Talking Economics - July 2015

Seeking a global locomotive, UK inflation fears, Grexit and emerging markets.


In summary:

  • Five years on from the world economy's initial rebound in 2010, it is clear that the growth environment is best described by a square-root sign. The initial U-shaped upswing has given way to a world of flat 2.5% growth, well below the performance prior to the financial crisis.
  • Notwithstanding the Greek crisis, we see signs of better activity in the developed world. However, the comparison with the pre-crisis world highlights the absence of a global locomotive and means that we are unlikely to break with the square-root recovery.
  • Labour market indicators in the UK suggest supply is becoming tight as wage data is now accelerating. Despite this, the Bank of England (BoE) remains relaxed. This may change later this year, but with inflation barely above zero and concerns over Greece and the euro, it does not seem feasible for the Bank to hike interest rates in 2015.
  • Direct links between a Greek exit (Grexit) and emerging markets (EM) are limited, but there is always the risk of contagion.

The square-root recovery

The recovery in growth from the Global Financial Crisis can best be described by a square-root sign. Following the initial collapse and rebound, global growth has flat-lined at a steady, but sub-par, rate of 2.5%, which is half the rate achieved prior to the financial crisis. This slowdown is largely accounted for by the emerging markets, where growth has slowed as a result of weaker demand from the West for emerging market exports. However, we expect a continued recovery in Europe and Japan, as well as steady growth in the US, to push global growth up to 2.9% in 2016. This in turn should feed through into better exports for the emerging markets.  

Looking for a global locomotive
In general though we are doubtful that global growth will return to its pre-crisis pace, largely because the US is no longer the global locomotive that it once was. With subdued credit growth, an ageing workforce, increasing inflationary pressure and looming interest rate rises, the economy is not in a position to reprise its role as the driver of global growth. It is difficult to see who might take on this responsibility: the eurozone is only just escaping deflation and, like Japan, is relying on currency depreciation to reflate activity, while China is in fact too small – we estimate that China represents less than 10% of global consumption compared to the US’s 25%. Hopes that India may become the new driver of global demand look a tad optimistic as domestic consumption is little more than 2.5% of the global total.

The comparison with the pre-crisis world highlights the absence of a global locomotive and means that we are unlikely to break with the square-root recovery.

UK: Labour shortages risk higher inflation

Warning bells are ringing
Evidence is mounting that the UK economy is running out of spare capacity. Most indicators point to a shortage of labour and early signs of significant wage inflation. These include data such as the unemployment rate (which is now at its lowest level since the summer of 2008 at 5.5% in April) and survey data which show that companies are finding it increasingly difficult to hire. This suggests that firms may have to compete more with each other to recruit and retain staff. The result should be an acceleration in wage growth, something we are finally beginning to see.

Wage growth arrives
For the economy as a whole, average nominal wages grew by 2.7% in the three months to April compared to the same period a year earlier - the fastest pace of annual wage growth for three years - and even more impressive when compared to current inflation of just 0.1% year-on-year. Industry-level data highlights the pressure in the labour force more starkly: half of the UK’s sectors have, in the last year, increased pay by at least the average growth rate of the five years preceding the financial crisis. Wage growth inflation has been the highest in those industries that are more labour intensive while it is far slower in those sectors where labour intensity is lower. 

Bank of England remains relaxed….for now
The BoE’s reasoning behind its cautious approach to interest rates centres on productivity growth. Since 2008, productivity growth has fallen to zero and BoE staff expect this to recover in time. If this happens, then as the economy continues to grow, the productivity recovery would reduce the need to hire many more workers, which would minimise additional pressure on unit wage costs or inflation, and thus reduce the need to hike interest rates. However, if productivity fails to recover, then firms will need to increase hiring further, causing wages to pick up. The chance of inflationary pressure, and the need for rate hikes, then rises.

With inflation still below the lower bound of the BoE’s target range, and not forecast to rise above 2% until the end of 2016 (this is our own estimate – the BoE sees inflation staying below 2% until much later), we believe the first interest rate hike will occur in February 2016 (we pushed this out from November 2015 last month). 

The prophesies of Delphi: would Grexit topple EM?

An oft-cited ancient Greek story tells of the prophetic powers of the oracle at Delphi, which King Croesus consulted when deciding whether to attack Persia. The oracle’s advice was supposedly: “If you cross the river, a great empire will be destroyed”. Croesus duly attacked, full of optimism, and saw his own empire destroyed as a result.

The discussion around a possible Grexit tends to focus on the damage to Greece and the eurozone. What if, though, like Croesus, the focus is on the wrong kingdom? Could Grexit trigger a broader based EM problem?

Trade links are limited
Greece itself does not rank as a major export partner for any large EM economy. Although about 10% of its 2014 imports came from Russia, this amounts to just 1% of that country's total exports. Elsewhere, EM exports to Greece rarely exceed 0.5% of GDP, and are usually lower. It should be noted that we believe the economic impact of a Greek exit on the eurozone would be limited, however, so any disruption on eurozone trade would be temporary at most.

Financial links are more concerning
Data from the Bank for International Settlements (BIS) shows minimal EM claims on Greece: out of a total $67 billion in foreign bank claims on the country, only $47 million are from EM banks (and these are almost entirely Turkish). However, going the other way, Greek banks retain significant claims on some EM countries, concentrated in the Central and Eastern European (CEE) region. Typically, these are small economies however, and claims on the larger CEE nations like Poland and Hungary are minimal. One possible area of concern is Turkey, for whom Greek banks account for around 12% of all foreign bank claims ($31 billion).

From a eurozone perspective, bank claims on Greece are, according to our banks analyst, typically collateralised, and generally represent only a small share of bank assets, such that Grexit is not a threat to eurozone banks. Only contagion risk poses a concern. 

A poisoned well
If a Grexit were to occur, it may be that as with the "Taper Tantrum" of 2013, a wide range of EM economies sell off at first, but stronger economies (as measured by fundamentals) recover these losses quickly. If we were to raise any concerns at all, they would centre on Turkey, which is connected to Greece through trade, finance, and geography, as well as reliant on international finance generally. If Turkey were to fall, the risk of contagion to the rest of EM rises considerably, particularly for those economies also heavily reliant on foreign capital flows: the rest of the Fragile Five (bar India) and some other Latin American countries. It is a tail risk, but we cannot completely rule out the fall of an empire should Greece cross the river out of the eurozone.

Talking Economics is based on Schroders Economic and Strategy Viewpoint, produced by the Schroders Economics Team: Keith Wade, Chief Economist, Azad Zangana, European Economist, and Craig Botham, Emerging Markets Economist.

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