Encima Global Projects World GDP Will Shrink in 2015

With disinflation spreading, we’re lowering our 2015 forecast for world dollar GDP. We had thought that global GDP would grow enough in 2015 to provide a platform for some further growth in U.S. corporate earnings, a key issue for equity prices and asset valuation.  However, we now think world dollar GDP will decline 0.4% to $76.7 trillion in 2015 from our 2014 forecast of $77 trillion. A 2015 decline would be the first since 2009, with negative implications for corporate earnings and equity prices.

• The reduction in our 2015 world dollar GDP forecast is due to recent foreign currency weakness, the oil price decline (which lowers the dollar value of the world’s output),  the sharp weakening in nominal GDP expectations for Japan and the Eurozone as their recessions deepen (new Europe data due Friday), and recessions in South America, Russia and eastern Europe.
• The IMF’s October forecast for 2015 world dollar GDP is $81.5 trillion, which we think is also the consensus that is priced into global equities.  That is too optimistic given recent developments, and relies on the assumption that central bank stimulus will suddenly start having a positive effect on growth and inflation. The IMF has $77.6T in 2014, up 3.9% from 2013.

A key longer-term issue is whether the disinflation process becomes self-reinforcing. The risk is that shrinkage in nominal terms causes the value of fixed assets and inventory to decline but leaves debt levels intact, in effect increasing the debt burden in real terms. Long debt maturities provide protection from inflation, but not from deflation, which will concentrate the problem on individual countries and companies with declining asset and inventory values regardless of their debt roll-over capabilities. 

• Rate cuts aren’t available as a policy response now since rates are near zero.  If there is disinflationary selling pressure (e.g. excess inventories beyond the oil sector), the lack of an interest rate safety net may exacerbate the selling pressure.  As discussed in our 2013 pieces, there’s no particular bottom for gold (or ceiling for the value of the dollar) unless U.S. regulators decide to improve regulatory policy (going the other direction so far); or the U.S. or Europe cuts tax rates (President Obama and Chancellor Merkel have largely rejected that approach, though Japan is considering a delay in its 2015 tax hike.)  An improvement in regulatory policy would allow more money in the private sector as financial leverage increased, allowing faster growth in the M2 money supply and in private sector credit and softening the disinflation spiral. 
• We think there is still an insufficient appreciation of the powerful disinflationary forces at work around the world. Euro-zone inflation year-over-year is only 0.4%, with the impact of recession and oil price declines still to come.  U.S. inflation expectations have fallen sharply in recent months (see graph).  Gold is continuing to fall and the CRB commodity price index has begun a sharp decline. 
• The forces at work include plentiful supply, weak wage growth, the collapsing pressure on balance sheets from Europe’s negative interest rates, dollar strength (as reflected in the continuing decline in gold prices), and tight financial regulatory policy, which is causing dollar strength and very slow growth in private sector credit and M2 money supply in many countries (see graph.)  Weak business lending remains a major overhang on the outlook. Commercial and industrial lending grew at only an 8.4% annual rate in the 13 weeks through October 29, down from a 23% rate through April 16, and well below the C&I growth rates in 2011-2013.

World dollar GDP provides a useful model for assessing the outlook for dollar-based corporate earnings.  Both are expressed in nominal terms and are sensitive to GDP growth rates, devaluations and oil prices.

• For example, in 1998, with gold and oil prices falling and currency devaluations at work, global dollar GDP shrank 0.4% in 1997 and 0.7% in 19998 despite continued U.S. GDP growth. The S&P 500 fell 22.4% from July to October 1998. In response to the 1998 crisis (devaluations in Asia spreading to Brazil and Russia, trading losses at Long-term Capital Management), the Fed lowered the Fed funds rate by 0.25% on September 29, October 15 and November 17, 1998 -- from 5.50% to 4.75%.  That policy isn’t available now.
• Even with new-norm growth in U.S. real GDP, dollar-based corporate earnings face a difficult environment in 2015.  Nominal GDP growth will be weaker-than-expected in most foreign markets; earnings from abroad will be translated into dollars using weaker-than-expected currency rates; and companies have fewer avenues for financial engineering than in recent years as interest rates and bond yields stabilize at low levels and many of the one-time expenses excluded from operating earnings turn out to be recurring. Currency hedges are usually short-term because of their high cost, so most of the protection for dollar earnings will wear off in 2014 or early 2015.  For many companies, cost cutting has been a major driver in earnings growth for several years, combining with reductions in interest expense to generate earnings growth.  We think those have run their course, limiting the outlook for earnings growth in 2015.  
• A shortfall in earnings from abroad and in financials is already showing up.  In the NIPA accounts, earnings from abroad peaked in the fourth quarter of 2011 at $438B and have fallen to $402B (all are annual rates).  We expect further declines as currency weakness takes effect.  Earnings from financials peaked in the third quarter of 2013 at $510B and have fallen to $449B, of which the Federal Reserve provide $93B.  Domestic nonfinancial earnings reached a new high in the second quarter, but the quality of those earnings has been deteriorating (e.g. gap between operating and reported profits.)

Conclusion: The ongoing weakness in global GDP growth is due to bad monetary/credit policy and lack of structural reforms, in our view.   Monetary and credit policies are contractionary and disinflationary, causing deterioration. We think structural reforms in Europe are the key variable in the outlook because their economic decline is proceeding so rapidly.  We disagree with the view that ECB stimulus or negative interest rates can be effective in providing stimulus.  They worsen the deflation rather than softening it.  The policy paralysis in Europe and Japan calls into question the equity market’s still-optimistic consensus about earnings and global growth in 2015.

David Malpass is the President of Encima Global and a contributor to e21.

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