Market concerns in 2016 have reflected uneasiness about the strength of global economic activity and have focussed on two specific sectors – energy and banking. The ranking of developed world stock market performance (in local currency terms) was in line with expected economic growth prospects for 2016: strongest in the US, followed by the UK; with the eurozone and Japan lagging.
Underscoring the relative weakness of the latter two areas, policy interest rates were cut to negative levels during the quarter. However, the opposite relationship between stock markets and growth was the case in the major emerging markets: two economies likely to remain in recession in 2016 – Brazil and Russia – made strong equity market gains. In India and China, where growth is expected to remain firm, equity markets were relatively weaker. The ranking of economic growth expected in 2016 in the major developed economies corresponds to the pattern seen over a much longer period – since 2000.
Partly that reflects structural issues – poorer demographics and a slower pace of structural reform in Japan and the Eurozone, but looking ahead, it may be that Japan and the eurozone are now constrained because of a lack of policy flexibility. The concern is that they have tried both conventional and now unconventional policy stimulus measures, but that these have had limited effect. Even in the US and UK, where policy has been more effective in lifting growth, there is a fear that as interest rates remain so low and fiscal policy constrained, dealing with the next downturn, when it comes, will be problematic. In short, policy makers may be “out of ammunition”. How valid is this concern?
Out of ammunition?
Three main options are potentially available for a country wanting to stimulate its economic growth: looser monetary policy – cutting interest rates and quantitative easing measures; related to that, and often reflective of it, a weaker exchange rate – to boost the competitiveness of industry and thereby exports; and fiscal policy easing – cuts in taxation or increases in government spending.
Look no further than Japan - For several years, and in a more determined fashion since Abenomics was launched in 2012, Japan has tried all three measures. First, interest rates have been cut – now into negative territory – and quantitative easing has been taken to extreme levels. Yet inflation has not risen.
A weaker yen from 2012 to mid-2015 helped to restore Japanese companies’ revenues and profitability but the recent strengthening of the currency indicates the vulnerability of relying on exchange rate changes as a source of improved growth.
As far as fiscal policy is concerned, Japan is constrained by the fact that government debt is already large relative to the size of the economy and continues to rise. The government has sought to raise, not cut, taxes. Renewed fiscal stimulus is planned but the government also wants to press ahead with another sales tax increase and the fiscal easing measures under consideration – more infrastructure spending, for example – have been tried and (largely) failed in the past.
We see the eurozone as in a relatively better position than Japan in each of these areas of policy flexibility. There are good grounds for thinking the European Central Bank’s latest moves to ease monetary policy can be effective, especially as, in contrast to Japan, deflationary expectations have not yet become ingrained by companies or consumers.
Low interest rates already seem to be contributing to a recovery in the housing market in some countries (notably Spain). Companies continue to benefit from the weaker value of the euro and government debt levels – for the eurozone in aggregate – are not nearly as high as in Japan. There is also some scope for targeted fiscal easing, if the political will to do so can be found.