A World Divided

As we prepare to head into 2015, we find the world’s economies split between those ready for growth, and those teetering on the brink of recession.

By Sameer Massis

It was 160 years ago this month that Louis Pasteur stood in front of an audience of fellow scientists and uttered the immortal line: “Chance only favors the prepared mind.” Similarly in business, we believe good luck favors those that plan ahead. So, with barely a month left of open markets, it’s time to prepare our portfolios for 2015 by focusing on the investment themes likely to drive the world economy over the coming year.

It’s clear that we are in a “so-so” world economy, one which is half good and half bad. Even though 2014 started slowly, Q1’s 1.6 percent global growth rate only modestly accelerated to 2.1 percent in Q2. But economic signs abound indicating global growth is likely to have accelerated in the second half of the year, which should supersede the 2013 growth average of 2.5 percent. These numbers still mask the strength discrepancies amongst the world’s growth engines. The United States largely led global growth, with an extra boost coming from China and India later in the year. In contrast, Japan suffered a sharp economic decline following its April VAT hike, the Euro market suffered unexpected growth stagnation, and emerging markets slowed down.

A pivotal moment came in October, when the divergent economic policies of the G8 countries became apparent. The US Federal Reserve announced it was halting the third round of quantitative easing that completed a $1.6 trillion injection into the world’s largest economy. Shortly after, the European Central Bank stated it would boost its economy by $1.3 billion over the next two years, while Japan’s Central Bank announced it would add $0.7 billion.

No Love for Russia

Russia was excluded from the G8 forum in the spring because of its role in the Ukraine crisis. Western sanctions further weakened the Russian economy, which managed to grow 0.7 percent in Q3, and is projected to slip to 0.6 percent in Q4. As reasons for pessimism are likely to linger, with the economic sanctions expected to remain for another two years, lack of foreign investments, tighter monetary policy, and lower oil prices, the risk of recession remains a real one. At current conditions, economists forecast virtually no growth for both 2015 and 2016, and only 1.6 percent in 2017 for the $2 trillion economy, which ranks eighth in the world.

The Russian Central Bank had already raised its rate to 9.5 percent to stave off the fall of the ruble, which fell by 30 percent against the dollar this year. Most of the currency’s fall came after June, as the oil price started to fall and geopolitical tensions increased. Whereas a cheap ruble is good news for Russian exporters, foreign debt becomes harder to pay. In turn, bankruptcy risk will likely materialize as a real threat as $40 billion in foreign debt comes due towards the end of the year for Russian banks and corporate borrowers.

Brazil is another country that is also trying to stave off a precipitous currency fall. The government in charge of this $2.3 trillion economy, which is even larger than Russia’s, faces the challenge of reviving growth, slowing inflation, and stemming deficits. Over the last three months, the Brazilian real already fell by over 13 percent to a nine-year low as the government of Dilma Rousseff was re-elected in October. Just three days after Rousseff won, Brazil’s Central Bank raised its rate unexpectedly to 11.25 percent in an attempt to curb an incessantly high inflation rate. Brazil’s currency is likely to remain volatile as it continues to weaken, especially amidst a backdrop of weakening commodities prices. Earlier in the year, S&P downgraded Brazil’s economy to investment grade, with Fitch and Moody’s also likely to match the rating in the near future. This places added pressure on the Brazilian government to restore growth and fiscal performance in 2015.

Emerging Markets Aren’t

Both Brazil’s currency and stock market weren’t able to escape the general trajectory of emerging markets, which weakened significantly in 2014. Should OPEC fail to cut output to curb falling oil prices, it would only add to the weakened commodities markets. Notably, the price of gold is likely to remain weak, especially after the quantitative easing announcements of the EU and Japan’s Central Banks. Add to this a continuation of the strengthening of the US dollar (the Federal Reserve is expected to raise rates in mid-2015), and the price of gold is therefore more likely to plateau at the $1,000 mark next year.

Furthermore, the expected continuation of a rising US dollar is likely to continue pressuring emerging market currencies and economies in general. In its Emerging Market Equity Research note, J.P. Morgan underweights Korea, Chile, Peru, Poland, South Africa, and Malaysia. On the positive side, it overweighs Taiwan, India, Mexico, Thailand, Indonesia, and Greece.

A notable exception to the negative effects of a rising US dollar and US monetary tightening is China, which historically was able to offset its effects. The Chinese economy will continue its deleveraging process into 2015. However, the removal of debt from its balance sheet caused a significant decrease in credit demand, which precipitated a fall in real estate prices. China still risks falling into a balance sheet recession, but its currency remains in a strong shape to continue to appreciate in the new year.

All in all, 2014 was a mixed bag economically. The world’s economies are emerging at the end of the year more divergent than at its start. Some economies are entering a growth phase, while others risk recession.

The performance of the MENA region in 2014 is even more mixed, as a glaring gap emerged between high-income countries projected to grow at 4.9 percent and others projected to expand at a meager 0.7 percent.

Despite a dark cloud of political instability hanging over the region, the World Bank expects a pickup in growth in 2015. This optimism stems from an expected increase in public and private consumption due to expansionary fiscal policies, and easing political tensions in Egypt and Tunisia, as well as a continued subsidy reforms in Egypt, Jordan, and Yemen. Libya will also likely resume its oil production, as it reignites its growth engine. As Louis Pasteur once said: “It is surmounting difficulties that make heroes.”