The Big Trends in the Global Economy

Global Growth

A lot has seemingly happened in the global economy in recent months, from a plunge in the oil price to a surge in the value of the US dollar against foreign currencies to an election in Greece that led to renewed fears about the possibility that the euro zone would break apart. But what’s been the upshot of all these changes? The latest World Economic Outlook report from the International Monetary Fund provides some data to answer that question.

According to the IMF’s report, the global economy is expected to grow by 3.5% this year. That’s lower than the projection of 3.8% growth that the IMF made six months ago. The change is largely the result of slower expected growth from emerging markets (5.0% six months ago versus 4.3% now). The prospects for developed economies, on the other hand, have actually improved slightly. While the estimated 2015 growth for the US hasn’t changed (it’s still 3.1%), the IMF boosted its growth estimates for the euro area and Japan.

Even though expectations have declined for emerging economies as a whole, not every country has a similar story. Six months ago the IMF expected a positive growth rate this year in Russia and Brazil; now it expects both countries’ economies to get smaller. The anticipated growth rate for China has also declined, although it’s still very high at 6.8%. India has gone in the other direction. Six months ago the IMF was projecting that India’s growth this year would be 6.4%. The latest estimate is 7.5%.

It’s important to remember that there’s only a weak link between economic growth and stock market performance, so simply buying stocks of fast-growing countries (or stocks of countries where the economic outlook has improved) probably isn’t a good idea. In fact, China and Russia have been among the best-performing stock markets so far this year. Still, thinking about the global economy in terms of these numbers may make the big-picture trends more apparent.

How a Strong US Dollar Can Hurt Emerging Markets

Strong Dollar

The US Dollar has surged in 2014, increasing in value since the start of the year versus every other major currency. A strong US dollar has big implications for the global economy and affects almost every investment in your portfolio. Not all of these effects are the same, however, and the most substantial impact may be on investments in emerging markets.

The most straightforward effect from a stronger US dollar is a decline in the value of international holdings for US investors. This is simply math: when the values of the investments in foreign currencies are converted back to US dollars, they’re worth less than they previously had been.

For some foreign companies part of this decline may be offset because a stronger dollar means that their exports become more affordable. But overall these direct effects of a stronger dollar tend to hurt emerging market investments. Both emerging market stocks and local-currency emerging market bonds have returned about -5% so far this year.

A stronger dollar has other effects as well. It tends to be associated with lower prices for commodities such as oil (there are a number of reasons for this association, with both a stronger dollar contributing to a lower oil price and a lower oil price contributing to a stronger dollar). The oil price has indeed plunged this year, particularly hurting oil-producing countries such as Russia, Venezuela, and a number of countries in the Middle East. With declining oil revenues and a tanking currency, Russia appears to be on the verge of a financial crisis that could wreak havoc on its economy.

There could be additional emerging market victims if the US dollar continues to gain strength. Many emerging markets have debts denominated in dollars, and a stronger dollar makes these debts harder to repay. Given their external debts and their proximity (both geographically and economically) to Russia, a number of other Eastern European countries may be vulnerable.

The Biggest Political Risk

China-US Diplomacy

We recently discussed the rise in political risk that investors have had to deal with over the past few years. But where is this risk most likely to have a meaningful impact on US investors? The answer, perhaps surprisingly, is East Asia.

That answer may seem odd given the political uncertainties in other parts of the world. Syria has been racked for years by a deadly civil war, Iraq’s government is trying to fight off an insurgency, Russian-linked separatists have been stirring up trouble in Ukraine, and military leaders have claimed power in countries such as Egypt and Thailand. But when it comes to global financial markets, these countries are bit players. Even Russian stocks comprise only about one half of one percent of the value of the global stock market. While it’s true that events in small countries can have an impact—trouble in Syria or Iraq could spread throughout the Middle East and affect global oil supplies, for example—political risks related to larger countries would be more consequential.

Since 2012, a diplomatic conflict has been escalating between China and Japan over a group of uninhabited islands in the South China Sea. China also has territorial disputes with other countries in the region, including Malaysia, the Philippines, and Vietnam. So far these conflicts have remained mostly diplomatic rather than military disputes, but there are routinely provocations that threaten further escalation. Last month China stationed an oil rig in territory claimed by Vietnam, leading to riots in Vietnam targeting foreign businesses.

A military conflict between any of these countries could roil financial markets: Japan is the second-largest country in the iShares MSCI All Country World Index ETF, while China is the ninth-largest. Furthermore, the United States could intervene in such a situation (the US has a security agreement with Japan), making the strife truly global.

The good news is that the probability of a large-scale military conflict is still very low. Yet even if the disputes remain the purview of diplomats, investors could feel some effects: trade between China and Japan has fallen substantially since their territorial squabble metastasized in 2012.

The Rise of Political Risk

One important trend in global financial markets during the last few years has been a rise in political risk, a concept referring to political changes that could affect the value of an investment. The number of events associated with political risk—such as elections, mass protests, and military interventions—has increased by 54% since 2011, according to a study by analysts at Citigroup. This kind of increase has a couple key implications for investors.

The first is that it can affect the relative performance of emerging markets versus developed markets. Interestingly, while political risk has historically been most closely associated with poorer countries, in recent years it has appeared in some of the wealthier emerging markets and even developed ones.

In emerging markets there have been protests in a wide range of countries, including Brazil, Russia, South Africa, Thailand, and Turkey. In developed markets, political posturing opened up the possibility that the United States government would default on its debt in the summer of 2011, and extremist parties opposed to the European Union did well in recent elections for the European Parliament.

A continued increase in political risk would likely hurt emerging markets more than developed markets, even if the risks aren’t isolated to emerging markets themselves. Investment typically flows from emerging markets into “safer” markets (such as the United States, Switzerland, and Japan) when perceived risk increases. This shift can take place even when the risk originates in the developed countries, as was the case when emerging markets were pummeled during the 2008 financial crisis.

A second implication of increased political risk is that it may lead to more divergence in the performance of stocks in different countries. This trend is already evident in some of the countries that have recently experienced notable political events. For example, Russian stocks have lost 8% so far this year (and at one point were down close to 25%) as the country became involved in territorial battles with Ukraine. Indian stocks, by contrast, have risen more than 20% this year as political power shifted in the country’s May elections.

EM 2014 Performance

Q1 Recap: US Stocks Overcome Russia, China to Stay in Positive Territory

The first quarter of 2014 had a few bumps in store for financial markets, yet in the end almost every asset class ended up with positive returns. Bonds performed well as interest rates declined and the US inflation rate remained below the Federal Reserve’s 2% target. US stocks recovered from January jitters to end the quarter in positive territory. Even emerging market stocks, buffeted by fears of financial instability in countries such as Turkey, Russia’s military adventurism in Ukraine, and weak economic data from China, finished the quarter only slightly down.

Q12014 Asset Classes

Despite the continued US stock market gains in the first quarter, the economic optimism that fueled last year’s stock market surge showed signs of fading. Weak housing market data helped more defensive sectors such a utilities and health care outperform the broader market.

Q12014 Stock Sectors

The Russian stock market was pummeled in the first quarter as fears mounted that the country’s annexation of Crimea would crimp its economy and its ability to export natural resources. Russia’s troubles may have obscured a more important development, however: disappointing economic data in Japan and China led to a weak first quarter for Asian stocks.

Q12014 Countries

The outlook for the Chinese economy is likely to be one of the key drivers of financial markets for the rest of 2014. For years bearish analysts have been predicting a financial crisis in the world’s second-largest economy, and declining property prices in China could be the start of a broader collapse that finally validates these gloomy prognostications.

Yet so far the Chinese government has overseen a fairly orderly decline in the country’s economic growth rate, and it has the capacity to stimulate the economy if it fears that trouble in the real estate market is spreading. Success in containing the fallout from the economy’s slowing growth would provide a boost for stocks around the world, particularly in China itself where valuations are very low compared to other countries.