New kids on the economic bloc make their presence felt

By Ian Fraser

Published: Sunday Herald

Date: January 1st, 2006

World economy, weighted
Diagram: Forbes

2005 was a remarkable year in which a sudden surge in oil prices failed either to spark inflation or derail global economic growth. But given that average oil prices could be even higher this year and that US interest rates are expected to continue to rise during 2006, can the global economy continue to escape unscathed?

Forecasters at the Centre for Economics and Business Research (CEBR) believe global economic growth will slow only marginally in 2006 — to 4.1 per cent from 4.3 per cent in 2005 — largely due to higher oil prices and interest rate rises from the Federal Reserve. The CEBR believes the real harm will not happen until 2007, when it predicts global growth will slow to 3.5 per cent, with France and Germany being among the worst performers.

Joseph Stiglitz, professor of finance and economics at Columbia University in New York, says: “US interest rates will continue to rise and another factor that will continue to depress global economic growth will be the continuation of high oil prices.” The Nobel laureate expects oil to be priced at an average of $50 to $65 per barrel during 2006, up from an average of $55 in 2005 and $36 in 2004. He believes continuing instability in the Middle East is dissuading oil companies from investing in expanding production there, while the possibility of peace in the Middle East limits their appetite for building up production elsewhere.

“In the long run the Middle East is the low-cost producer, and [oil companies] are reluctant to make large investments in other parts of the world to take up the gap.” One of Stiglitz’s main wishes for 2006 is to see “peace in the Middle East”, which he believes would knock tens of dollars of the oil price. He also hopes the US “realises the folly of its fiscal policies, increases taxes, and addresses some off the problems of huge inequality in our society, to get the economy going again”.

CEBR economist Jonathan Said says the biggest risk to global growth in 2006 is the US consumer. If consumers rein in spending and starts to save more “it would have a major impact on world demand. Imports to the US would fall, with knock-on effects for Germany and Asia, which are dependent on exporting cars, electronics and textiles to the US.” Andrew Milligan, head of strategy at Standard Life Investments, says: “While there are risks that rising oil and commodity prices could force core inflation higher, we think the deep drivers of productivity growth, deregulation, corporate restructuring and globalisation will continue to restrain inflation pressures. Central banks will talk tough but act softly.”

2006: UNITED STATES OF AMERICA

DESPITE a quickening of growth in the third-quarter of 2005, the prospects for the US economy are shaky. A housing market slowdown is expected to combine with at least two interest rate hikes by the Federal Reserve to prompt consumers to reduce spending.

The CEBR forecasts US economic growth will slow from 3.8 per cent in 2005 to 3.6 per cent this year, with the latter figure propped up by reconstruction in the wake of Hurricane Katrina. Aberdeen Asset Management’s Bruce Stout, who manages the Murray International investment trust, says: “Unprecedented credit-fuelled consumer spending and irresponsible fiscal policies have enabled the US economy to grow only by living well beyond its means. Such debt-dependency has produced unsustainable deficits that history tells us are very painful to correct. We believe the post credit-binge hangover is rapidly approaching.”

Stiglitz says: “The fundamental problem is that, for the past several years, the US economy has been fuelled by people taking equity out of their houses. But that will come to an end as interest rates rise and the house market weakens. The full consequences will be felt by the end of 2006 when it will become apparent consumption cannot continue and there will be a significant slowdown.” He added that General Motors’s “desperate attempts to restructure and cut costs will also have a further depressing effect on the economy”. He says retiring Fed chairman Alan Greenspan has left a major headache for his successor Ben Bernanke, in the shape of “huge deficits and huge household debt”. Stiglitz says Greenspan was a major contributor to both, partly as a result of his endorsement of President George Bush’s 2001 tax cuts.

But Alan Young, investment director at Alliance Trusts, believes infrastructure investment will provide a fillip. “For decades there’s been a lack of expenditure on resources, including oil production and exploration. Nuclear power is back on the agenda, with all its associated investment.”

2006: THE EUROZONE

THE European Union’s Lisbon Agenda of 2000 was meant to transform Europe into “the most dynamic and competitive knowledge-based economy in the world” by 2010.

However the agenda’s targets for job creation and economic growth have been quietly watered down in the face of the eurozone’s anaemic recovery from the dotcom bubble burst of five years ago. Michael Dicks, chief European economist at Lehman Brothers, predicts eurozone growth of just 1 per cent for 2006. He says: “With both monetary and fiscal policy set to tighten we remain comfortable with our forecast of a mere 1 per cent expansion.” This is well short of forecasts from the European Central Bank (1.8 per cent) and a consensus of economists (2 per cent), which would imply the 12-nation eurozone is actually in recovery mode from the 1.3 per cent growth of 2005.

Stiglitz says: “The sad thing is that European Central Bank president Jean-Claude Trichet continues to focus on inflation when that is not the key problem for Europe and that the new German government has announced efforts to reduce its fiscal deficit which is premature. In the short-run that will depress the economy.” But SLI’s Milligan says VAT rises planned by Angela Merkel’s government do not take effect until 2007. “That could fuel consumer spending and investment in 2006, but makes us more worried about 2007.”

2006: BRAZIL, RUSSIA, INDIA & CHINA

THERE is a growing trend to group Brazil, Russia, India and China together as the Bric economy. All four are poised for continuing rapid growth in 2006 and most are expected to rank among the world’s top five economies by 2030.

The Bric nations enjoy a symbiotic relationship, with demand for oil, gas, soya beans, coffee and iron ore from China and India likely to continue to benefit the economies of Russia (which has the world’s largest oil and gas reserves) and Brazil (a major commodities producer). Stiglitz says: “I have every reason to believe that India and China will continue to grow in a robust way. They are fuelling the global economy and are playing a big role in Asia, but they’re still too small to be a substitute for the weaknesses in America and Europe.”

The OECD predicts China’s economy will grow by 9.4 per cent in 2006 and 9.5 per cent next year. And although there are signs of overheating in India, its economy is predicted to grow by 6 per cent to 7 per cent in 2006.

Ronnie Petrie, head of emerging markets at Standard Life Investments, believes the limited impact of Brazil’s “money for votes” scandal underlines the robustness of economic and stock market growth there. “In the past, this type of scandal would have sent share prices into a tailspin.” Stiglitz says: “Brazil is benefiting from high commodity prices, they’ve also been performing very strongly in exports, but the growth in their economy is a disappointment. It’s very hard to have robust growth with real interest rates at 19 per cent. And while Russia continues to benefit enormously from high oil prices, the other parts of the economy have not done as well.”

2006: JAPAN

LAZARUS-like, Japan’s economy is recovering from 15 years of torpor that followed bursting of its stock market bubble in 1990. The Nikkei index rose by 31 per cent in 2005.

Stephen Mitchell, manager of the JP Morgan Fleming Japanese Investment Trust says: “Since 1990, Japan’s huge real estate market has been in continuous freefall. A lengthy catch-up period is well underway. Japan has nine car makers and dozens of auto-parts companies that are all winning market share around the globe, and which are dominating the growth in demand in Bric countries. Japan leads the world in hybrid engine technology and is using this to accelerate market share gains.”

Japan’s trade surplus with the rest of the world runs into hundreds of millions of dollars on the back of strong R&D. Mitchell says: “Even in the lost decade of the 1990s, R&D was always the last item to be cut. Small wonder then that Japan leads the world in key products that consumers wanted to buy this Christmas.”

Rod Paris head of global bonds at Standard Life Investments says: “We have increasing conviction that Japan’s economic recovery is more sustainable this time. In 2006 we anticipate an end both to deflation and the zero interest rate policy.” The CEBR’s Said is more bearish. “Our forecast is for Japanese growth to slip from 2.5 per cent in 2005 to 2.3 per cent in 2006 and 2 per cent in 2007 as the upswing runs into high oil prices and a slowdown in the US and neighbouring Asian countries. With a demographic squeeze affecting the size of the Japanese workforce, it will be hard for GDP to increase by more than 2.5 per cent without the assistance of an asset price and borrowing boom.”

2006: UNITED KINGDOM

UNUSUALLY, economic growth in Scotland marginally outpaced that in the wider UK during 2005 – with 1.7 per cent expected for Scotland and 1.6 per cent for the UK. But will this trend continue this year? Not according to the Ernst & Young Scottish Item Club, which predicts GDP growth in Scotland will revert to trailing the UK’s this year. The forecaster predicts Scottish growth of 1.9 per cent for 2006, marginally below the UK level of 2.2 per cent.

However, both figures are marginally up on 2005, reflecting a predicted thaw in consumer spending and the stabilisation of house prices. “The UK and Scottish cycles are expected to be much more in step again in 2006 and beyond, ” says Dougie Adams, economic adviser to the Scottish Item Club. “In Scotland, we expect manufacturing to see a return to growth and electronics to show its first growth since 2000.” But he notes there are risks, including a slackening of growth in financial and business services and, particularly, a “soft patch” in fund management and insurance.

Stuart Thomson, economist at Charles Stanley Sutherlands, foresees at least two UK interest rate cuts in 2006. “We believe that low inflation will determine the first interest rate cut in February, but weaker growth will determine the second in May. These two cuts are going to be necessary to produce stronger consumer spending and investment in the second half of the year.”

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