Policy makers – particularly those that transcend national borders – normally ensure that they are singing from the same hymn sheet. But the updated World Economic Outlook (WEO) reveals that the IMF is (rightly) fed up with the ECB’s timid approach to monetary policy.
The IMF argues that monetary policy in the euro area remains slow to respond to the persistent decline in inflation and as a result, the region is vulnerable to any shock that leads to further disinflation or outright deflation. The IMF urges the ECB to take heed of market expectations, arguing that financial markets are already broadly anticipating further monetary policy (at the forthcoming ECB meeting on 22 January).
The IMF’s frustration with the ECB is understandable because it expects euro area to remain anaemic, growing by a paltry 1.2% and 1.4% in 2015 and 2016, revised down by around 25 basis points from the last WEO update in October 2014. This on the heels of the euro area expanding by only 0.8% in 2014.
The New Mediocrity and Dormant Animal Spirits
More generally, the IMF appears to have adopted the Larry Summers ‘secular stagnation’ view of the post crisis global economy, which it describes as the ‘new mediocrity.’ This view draws heavily on the Reinhart/Rogoff interpretation of history which shows that recoveries from balance sheet recessions are structural and therefore painfully slow.
The IMF lends support to this view by arguing that the downgrade to the global growth outlook primarily reflects dormant animal spirits; ‘investment weakness as adjustment to diminished expectations about medium term growth prospects’ and highlights the downside risks to prospective potential output. In terms of the numbers, the IMF expects the world economy to expand by 3.5% and 3.7% in 2015 and 2016, around 30 basis points lower than in October 2014.
But the IMF’s significant lift to the growth outlook for the US (to 3.6% and 3.3% for 2015 and 2016) should provide a reminder that cyclical factors have played an important role in the slow post-crisis recovery. Since 2012, the US Federal Reserve has been arguably the most aggressive central bank in its conduct of forward guidance and quantitative easing, an approach which has clearly been informed by the policy errors committed around the Great Depression and recession in 1937.
The divergent growth paths of the United States and euro area in recent years should help to dispel the myth that the monetary policy is ineffective at the zero lower bound. The counterfactual of tighter monetary policy in the United States would surely have been associated with higher and rising unemployment and slower growth, which the euro area has experienced.
Encouragingly, the IMF endorses the aggressive conduct of monetary policy to reduce the still large output gaps in most economies. It argues that central banks must remain alert to the possibility that further disinflation does not lead to an additional drop in inflation expectations. This would surely be a positive for most asset classes thanks to an abundant supply of liquidity.
Please Curb Your Enthusiasm...
The IMF is not alone in downgrading the outlook. Like many economic forecasters, it has under-estimated the lingering effect of the financial crisis and the timid responses from many central banks. But the IMF has tended to be too optimistic over the sweep of the past two decades; it has persistently over-estimated world growth over two thirds of the time (a chart is available on request).
Unlike sector analysts who are incentivised to offer excessively optimistic forecasts of company profitability to curry favour with management and garner corporate banking business, it is a puzzle that the IMF’s forecasts have exhibited excessive optimism.
...but China's Outlook Is Too Pessimistic
But its forecasts for China look unusually downbeat. It has downgraded China’s growth to 6.8% and 6.3% in 2015 and 2016, citing the greater willingness of authorities to address the vulnerabilities associated with rapid growth in credit and investment of recent years. But growth of sub-7% appears to be at odds with the history of growth for a number of Asian economies over the past half century, at a comparable level of China’s development today.
My yet to be published analysis suggests that growth in GDP per capita of 7.5% is sustainable over the next two decades, underpinned by catch-up as it continues to borrow from already developed technologies and know-how.
Investment Implications - Overweight Safety
As long as the IMF and other economic forecasters continue to downgrade expectations of global growth, investors should be overweight safe assets and defensive sectors within stock markets, particularly companies that offer sustainably high payout yields, and strong earnings predictability.
Australian stocks that score strongly across screens for payout yield (including capital returned via buybacks) and earnings predictability include: CSL, NVT, AMC, TLS, DLX, WOW, APA, CBA, BXB, SYD and CPU (the full rank of stocks is available on request).