist into the medium-term. This is not welcome news for business leaders that would prefer some measure of predictability when assessing bottom-line performance for the upcoming year or several years into the future. On the positive side, we can still confidently state that the worst is behind us on several fronts.

Certainly, momentary bouts of volatility are to be expected in China as the economy rebalances away from investment and towards consumption. The Middle Kingdom is in the process of opening its capital account to allow greater access to foreign investment and this is not guaranteed to be a smooth process. But we see signs that growth is stabilizing, rather than collapsing, which buttresses our view that market bearishness on China has peaked.

For several years in the United States, it seems that we have all been preoccupied with the threat of tighter monetary policy and what it means for markets. However, the Federal Reserve has been clear on several occasions that the path to higher rates will be gradual to reflect a tepid domestic recovery. Markets appear to be getting the message, which should limit the volatility spillover into the developing world.

In the Eurozone and Japan, we expect the accommodative monetary conditions implemented by both the European Central Bank and the Bank of Japan to have a positive impact on the real economy, though this will be more apparent in the quarters to come. Monetary policy usually operates with a lag and the excessive measures taken in both jurisdictions provide fertile ground for global demand to pick up.

Indeed, the more supportive environment for global demand should help to ease the burden of the global supply overhang that has kept commodity prices low over the past few years. While the commodity super cycle may be over, a recovery from oversold levels is to be expected for both energy prices and metals. Of course, this will help to mitigate the pain that exporters have felt from the decline, including Canada.

And when it comes to commodities, Canada and India stand on opposite sides of the fence. For Canada, the collapse in oil prices pointed to a lack of diversity within our economy that we are still smarting from.

The contribution from fiscal stimulus will help shoulder the burden to drive growth which should keep the Bank of Canada from easing interest rates further this cycle. Still, the transition from consumption-led growth to business investment and export-led growth will take time as the legacy of the oil shock continues to filter through.

In India, the recovery in oil prices will remain below past cyclical highs, which should continue to benefit consumers on the subcontinent. This is good news for an economy that now can boast about a growth rate that has surpassed China’s over the past few years. Indeed, the Indian economy is well-positioned given its favourable demographics and growing middle class, with a still very low penetration of goods and services relative to other large markets.

Still, if India is to make the leap forward it will need to address glaring issues that have been a problem since the days of the much maligned ‘License Raj’. The Modi government has made it clear that it plans to become a leading exporter of high value-add goods, but this will be stunted by underinvestment in infrastructure.

The ‘Setu Bharatam’ project is a step in the right direction, but if India will need additional spending plans that are aligned with increased investment in roads, rails and electricity going forward.

Globally, there are nascent signs of optimism. One of the many virtues of a good business leader or politician is to prepare for both unforeseen risks and upcoming opportunities. That requires staying flexible and also in tune with what how the global environment is developing.

Bipan Rai is the Executive Director, Macro Strategy, CIBC Capital Markets

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