The Global AnAlyst | JULY 201544 |

INTERNATIONAL

UNITED STATESIs a Slowdown in the Offing?

In the absence of potential tail risk events/severe shocks and externalities, the rate of GDP growth in the US should eventually rebound in the coming quarters.

- Dr. IVO PEZZUTO, Global Markets Analyst, Management Consultant, Economics and Management Professor

Author of the Book “Predictable and Avoidable” ISTUD Business School and Catholic University of the Sacred Heart. Milan, Italy

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The second estimate of first-quarter of 2015 GDP of the US economy shrank at a 0.7 per cent annualized rate. This contraction proved to be a bit less than expected (i.e. 0.9 per cent on an annualized basis to start 2015). The ini-

tial estimate of Q1 2015 GDP, released April 29, showed the economy grew 0.2 per cent to start the year, but well below then-consensus expectations for a 1 per cent in-crease. Industrial production has been affected by a strong US dollar and sluggish global growth, however, business confidence and consumer confidence indicators and other indicators seem to suggest that the surprise Q1 contraction will not last much longer despite the fragile US and Eurozone recovery. • A number of factors seem to have contributed to the

Q1 2015 GDP contraction, among these notable ones are:

• The harsh winter conditions;• Dockers’ strikes all across the West Coast;• Increased trade deficit due to a stronger dollar which

has allowed American consumers to purchase a larg-er amount of the depreciated foreign-made goods;

• Manufacturing has been undermined by the buoyant dollar, whose 12.1 per cent appreciation against the currencies of the United States’ main trading part-ners since last June has eroded overseas profits of multinational companies. Cheap oil and a strong dollar, while beneficial to consumers, are putting se-rious pressure on manufacturers.

• Lower increase in domestic stockpiles of goods. Do-mestic inventories decreased due to a pickup in busi-ness activity, the results of which are expected to re-veal themselves in Q2;

• A slightly weaker-than-expected consumer spending;• Decreased investment in the energy sector following

the drop in fuel prices (lower crude prices triggered a partial freeze in the shale boom). Capital spend-ing in oil field exploration and drilling slumped 48.6 per cent in Q1, the greatest decline since 2009. The stronger dollar and reduced capex spending by oil-field firms combined with a harsh winter and softer global demand contributed to slow U.S. growth at the start of the year.

• Slowing exports, non-residential fixed income invest-ment and local government spending

• Corporate profits also fell in the first quarterNevertheless, in the absence of potential tail risk events/severe shocks and externalities (i.e., “Grexit” or poten-tial Eurozone political and social tensions, further geo-political issues related to Russia/Ukraine, or potential crises affecting the Emerging Markets, etc.), the rate of GDP growth in the US should eventually rebound in the coming quarters. An improving labour market is among reasons consumers may be more willing to spend in the next quarters if the economy continues to improve and

there will be no negative impact of a potential rate hike by the Federal Reserve.

A revival is not far off, thoughGallup’s US Economic Confidence Index registered at -9 for the week ending June 7, the sixth straight week the index has been at or below -5. (Gallup 2015). Based on the latest forecast on the US Economy by Oxford Economics, it seems quite unlikely that the Federal Reserve will com-mit itself in June 2015 to a specific rate lift-off date (the timing and pace of rates lift-off; Fed in its meeting on June 17 did not press for rate hike while sounding cautionary about GDP growth), but consumer spending is expected to strengthen through the rest of the year as faster wage growth, lower oil prices, and upbeat confidence lead consumers to spend more. Furthermore, increased wage growth, historically high affordability, and a slow release of pent-up demand are expected to underpin a stronger pace of activity in the housing sector. Lower oil prices, a stronger dollar, and slow global growth will continue to drag on business investment, but in the coming quarters the impact of factors will diminish and domestic activity will probably strengthen. Lower energy prices will con-tinue to weigh on headline inflation, while core inflation will remain well-anchored.With real GDP growth averaging 2 per cent towards the end of the year, the unemployment rate hovering close to 5 per cent and inflation moving back toward 2 per cent, it is likely to expect a potential rate hike by the Federal Reserve in September 2015 or December 2015 (policy nor-malization), in the absence of major risk events/severe global shocks, externalities, slow recovery and subdued inflation, or lower productivity growth.

Needed a ‘New Deal’ to end the Greece Crisis Financial markets, however, can be quite volatile when hit by fears of potential economic and financial crises (i.e., “Grexit” - S&P has recently downgraded Greece to CCC, with negative outlook and IMF payment has been deferred), potential contagion risks, or geo-political ten-sions in various areas of the world. All these elements might have a sudden impact on the emotional reactions of investors who might turn immediately risk averse due to the rising uncertainty, markets’ interconnected-ness and complexity. ECB President Mario Draghi said in April 2015 that “the euro area is better equipped than it had been in the past to deal with a new Greek crisis, but warned of ‘uncharted waters’ if the situation were to deteriorate badly.” No one can fully predict the unin-tended geo-political, economic and social consequences of a potential “Grexit” scenario. In the last six months, that is, since the beginning of the new Greek crisis in 2015, we have not yet seen a signifi-cant emotional or panic reaction of international inves-tors about a potential “Grexit” event (Exit of Greece from the Eurozone). This apparent calm reaction of the finan-cial markets can be probably related to the higher confi-dence investors have in Greece’s major creditors’ ability

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(i.e. IMF, ECB, and EU Countries) to figure out a sustainable agreement to keep Greece in the Eurozone at any cost, or at least, to be able to mitigate the negative effects of a potential “Grexit” event. It could be also due to the fact that the international pri-vate financial institutions currently have only a marginal exposure to the Greek debt.Whatever will be the outcome of the current Greek crisis, in order to avoid in the future additional poten-tial systemic risks (i.e. liquidity, sol-vency, banking, political crises) and potential spillorver effects, and to revamp long-term economic growth and prosperity in the Eurozone, it is crucial to reach an agreement to pre-vent the further deterioration of the economic and financial situation in the Country and to keep Greece sol-vent in the long term. Furthermore, It would be also beneficial for the European leaders to envision and implement in the coming years (the sooner, the better), a stronger and more cohesive integration process and a new deal (i.e., revision of the Eurozone Treaties) in order to mini-mize the risks of potential durable spillover effects to the rest of the euro zone or global economy in case of a potential default of a member state. The new deal should probably in-clude the following ambitious and daring policy decisions (political courage) while trying to avoid any potential risk related to moral haz-ard:• Allow a more pro-active use of

the crisis resolution mechanism/ fund and of the regional institu-tions and facilties to prevent cri-ses (i.e. ECB, European Stability Mechanism, European Invest-ment Bank, or the creation of a European Monetary Fund), i.e., before the default occurs;

• Assure proper capital controls policies and bail-in regime for banks’ crisis resolution and loss absorption

• Assure full risk sharing mecha-nisms among member states for QE programs and a common fis-cal backstop for solvency/sover-

eign debt crises;• Assure full integration in the

Euro zone of the fiscal (i.e. the assurance of a fiscal backstop and fiscal transfers), economic, monetary, banking, capital mar-kets, financial, and political sys-tems;

• Introduce a single deposit-insur-ance mechanism covering all banks in the Union;

• Assure adequate powers for the single supervisory mechanism in the Euro zone and effective and forward looking macropru-dential regulation of all financial institutions (i,e. banks, shadow banking, investment funds, hedge funds, asset management firms, and insurance firms), as well as, harmonized bankruptcy laws, accounting rules, and fiscal criteria in the region, and a sin-gle and fully empowered crisis resolution authority;

• Implement a common mecha-nism to support job flexibility in countries with high unemploy-ment;

• Introduce clear policies and res-olution criteria for managing bank crises, banks recapitaliza-tions, collateral haircuts policy, balance of payments imbalanc-es, asymmetric shocks, and debt restructuring solutions in case of fiscal and debt restructuring/

solvency crises. Thus, it is im-portant to allow member states to restructure their debt.

• Reduce the “revolving doors” practices between regulators, supervisory authorities and fi-nancial institutions introducing policies that a ban the “common practice” for a number of years (i.e. 5 years or more)

• Monitor that the ultra-accommo-dative monetary policies do not create perverse incentives for the corporate world to pursue mas-sive leverage strategies issuing unprecedented levels of corpo-rate bonds. This practice is facili-tated by the excess of liquidity and cheap funding guaranteed by the central banks, and allows corporations to lever up (e.g. higher leverage) their balance sheets and to conduct stockhold-er-friendly actions, like buying back stock or paying dividends. As a result of these strategies, the corporate world can artificially increase the profitability of their businesses (and their earnings per share) for common stock-holders, but without changing also the fundamentals of their businesses through investments in capital expenditures.

• Differently from the stock mar-ket, the corporate bond market, in general, is far less liquid and

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tends to perform quite poorly during periods of rising interest rates and, in general, its securi-ties are not traded in more liquid exchanges, as stocks are, but they are traded mostly over the coun-ter in illiquid markets. As stated by Economist Nouriel Roubini, “private and public debts be-fore and after the financial cri-sis – are held in open-ended funds that allow investors to exit overnight.” (Roubini, 2015)Prof. Roubini also added the follow-ing: “This combination of macro liquidity and market illiquidity is a time bomb. So far, it has led only to volatile flash crashes and sudden changes in bond yields and stock prices. But, over time, the longer central banks create liquidity to suppress short-run volatility, the more they will feed price bubbles in equity, bond, and other asset markets. As more investors pile into over-valued, increasingly illiquid as-sets – such as bonds – the risk of a long-term crash increases.” (Roubini, 2015)

• Furthermore, as I have stated in an interview with the Brazilian news agency, Agência Estado, in 2011, “a generalized approach of contractionary fiscal policies in the peripheral European coun-tries, based only on tough na-tional austerity programs; rigid budget discipline, fiscal consoli-dation, state-owned assets and shareholdings’ dismissals/priva-tizations, and higher taxation; with limited or no commitment also to contra-cyclical measures towards growth (i.e. invest-ments on innovation, educa-tion, infrastructures, tax breaks, tax incentives, and tax wedge reduction); effective structural reforms, spending cuts of non-productive expenditures (to fill the ‘competitive gap’ and to re-vamp productivity and expecta-tions), and some degree of flex-ibility to reach budget and fiscal consolidation targets during adverse economic cycles, would eventually turn a bad situation into a worse one (self-defeating

strategy) or prolonged recession, or stagnation, or slow and anae-mic, and uneven growth (Pez-zuto 2011).

The QE program introduced in the Eurozone in 2015 is very important to help restore confidence and to af-fect, over the years, inflation expec-tations, but it might not be sufficient to guarantee long-term economic growth and higher employment un-less it is also combined with non-conventional and ultra-aggressive economic policies, fiscal policies/in-centives, industrial and investment plans, innovation programs, and radical structural reforms affecting private firms’ and public adminis-tration productivity, labour market, welfare systems, free market compe-tition, performance-based compen-sation, meritocracy, etc. As I have reported in my paper of September 2014 titled, “Predictable and Avoidable: What’s Next?”, “The peripheral Eurozone countries need to focus their most critical resources on long-term development projects, strategic industries, infrastructures, new economic and business models, and innovative cultural and mana-gerial paradigms in order to gain new competitive advantages and to achieve global competitiveness. The

shift toward a more integrated and interdependent world economy, with falling barriers to cross-border trade and the progressive globaliza-tion of markets and consumer tastes, are rapidly forcing western econo-mies to rethink the sustainability of their economic and social models. Thus, the so-called advanced econo-mies, and in particular the Eurozone countries, need to pursue their chal-lenging goals of economic revival while trying at the same time to avoid generating the following nega-tive consequences.• Destabilizing social cohesion and

trust among member states;• Decreasing consumer and busi-

ness confidence;• Increasing distrust in national

and regional political and eco-nomic leaders;

• Rising levels of inequality and so-cial exclusion.” (Pezzuto, 2014)

Challenging global environ-mentThere is no doubt that we are cur-rently facing a challenging global economic cycle. Recently, the IMF revised downward global growth, while it also cautioned the Federal Reserve against raising interest rates

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Slowdown Blues

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in 2015 and suggested it to postpone rate lift-off to First Half of 2016. The IMF has reported that the dollar is “moderately overvalued” and a fur-ther marked appreciation would be “harmful”. The IMF has also stated: “We still believe that the underpin-nings for continued expansion are in place,” and that “The inflation rate is not progressing at a rate that would warrant, without risk (i.e. high volatility in the markets, correc-tions, potential spillover effects on the emerging markets, flash crash), a rate hike in the next few months. That means the Fed might decide to wait until early 2016, even if according to Christine Lagarde, IMF’s Managing Director, there’s a risk of “slight over-inflation” relative to the central bank’s 2 per cent target. A stronger dollar, declining oil investment and a West Coast port strike in the first quarter will pull down U.S. growth to 2 per cent this year, according to the IMF. Furthermore, she stated that the Fed’s policy-setting committee “should re-main data dependent and defer its first increase in policy rates until there are greater signs of wage or price in-flation than are currently evident.”

Beware of De-coupling risk!Although the US economy seems to be in a much better shape than most other ones, it cannot be considered in total decoupling from the rest of the world despite its unique innova-tive and entrepreneurial spirit and its numerous competitive advan-tages and comparative advantages versus other countries. The current global slowdown and the numerous externalities and potential economic, financial, and geo-political risks aris-ing around the world might have an important impact even on the US economy, and mostly on the busi-

ness interests of multinational firms operating on a global scale.The US economy, as some econo-mists fear, might be bracing for one of the worst first-half performances since 2011, but even if this will be confirmed by the data, would be probably triggered mainly by exter-nalities, global slowdown, high vola-tility, and structural problems.The major challenges that the US probably faces in its effort to revive its economy, like most of the advanced countries, include the long-term wel-fare system sustainability (i.e. pen-sion/retirement plans), its ability to balance sustained economic growth and the threat of shadow banking expansion, a generalized reduced trust in the financial institutions by the local consumers and investors as a consequence of the aftermath of the 2007 – 2009 financial crisis, the ability to reduce inequality and strengthen the economic prosperity and oppor-tunities for its the middle class and the less educated population, which has been severely penalized by badly planned globalization/unfair global competition, before and after the fi-nancial crisis, (i.e. “no enforceable

Is a Slowdown in the Offing?

“The appropriate policy decision is going to be data

dependent. Our opinions will shift as the data evolves

… there are a set of risks all of us need to weigh — in judging the appropriate

time. Waiting too long for normalization can risk overshooting our inflation

(targets), and beginning too early could derail a recovery we have tried to achieve for

a long time.” JANET YELLEN, US Fed Chair

with the ability to establish new in-ternational trade agreements to cre-ate a plain field competition that might further strengthen its global competitiveness and on the ability to encourage further expansion of internal consumption, investments, markets’ liberalizations, and innova-tive business models and global val-ue chains in the fast-growing emerg-ing marketsAnother potential risk for the US Economy could be related to the Fed-eral Reserve rate hike if not properly managed, although they are very much aware of this potential risk. Some analysts say that when the Fed starts raising interest rates, with bond prices falling, banks will be left with depreciating assets (Treasuries) and stuck with low yielding long-term loans. As the ‘rug is pulled from under the banks,’ the housing mar-ket might collapse as well, as stated by Peter Schiff. In fact, if monetary policy normalization in the USA is not completed smoothly and care-fully, in spite of improved corpo-rate profits and stock market record highs, there could be the potential risk of a strong correction in the markets, since the prices of various asset classes have been “artificially” inflated since 2008 by seven years of consecutive close to zero percent Fed Funds rates and three rounds of mas-sive QEs (Pezzuto, 2013). Overall, there might be challenges along the way, but I believe that the US econ-omy will remain a leading competi-tive player in the global arena and an influential and powerful trendsetter and benchmark for all economies.

TGA

strong labour standards, no en-vironmental stan-dards, low cost productions ar-eas, child labour, etc.”), as Stated by President Barack Obama. One of the key challenges for the US will be related