Is the glass half empty or full?

By Lewis South

Softening in financial markets combined with the continued sharp decline in US housing activity has left many analysts pessimistic on the global economic outlook.

However, there are a number reasons for optimism regarding the global outlook.

Though the International Monetary Fund (IMF) expects weakness in the main industrial economies to result in a slowing in world growth in 2008, the global economy is expected to expand in line with the average recorded during the past three decades.

This apparent contradiction reflects the shrinking contribution to growth from the US and the increasing importance of emerging markets.

Growth in these economies is increasingly being driven by domestic forces, including the continuing urbanisation and industrialisation of China and India, while proving relatively immune to developments in credit markets, given their position as significant net contributors of capital to the rest of the world and the small role of non-bank lending as a source of finance.

Impact of emerging markets on Australia

Continued strength in emerging markets has significant implications for the Australian outlook given the increasing importance of these economies for our exports.

In 1991, when Australia last followed the US into recession, the US was Australia’s second largest trading partner, taking 10 per cent of our exports. Today, the US has fallen considerably as an export destination, while China has risen to be our second largest trading partner, receiving more than double the exports sent to the US.

This changing trade pattern has seen Australia become more closely linked to developments in emerging markets, especially in Asia.

As a result, while the IMF’s forecast growth in the major industrial economies was in line with that during the 2001 downturn, a trade weighted measure of Australia’s trading partner growth remains quite strong.

Thus the global growth environment continues to support the domestic economy, driving a substantial increase in commodity prices and with it a further significant rise in Australia’s already elevated terms of trade.

The downside of this strength, against a backdrop of extremely low levels of spare capacity, is a clear increase in inflationary pressures.

As the unemployment rate has fallen to a 34 year low, underlying inflation has risen to 4.25 per cent. This is the highest level since the Reserve Bank of Australia (RBA) began targeting inflation in 1993; and well above its target band.

To balance the ledger, the RBA has said a sustained period of weaker domestic demand growth is needed. Having increased interest rates on four occasions since last August, this slowing in demand may now be occurring.

Retail sales have softened since the end of 2007, housing activity has recorded a large decline and indicators of business conditions have slowed — though for now they remain consistent with a healthy pace of growth.

The RBA is prepared to allow this slowdown to play out for now. But should inflation pressures prove to be stronger than anticipated, or growth not slow as expected, then a further rate increase is clearly on the cards.

The longer-term view

The urbanisation and industrialisation of China and India is likely to remain an important driver of the Australian and global economic landscape over the longer term.

With 40 per cent of the world’s population living in these two economies, this transition will continue to exert a considerably larger effect than that seen in recently industrialised economies such as Korea.

The enormity of these developments becomes apparent when you consider the current pace of China’s urbanisation requires it to build the equivalent of Australia’s housing stock and associated infrastructure every 16 months.

This backdrop suggests long-term support is likely for commodity-producing economies such as Australia.

However, one implication of this development, which has gained a lot of attention in recent months, relates to food prices. The interaction between strong growth in demand and problems with supply (including the drought in Australia) has driven global grain stocks down to their lowest level in 45 years.

This in turn has seen a dramatic increase in prices for many commodities, such as wheat and rice. As China and India become wealthier, demand for food will increase significantly; while competing sources of demand from things such as bio-fuel production are likely to rise.

With global warming potentially making supply less certain, and with stock levels already historically low, these factors suggest the risks are skewed towards a further sustained rise in food prices.

In addition to the social unrest this could cause within poorer economies where food comprises a larger share of household consumption, the sharp rise in global commodity prices could have significant implications for inflation and growth in industrial economies.

Having been a source of goods price disinflation over much of the past decade, China and India are beginning to export inflation to the rest of the world.

If central banks in the industrialised world are to achieve their current inflation targets, growth over the period ahead will likely need to be somewhat lower than what we have seen over much of this decade. We may already be seeing this impact now, judging by the RBA’s latest forecasts for weak growth but still elevated inflation.

Along with the continued risk aversion that presently dominates financial markets, these developments suggest financial market returns are likely to be somewhat less than we have become used to in recent years. Moreover, many strategies that performed well during the recent boom may prove less successful over the period ahead.

Lewis South is the chief economist at Macquarie Funds Management Group.