The global economy - lessons learned

In mid June, eight members of the PortfolioConstruction Forum Academy travelled to Boston, to undertake a four-day Harvard Business School short course on the global economy, led by Professor Niall Ferguson. These are some of the group’s key take outs.

What have we learned?

The course firstly considered the lead up to the crisis of 1914 and the similarities with the period leading up to 2007.

Both ages of globalisation were marked by increased growth, decreased inflation and decreased volatility causing a shift in expectations about volatility and risk, which in turn encouraged leverage.

In both cases, something triggered a crisis.

In 1914, it was a geopolitical event; the assassination of Austria’s Archduke Franz Ferdinand and his wife. In 2007, it was the subprime crisis.

In both cases, liquidity dried up overnight and necessitated a massive increase in state involvement in the economy. In the aftermath of 1914, it was very difficult to reduce the role of government in the economy – globalisation took 65 years to recover.

What next? 

Does a crisis of sovereign debt always end in inflation? Or is it more likely that real interest rates will increase while rates of growth decrease?

We considered the lessons of German hyperinflation in the early 1920s, the Great Depression of the 1930s, and the Japanese experience of the 1990s, as well as more recent events including state capitalism, the difficulties created by a property crash in Dubai, the risks and opportunities surrounding energy and politics in Iraq, and whether the recent growth in Brazil is sustainable.

A substantial amount of time was spent discussing China, its relationship with the US, and the implications for the global economy. The group consensus was that ‘Chimerica’ is unsustainable – a marriage of convenience for China that it no longer requires. China’s 12th Five-Year Plan focuses on innovation and services – it will invest in research and development to move from replication to innovation, and increase internal consumption and urbanisation.

Professor Ferguson proposed that the result of the breakdown of ‘Chimerica’ is structural change in the global economy, rather than mean reversion. The likely outcomes are lower growth and higher unemployment, which is not responsive to monetary policy.

His final statement was most revealing: “The key decisions of the next 20 years will be taken in Asia, not the West”.

By Greg Hanson, Colonial First State 

Multiple global scenarios

Europe

European economic disintegration is under way. Monetary union without fiscal integration places immense pressure on the European Union and the Euro.

While the break up of the Eurozone has a low probability at this stage, it can’t continue to bail out its troubled member economies.

There is a high probability that Greece will default this year, via a deferral or restructure of debt.

Ferguson did not rule out the rapid disaggregation of EU member countries, particularly the weaker states.

United States 

There is a very high probability of a double dip recession in the US, despite the Federal Reserve being highly focussed on not repeating past policy mistakes, particularly around the Great Depression, where money supply was restricted and credit availability was very tight.

The Fed’s monetary accommodation is in part designed to offset an increase in household savings and increase (velocity) money in circulation, but it is proving to be tricky.

The US requires sustainable growth in excess of 2.5 per cent per annum (preferably above 3 per cent) to reduce high unemployment, thus placing more pressure on monetary stimulus.

China

China’s development strategy is based on three core areas – productivity (leadership, planning, technology, internal migration); export growth (managing the exchange rate, ie, keeping it artificially low, access to new markets, cheap labour); and increasing internal consumption, which is currently around 36 per cent gross domestic product (GDP) compared to 77 per cent in the US.

Chinese authorities are most concerned about social unrest, and so are focussed on keeping a lid on inflation, particularly food and wages inflation.

The new Five Year Plan is aimed at China becoming an innovation society, less reliant on manufacturing and cheap labour.

Middle East

What emerges from the conflicts and uprising in the Middle East could be far more unstable than previous regimes, Ferguson warned. This is positive for commodities, especially oil prices, longer term.

Emerging markets

Emerging economies will soon account for over 50 per cent of global GDP growth, while the developed world accounts for a very large percentage of global debt to GDP.

Demographics also favour emerging markets. Expect to see a step-up in developed world exposure to emerging markets (currently very low), but expect volatility in these financial markets.

By Richard Kovacs, Ottomin Investment Group.

Three crucial themes impacting the global economy 

To close the course, Professor Ferguson discussed three crucial themes impacting the global economy.

European sovereign crisis

Although the Euro was originally created to provide financial integration across Europe, it has done the opposite.

There is massive financial divergence between member countries. Ferguson argued that bailouts are just government short-term bandaids that do not address the source of the problem.

Inevitably, Greece will default – more than likely this year. In fact, Greece should have never been allowed to join the Euro, as there were many conditions of membership that were never met, he explained.

The real concern now is with Spain and Italy, he warned – they are much larger economies and have far bigger debt than Greece, so if they default, the consequences will be dire for the Euro. 

US double-dip

There are remarkable similarities between the US today and the US during 1936 and 1937, Ferguson explained.

In 1937, the Federal Reserve tightened monetary policy by raising the official cash rate. Today, the Fed is also entering the phase of tightening monetary policy.

As a result of the Fed’s actions in 1937 the US, after four years of economic growth of between 5 per cent and 14 per cent per annum, plunged back into another depression – a depression within a depression, if you like – and the US share market then plunged 54 per cent.

The key question, Ferguson said, is whether the US sharemarket will follow a similar path in the years ahead. He was very cautious (and is himself not invested in equities).

Emerging markets emergencies

There is a lot of instability in the emerging world, with unemployment a lot higher among youth compared to other age groups – and political corruption.

While the politicians are not providing employment opportunities for the young, they do give them cell phones – the inevitable outcome, Ferguson argued, is revolution.

He expects we may well see the recent public uprisings in Egypt, Syria, and Libya spread throughout Africa and the Middle East. 

Political unrest is a major concern for the price of oil, and Ferguson believes it is likely to appreciate over coming years.

This will impact greatly on the US economy, with rising oil prices acting like a tax on its economy, leading to higher inflation and less consumer spending. That’s another reason why the US is likely to double-dip at some point.

By Peter Lanham, Lanham Investment Advisory.