2014 and the Business Cycle: Continuing Recovery and Another Year of Opportunity in the Stockmarkets?

First off, Happy New Year to all my Econoblog readers.  If you want a review of 2013, rather than rabbittng on here, I thought I would just point you to a wonderful article in The Atlantic on the Most Important Economic Trends in 2013 which you can find here. In this Econoblog I want to look ahead to what might happen in 2014, as some eminent economists have been doing at the most recent American Economics Association meeting..

As the business cycle is now in heading into the later part of the cycle, with the danger of recession and deflation receding, most countries will experience accelerating growth this year.  Although markets are jittery about the Fed’s signal to taper monetary policy, this is long overdue in my view, and will only have a marginal effect on economic growth in the US and other developing countries.  The economic process of re-invigorating the economy through stimulus has now done its magic, and in North America, Europe and now Japan, the growth dynamic has started to take on a life of its own, so that the agents of stimulus can now withdraw their assistance as a catalyst for economic growth.

So there are 2 further issues here – first, how will economic growth be distributed among the developed countries, and second, given what is going on in the developed world, what are the prospects for the developing countries.

Although the consensus is almost uniformally positive for the US for 2014, it is still probably the most uncertain country in the developing world to forecast for 2014, as there are so many factors that might impinge upon economic growth rates. The most notable are fiscal matters and the political problems in Congress, the ongoing taper, and when the actual tightening of monetary policy will begin, how movements in long term interest rates will impact the housing market and also lastly, how the dollar will behave during the upcoming year.  If the current truce in Congress yields more bi-partisan consensus on how to move ahead in other contentious areas (such as immigration reform, for example), then this could boost growth as confidence is at least partially restored in the US political process.  Given a brighter fiscal outlook, this would mean that Fed purchases of government bonds could be slowed much more quickly than Mortgage backed securities (MBS), which would allow a residual boost to the housing market rather than propping up a shaky Federal government credit rating. Longer term interest rates are key in determining the course of mortgage rates, and if the Fed keeps these low enough for long enough, the housing market could really boom, setting off a real investment boom in the rest of the economy.  Of course everything could go the other way as well, leading to a further downgrade in the credit rating of US debt, a Fed that ends up having to reverse the taper because of a sagging labor market, and a housing market that experiences a bubble because of prices rising too far too fast. 

In my view, the history of economic cycles points to a positive future though for the US, and although some of the shorter term cyclical effects will be present, the dominant longer term cyclical features will push the US forward without any major internal economic dislocations, leading to another good year for both the housing and stock markets.  This of course implies another bad year for the bond market with yields moving upwards to levels more typically associated with this stage of the business cycle.

But perhaps the best opportunities in North America lie not in the US, but in Canada.  The Canadian market has been extremely stable through the recent turmoil and the Canadian stockmarket has really not shown much of a return compared with its US counterpart, which in my opinion is almost counter-intuitive, but is probably based on the perception that Canada has an economy based much more on commodities than the US does.  Nevertheless, in my view the Canadian market still has much less downside risk that the US market does, and much more upside.

Japan and the EU have less potential for growth as demographic factors restrain both entities. The fact that Abenomics seems to continue to deliver the goods will push Japanese markets higher and lead to the deflationary threat receding.  In the EU the resurgence of the northern member states will continue and the Southern member states will start to emerge from the difficult deflationary period they have been in. 

The biggest risks, but also the biggest rewards in 2014, lie in the developing world.  Developing country markets were rocked by the initial announcement of a taper, but now that the ongoing taper and then tightening has been priced into the markets the real effects on the developing markets should be apparent. As monetary tightening occurs in the US, so the liquidity glut will start to disappear, putting some pressure on developing countries.  Now the big question is, how big will the impact be on countries like the BRICSA countries.  Brazil should be cushioned by the massive infrastructure spending going on there for the Olympics and the World Cup, while Russia really is not dependent on the stimulus as it is natural resource prices that really drive the Russian market.  South Africa is certainly not a large holder of US bonds so the taper will likely have minimal effects on that country.  No, the biggest risk is in both China and India, where both countries have a significant interest in holdings of US debt. 

Given the negative announcement effect of the Fed’s taper, I believe that possibly the best performing markets will be in Canada, parts of Latin America, Africa and parts of Europe next year. Now I have put my neck on the line, let's see what happens!

Europe, the US and a missed opportunity to initiate a EUSATA

Spencer Gore - The Cinder Path (from the Tate Collection)

Now you're probably thinking "what has happened to this Crowley dude?"  Why hasn't he been posting like crazy with all that's been going on in Europe?  Well, to be honest I've been busy - very busy as a matter of fact - setting up and then hosting a workshop in Helsinki at the Bank of Finland (see here if you don't believe me). After getting over the jetlag, then catching up on the backlog of things that needed to be done at University, I have only had a chance over the last few days to really reflect on what has been going on (and is still going on) in Europe and indeed on the world stage.

And (as they say in Texas) it ain't pretty!  But rather than dwell on events that change by the day, hour and sometimes the minute, I thought I would reflect on what could have been done and what really   matters in Europe now.

I remember when the euro was first launched that I was sceptical - I wrote a few papers using cluster analysis  (still available on my website) that showed that the peripheral EU countries did not display the same macroeconomic dynamics as the "core" countries in the centre of Europe. Underlying this view in economics is something called the optimal currency area theory which basically says that if your cycles are different from a bunch of other countries, then you shouldn't be using the same money. And just to make the point here, when I say "cycles" I mean all cycles, not just the business cycle.  Of course we all know what happened - the euro area happened and the criteria for joining the euro had virtually nothing to do with the optimal currency area criteria.  At first I thought that the euro area wouldn't last, as not only was it not an optimum currency area but also the legal underpinnings did not appear to be in place to support the single currency. Well I was proven wrong on that one and indeed the euro lasted through it's 10th birthday in 2009 to much fanfare, but after 2009 things have started to fall apart, and not at the point that you'd expect - after a severe recession. If you look at the growth dynamic of countries emerging from a recession the dynamics are usually extremely aligned - I've also done some research on this using a technique from physics called "recurrence plots". The difference though here is the debt problem that Greece faces, the fact that the debt was much higher than it should have been on entering the euro area and also their inability now to do much about it as their economy is mired in a downward growth spiral caused by the cutbacks and tax increases necessary to put them on a "sustainable path".

The problem is not just that the peripheral European countries shouldn't have been in the euro, the problem is that even with the low interest rates that the ECB is now delivering ( - now even lower after Draghi's surprise decision to lower rates last week) the peripheral euro area member states are just not growing, and the best way to get the debt to GDP ratio down is to have growth to lower the ratio as the UK is now also finding out.

So how do you stimulate growth? There are two approaches - spend and lower taxes ( - which is usually the favored route in the US) - or go for structural reforms which change the economy or its external relations in such a way that it gives businesses new incentives which jolts the economy into growth. It was heartwarming the other day to hear that that is exactly what is happening (and what I predicted) right now in Japan after the Tsunami. Just listed to this and you'll see what I mean. European member states cannot initiate more government spending or tax cuts, so structural reforms (so most economists say) are what is needed. But these are going to be hard - noone likes to lose job security in a high unemployment environment, and noone likes to have government programs reformed to give people less benefits (as has happened with teachers in the UK, Greece and it's on the tables in Italy as well).

But there is a solution that would help, and rather surprisingly the politicians who meet at the G20 summit in Cannes, France this week did not seem to get it. Indeed this was rather surprising given the motto of the summit in french read "New World, New Ideas" ( - sorry I know, I'm being sarcastic!) - in fact the lack of new ideas was enough to make anyone following all this to get out the St. John Wort tablets. This idea I had is not new, it's just that noone seems to have thought about it in the context of trying to solve the current global growth problems. At a roundtable of Consuls General from France, Germany and Italy in Houston lately, I asked it as a question and I seemed to get a bemused response from the participants. The Italian Consul General even said "it's just too complicated so it is never really considered an option", and the other Consuls General appeared to agree with this view.

So what am I talking about? In short, a TAFTA - which stands for a TransAtlantic Free Trade Agreement. Of course this is not technically correct as a TransAtlantic trade agreement should really include Canada....but wait, the Canadians are soon going to conclude their OWN trade agreement with the EU called the CETA (Comprehensive Economic and Trade Agreement) and the Mexicans already have agreements with the EU in place. I guess I would call what might emerge a EUSAFTA (- an EU-USA FTA).

But why now? First, the US Congress passed and President Obama recently signed and recently lauded new trade deals with both South Korea, Columbia and Panama. So although the US government is "broken", lawmakers on this side of the Atlantic seem to still be able to get their act together when it comes to trade deals, so there is at least a glimmer of hope there. Second, the trade flows that we're talking about are the largest in the world when you add up all the European Union member states - and yet these trade flows have not been liberalized (as anyone shopping for European cheeses knows only too well). But more to the point, the structural change (and hopefully "net boost") to the economies on both sides of the Atlantic would be significant, leading to an acceleration in growth, and indeed given how big both entities are, global growth. And third, as part of the G20 communique, leaders called for a study to be done on how to get an "early harvest" on some of the gains that could be culled from the failed "Doha round" of GATT talks which were held under the auspices of the WTO - well, hmmmm, let's think what caused the GATT talks to collapse in the first place - yes, you got it, the EU and the USA not being able to agree on agriculture! So getting them to push their heads together and negotiate something (even if you leave agriculture out) would get the diplomatic channels opened up further, and might allow a deal to also be done on agriculture which could allow the Doha round to be restarted.

Clearly getting agreement on a EUSATA would not be easy, but the potential payoff is just too great to ignore right now. We all know that just getting the trade representatives to sit down and talk will boost economic growth as businesspeople will become more optimistic about the fact that something is being done by our governments to try and boost growth. In my opinion it is the best way to get the economies on both sides of the Atlantic out of their current economic policy quagmires.