By: Daniel Solomon

2013 appears to be the year when the world’s developed economies finally stabilised, on the way to a more sustainable recovery in 2014. The situation has improved especially for the US and Japan. The Eurozone is expected to grow this year, but its recovery is extremely fragile. Meanwhile Chinese growth rates seem to have started a longer-term decline towards 6% over the next decade, but the recent reforms at the Third Party Plenum increase the likelihood of China escaping the “middle income trap” and eventually becoming a developed economy.

GDP growth in key economies
United Kingdom0.

Source: Euromonitor International Macro Model (EMM)

The US

  • Despite the temporary federal government shutdown and the debt limit political standoff in October, the US economy at the end of 2013 showed increasing signs of a faster recovery going forward. We estimate that the US economy grew by 1.8% in 2013. GDP growth should accelerate to 2.6% in 2014 and 2.9% in 2015, gradually declining thereafter to a longer-run growth rate of 2.4%.
  • Real GDP growth reached an annualised rate of 4.1% in the third quarter of 2013, up from 2.5% in the second quarter. While part of this fast pace came from a burst in inventory investment which is likely to reverse over the next quarters, the growth rate excluding inventories was still a healthy 2.5%. Business non-residential fixed investment rose by 4.8% and durable goods sales by 7.9% in the third quarter (compared to 4.7% and 6.2% in the second quarter).
  • In December, the University of Michigan’s consumer confidence index increased to the highest level since July, and year-on-year retail sales were up 4.1%. The S&P500 stock market index increased by almost 32% in 2013, reaching a record high. All these indicators suggest growing business and consumer confidence about future economic conditions, confidence which should itself boost economic activity.
  • The unemployment rate gradually declined from 7.7% at the beginning of the year to 6.7% in December, getting closer to the Fed’s 6.5% threshold for increasing short run interest rates. However, the December unemployment rate would have been 6.9% excluding the drop in labour force participation. The overall employment rate of 58.6% is still 3.3 percentage points lower than at the start of the financial crisis.
  • Deleveraging proceeded well throughout 2013, and the US financial system is much more robust than in 2008, with various indicators of financial stress such as interbank borrowing costs and commercial paper- T-bill spreads continuing to decline. US household net worth rose to a record of US$ 77.2 trillion in the third quarter of 2013 and the household debt to income ratio declined to 0.99 from a high of 1.22 in 2009. The greatly improved financial health of US businesses and consumers sets a strong foundation for recovery.
  • Despite the relatively low inflation rate, the Federal Reserve felt there was enough improvement in the economic outlook to justify a cutback in its financial asset purchases from US$85 billion per month to US$75 billion. At the same time the Federal Reserve qualified this reduction in quantitative easing by stressing that it may maintain short term interest rates close to zero for a while even if the unemployment rate drops below 6.5%. Market based expectations are for short run interest rates to remain close to zero until the middle of 2015. And any further reductions in asset purchases are conditional on continuing signs of recovery. Financial markets reacted positively with stock prices increasing at the announcement, in contrast to the negative reaction to the June tapering announcement.
  • Key downside risk factors are low inflation that could feed into lower inflation expectations and higher real (inflation adjusted) interest rates, and a potentially overvalued stock market. Inflation in the US in the second half of 2013 was significantly below the Federal Reserve’s 2% target, with year-on-year CPI inflation of 1.2%. However, core CPI (which many economists argue is a more accurate measure of the level of aggregate demand) increased by 1.7% year-on-year, much closer to the Fed’s target inflation rate. Stock market prices may also have increased too fast relative to fundamentals in 2013, with the S&P500 increasing by almost 32% to a record high. This increases the risk of a stock market crash depressing economic growth in 2014. The current price to earnings ratio of around 18 is not excessive by historical standards. Furthermore, analysis by the Federal Reserve suggests the current stock market valuation is compatible with a decline in the long-run rate of return required by investors of around 1%, a plausible shift in light of the possibility of a more persistent increase in household saving and risk aversion. Still, current stock market prices may be excessive in light of the modest recovery in the baseline forecast, and some measures such as Shiller’s cyclically adjusted price to earnings ratio do suggest overvaluation.

S&P 500 P/E (Cyclically Adjusted)

Source: http://www.econ.yale.edu/~shiller/data.htm

Note: The cyclically adjusted price to earnings ratio is calculated as the ratio of S&P 500 real (inflation adjusted) price to the average of real earnings per S&P500 unit over the previous 10 years.

The Eurozone

  • Our forecast is for the Eurozone to exit recession in 2014 at a slow pace, with GDP growing by 0.8%. We expect GDP growth to return close to its longer-run trend of 1.6% in 2015 and beyond. 2013 continued the recent strong divergence inside the Eurozone, with growth among Europe’s biggest economies ranging from 0.5% in Germany to -1.3% in Spain and -1.9% in Italy. Economic conditions inside the Eurozone are likely to keep diverging, but at a slower rate. Germany is expected to grow by 1.4%, but the Spanish and Italian economies are also expected to grow at 0.5%, and the gap in growth rates should narrow even further in 2015. Overall, the Eurozone economy remains fragile. Even moderate shocks within our 75% forecast uncertainty bands could push it close to a new recession, with growth of only 0.1% in 2014.
Eurozone inflation

Source: Euromonitor International Macro Model (EMM)

  • After a return to positive growth in the second quarter, the Eurozone economy stumbled during the third quarter. Eurozone GDP in the third quarter increased by only 0.1% (compared to 0.3% in the second quarter). Germany’s growth rate was more than halved to 0.3% relative to the second quarter growth rate of 0.7%, and the French economy contracted by 0.1%. In contrast, Italian and Spanish performance actually improved slightly, with the Spanish economy growing slightly by 0.1% and exiting recession, while Italy contracted by 0.1% (compared to a 0.3% decline in the second quarter). Low inflation, less than 1% year-on-year during the fourth quarter, is a further indicator of a sluggish Eurozone economy. The ECB responded by cutting its policy interest rate almost to zero, but this is probably not enough in the current conditions to significantly affect the recovery.
  • Eurozone economic growth is likely to have improved in the fourth quarter and in early 2014. In December Markit’s Purchasing Managers’ Index rose to the highest level since mid-2011, and retail sales increased by 1.6% year-on-year.
  • The Eurozone unemployment rate remains close to record highs of above 12%, with the Spanish unemployment rate still above 26% and a French unemployment rate of 10.9% in the third quarter (a 16-year high). High unemployment is likely to be an important factor still discouraging many households from increasing their consumption.
  • Credit market weakness continues to be one of the key factors dragging down the Eurozone. Loans to non-financial corporations contracted at an annual rate of 3% in October and 3.1% in November. European banks are still badly undercapitalised, many of them operating with leverage ratios of over 25. This makes them more conservative in their lending. At the same time, European firms are burdened by excessive debt, especially in countries such as Italy and Spain. The IMF estimates that over 40% of business debt in Spain and 30% of business debt in Italy is owed by companies that cannot cover interest payments out of their profits, meaning that they cannot expand their workforce or invest. The weak balance sheets of banks and non-financial firms reinforce each other, further worsening financing conditions. Credit is especially tight for small and medium-sized enterprises (SMEs), which account for roughly 70% of Eurozone employment. In a recent ECB survey 15% of SMEs in the Eurozone consider access to financing to be their main problem, with the proportion rising to 25% in Spain.
  • The combination of tight credit markets, continuing uncertainty about the future and on-going fiscal austerity measures have led to an anaemic recovery with 2014’s growth forecast to be well below longer run trend growth of 1.6%. As a result, for many households the Eurozone recovery will still feel like a recession.


  • After growing by 7.6% in 2013, we expect China’s economy to slow down further with an annual growth rate of 7.4% in 2014 and 2015. Over the rest of the decade we expect Chinese growth rates to gradually decline towards 6.3% in 2020. Most of this slowdown is a natural consequence of China becoming more developed, leaving fewer opportunities for rapid growth. On the positive side, the plans for reform announced in the Third Party Plenum in November increase the probability that over the next decades China will continue to develop into a rich country. On the negative side, high debt levels and a poorly regulated shadow banking system could cause a significant downturn. In the worst case scenario of a ”hard landing” GDP growth would plummet to 4.8% in 2014 and 4.1% in 2015.
  • After a disappointing second quarter, economic growth recovered in the third quarter to a year-on-year GDP growth of 7.8% (compared to 7.5% in the second quarter). Investment spending was again the most important contributor to growth, accounting for 56% of GDP growth. Net exports actually made a negative contribution to growth, while consumption spending was responsible for 45.9% of GDP growth. Leading indicators such as the government’s and HSBC’s PMI’s suggest slower growth in the fourth quarter. Our current forecast is for fourth quarter year-on-year GDP growth to be 7.3%.
  • Excess capacity in manufacturing was a concern throughout 2013, particularly among state-owned enterprises (SOEs). Average capacity utilisation in Chinese industry was estimated at 78% in the 1st half of 2013, the lowest since the end of 2009.  The government has responded by ordering firms in 19 industries to reduce production capacity and prohibiting credit to certain industries with overcapacity. Government efforts to rebalance the economy and further increase the role of the private sector should also reduce the problem by shifting production to more efficient establishments (the latest estimate is that private sector return on assets at 12.4% is 2.7 times that of SOEs).
  • China’s economy has accumulated an unusually high amount of debt for its level of economic development, making it vulnerable to financial system shocks. Private sector debt is now above 185% of GDP, while government debt is around 50% of GDP and growing. The government has sufficient resources to bail out state banks even if the proportion of non-performing loans increases significantly. The status of the lightly regulated and higher risk shadow banking sector is less secure. The shadow banking system’s loan volume has now reached more than 50% of GDP. It plays a critical role in funding the more dynamic private sector SMEs, which account for 60% of China’s GDP, 80% of employment and usually cannot borrow from state banks. Any credit crunch is likely to hit the shadow banking system hard, severely reducing credit to these SMEs. In the worst case scenario, financial sector problems could lead to a “hard landing” reducing China’s growth rate to 4.8% in 2014 and 4.1% in 2015.
  • At the beginning of November the Chinese government announced a new set of ambitious reforms. For now, we have kept our previous estimate of GDP growing at an annual rate of 6.3% towards the end of the decade despite the reform announcements. The list of possible reforms is impressive, including easier entry by private business into currently regulated sectors such as utilities, increasing labour mobility, greater access to social services for migrant workers and continued financial system liberalisation. However, the official communiqué is vague on implementation details, and many of the reforms are targeted for completion in 2020. This suggests that their impact is more likely to be felt in terms of faster growth rates in the next decade rather than over the next five years. Furthermore, our long-run forecasts had already factored in continuing reforms to the financial system, an ever increasing share of more efficient private enterprises in the economy and some rebalancing to more consumption-oriented growth. Our long run forecasts may become more optimistic in the future if new and more concrete details about China’s reform plans emerge during this year.


  • Japan’s economy got a significant boost from the mix of expanded quantitative easing, fiscal expansion and promises of structural reforms, known as Abenomics. Our current estimate is that Japan’s economy grew by 1.7% in 2013. 2014 is likely to see slower GDP growth of 1.4% due to the increase in the sales tax from 5% to 8%. Subsequently, we expect the effects of Abenomics to wear off, with GDP growth declining to around 1% for the rest of the decade.
  • After growing by 0.9% in the second quarter, Japan’s economy decelerated in the third quarter to a 0.5% GDP growth rate. Capital expenditures increased by 0.2%, while consumption barely increased by 0.1%. The slow increase in capital expenditures was particularly disappointing, since one of the main objectives of expanding quantitative easing was to boost investment through lower inflation-adjusted interest rates.
  • Preliminary indicators in the fourth quarter were more positive. Business confidence as measured by the Bank of Japan’s Tankan index increased to a six-year high, and business conditions as measured by the Purchasing Managers’ Index have improved in November.
  • Japan’s economy is expected to grow more slowly in 2014, in large part due to the planned sales tax increase from 5% to 8% in April. The impact of the sales tax will be mitigated by the US$51 billion fiscal stimulus announced in October and by increased confidence in the Japanese government’s ability to stabilise its massive 240% debt to GDP ratio. Nevertheless, GDP growth should decline to 1.4% in 2014.



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