Prospects for the world’s economy improved a bit in the closing months of 2004. Although US leading indicators were on a downward trend for much of last year (barring a very strong reading in March), they picked up in both November and December.
The latest business sentiment indicators for Europe and Japan also point to some improvement toward the end of last year. 2005 seems to have begun with the US growing at a fair pace — around 4% pa. On the other hand, few economists are expecting that growth this year in Euroland or Japan will be more than 2 percent.
On the basis of such forecasts, the US is likely to continue to run a massive current account deficit and global growth will therefore depend on the willingness of countries outside the US, especially in Asia, to continue to add to their dollar assets. Last year, rising US interest rates and the weaker dollar indicated that the rest of the world needed increasingly attractive terms if it was to continue to plough its savings into the US. Although the dollar has rallied in recent weeks, we suspect that balance in financial markets will require a further weakening of the US currency over the medium term.
There are a number of wild cards so far as the outlook for 2005 is concerned. Will the Chinese economy move efficiently to a slower growth path or will there be a “hard landing”? The answer here may have a bearing on a second uncertainty — What will happen to oil prices?
Experts say that this has the potential to move powerfully in either direction, or in both. A third issue is US fiscal policy. The second term of the Bush presidency has just begun and, in contrast to much of the previous 4 years, the US economy is now strong enough to withstand some fiscal tightening. If anything substantial is to be done, the political calendar dictates that a start should be made this year. In November 2006 the next US midterm congressional elections take place and in the final two years of a second four-year term, the incumbent president is often a “lame duck”.
A nearer-term uncertainty has to do more with how US companies react to the one-year reduction in tax — from 35% to 5.25% — on accumulated overseas earnings that are repatriated in 2005. No one knows how much money is out there — perhaps $500 billion could be shifted, maybe more, maybe less. Johnson & Johnson has just announced that it will repatriate $11 billion (75% of its undistributed overseas earnings).
Note that funds repatriated do not attract the low tax rate if used for dividends or for stock “buy backs”. There is the chance, therefore, of a big boost to capex or to M&A activity.
The view of the world economy is that it will continue to grow under the threat of rising imbalances. The US twin deficits have their counterpart in Asia’s huge savings ratios and trade surpluses. Market risks are therefore growing. One scenario is that economic demand starts the year reasonably strong, with the markets behaving reasonably well, so that the Fed is encouraged to raise interest rates regularly in a measured way, creating a progressively more difficult environment for markets.
At some stage, perhaps because markets take fright, the Fed decides it has done enough, laying the basis for a renewed market advance. But by then, perhaps toward the end of 2005, the global economy is noticeably slowing — because of the delayed effect of US monetary tightening and also because a tighter US fiscal policy is, by then, depressing demand.
(Habib F. Faris is vice president at Clariden Bank, London.)
