Domino effect

Why the IMF should take its own negative outlook more seriously  |  The IMF in its World Economic Outlook last week reduced its forecast for world GDP from 3.7% to 3.4%. A less-noticed fact was the reduction in its forecast for Goods and Services trade growth to 4%, from a bullish 4.7% back in April. As world trade growth has so far this year been zero, even a 4% increase for world trade growth seems rather too positive. Delta Economics is currently forecasting just 0.2% growth this year.

The IMF’s forecast is more negative because of a weak first quarter in emerging markets and the US. Its forecast for 2015 is unchanged and it sees the minor correction as simply a reflection of this. In other words, it sees the same recovery in the second half of 2014 that it saw back in December last year. Nothing has changed except the facts from the first quarter.

Far be it for Delta Economics to be cynical, but if the first quarter and the current evidence on the second quarter of 2014 is less positive than expected, then there will have to be a big improvement in economic fundamentals in the second half of the year to meet even the expected growth forecasts. As the IMF itself points out, there are big downside risks at present – geopolitical and economic. These suggest that maybe the IMF should be taking its own slower growth forecast more seriously than it currently is.

The first reason for the IMF to heed its own warnings is that there is increasing discussion about asset bubbles. While markets do not appear to be responding particularly adversely to anything at the moment, the volatility index (VIX) rose towards the end of July suggesting that, despite the apparent confidence in markets, investors are waiting for someone to make the first move. Trade has historically presented a good forward indicator of slower GDP and slower than expected trade growth, as in Figure 1, has to be a potential flashpoint for markets to start thinking about economic fundamentals.



Figure 1  |  Value of World Trade (USDbn) vs S&P 500 Last Price Monthly, June 2001-June 2014
Source  |  Trade data; DeltaMetrics 2014, S&P 500 data, Bloomberg


The ebullience of the S&P 500 is out of kilter with the underlying business fundamentals. Given the bad track record of economic forecasters over the last ten years, it is perhaps understandable that markets no longer trade on fluctuations in GDP. But trade is different: it represents the real activity of businesses, not of governments, and while it can be altered at the margins by policy at a country level, at a global level, flat trade means less international business activity.

Some of this may, of course, simply be because the emerging economies have been having a hard time since the beginning of the end of US tapering was mooted at the end of 2013. If there is any increase in US base rates and/or an increase in the value of the US Dollar against emerging market currencies, then the costs of dollar-denominated debt rise and nervousness about default increases. More than this, as trade weakens, there is pressure on governments to increase their interest rates in order to ensure that exports are price competitive putting further pressure on domestic consumption in emerging markets (or even peripheral European markets) as wages are squeezed.



Figure 2  |  Value of trade between emerging economies (USDbn) versus Yuan per USD Last Price Monthly, June 2001-June 2014
Source  |  Trade data: DeltaMetrics, 2014; CNY-USD data, Bloomberg


Does this matter? Figure 2 suggests yes for two reasons. First, trade between emerging economies is not growing at the rate it was immediately post-crisis or, indeed, fast enough to fuel rapid growth and development in smaller emerging economies. Second, the Chinese Yuan is managed and is increasingly important as a trade currency and arguably too as a bellwether currency for emerging markets. This process will accelerate as the BRICs Bank becomes more established as a source of trade and infrastructure finance.

More than this, the correlation between the Yuan’s value and trade between emerging economies is nearly 95%. If trade between emerging economies continues to grow at its lack-lustre pace, this will impact on the value of it and of other countries currencies as well. For example, the correlation between emerging market trade and currency value is nearly 70% for the Real, 93%, the Thai Baht 93% and the Turkish Lira, Mexican Peso, Nigerian Niara and the Singapore Dollar all between 60% and 98%. And before we think this is just an emerging market issue, if emerging market trade continues to be sluggish, it will affect the Australian dollar and the Euro as well with correlations respectively of nearly 90% and 66%.

Interdependency like this comes from the domino effect created by global supply chains and is the second reason why the IMF should heed its own warnings more closely. The July G20 Summit in Brazil was little noticed, largely because it was squeezed between the very geopolitical events that threaten world trade: the shooting down of the Malaysian Airlines flight MH17 over Ukraine, heightened tensions in Gaza and fear over the effects on investment of the current Ebola outbreak in Africa. It appealed for global growth to be led by trade and investment, and was supported by a report by the IMF, the World Trade Organisation and the OECD arguing that supply chains are an important part of driving this growth through the opportunities they offer across the world.

Delta Economics has stated this for sometime, but while the consequences of global supply chains on business competitiveness are clear there is still a long way to go before these are fully realised. Trade between emerging economies is largely in commodities and intermediate manufactured goods, for example. Trade between emerging economies and developed economies tends to be similar in terms of its structure. Value is added by developed world economies, which then export finished goods back to the emerging world. This yields the higher correlations between, for example, copper prices and trade between the developed world and the emerging world than between emerging world trade, as illustrated in Figure 3.



Figure 3  |  How the computer and electrical machinery supply chain explains the fragility of the global trade system
Source  |  Delta Economics analysis


In essence, the challenge is this. Global supply chains are highly correlated with asset prices. Copper in its raw forms is imported into, say, China, and converted into intermediate and final electrical machinery, such as computers. China’s imports of copper products from Chile (shown in Figure 4) are less correlated with copper prices than its imports from the either Australia or South Korea because although its largest importer is Chile, it is importing less processed copper from there.




Figure 4  |  Value of China’s imports of copper and copper products from Chile vs copper last price monthly
Source  |  Trade data – DeltaMetrics 2014, copper price data – Bloomberg


China adds value to the copper and its exports of computers and electrical/electronic machinery (including semi-conductors) is highly correlated with copper prices. Figure 5 shows the nearly 88% correlation between its exports of computers and electrical/electronic machinery to the Netherlands for distribution across Europe.




Figure 5  |  Value of Chinese exports (USDm) to the Netherlands of computers and electrical/electronic machinery vs copper last price monthly
Source  |  Trade data, DeltaMetrics 2014; Copper price, Bloomberg


If the financial crisis taught us anything it was that the world’s banks are inter-dependent: one topples and the others fall too. The importance of supply chains cannot be understated – there are undoubtedly opportunities for businesses globally. But arguably trade, through supply chains and trade finance, almost by definition exhibits the same interdependencies and, as a result, the same risks. Figure 3 shows the high correlations between copper prices and equities and currencies: if copper prices continue to fall because trade is stalling, then eventually we can expect equities and developed market currencies in particular to fall against the US Dollar.

The game dominoes originated in China, making its first appearance in Italy in the 18th Century. The Song Dynasty that is accredited with inventing the game was the first to have a paper money and the first to have a merchant navy. But it is the Dutch that have had a dominoes toppling competition since 1986. Let’s hope that the forecast growth in -0.2% and -0.8% respectively for Dutch imports and exports of computers into 2015 is not the start of a new domino toppling world record.

Trade and the Ides of March

Why the tide might not be rising | The International Monetary Fund (IMF) published its World Economic Outlook last week under the title, “Is the Tide Rising?”  For anyone struggling with floods in the UK at the moment, this title is either a bad joke or a timely reminder of the fact that economic forecasting, it is said, is designed to make weather forecasters look good.

The IMF expects World GDP growth to be higher, at 3.7% during 2014 rising to 3.9% in 2014 and while it points out the downside risks to the recovery, especially in emerging markets, there is a distinct air of optimism about the forecast.

Yet world trade, and the World Trade Organisation’s (WTO’s) outlook for world trade, remains flat with no return to the multiples of GDP that were seen prior to 2011.  The last forecast that the WTO published for 2013 was that world trade would grow and their own Head, Roberto Azevêdo was last month expecting the actual numbers to come in lower than that calling its relatively optimistic forecast for growth in 2014, of 4.5%, into question immediately.

The WTO is being characteristically positive at the start of the year as illustrated in Figure 1 which shows the forecast against actual trade.  The figure for December 2013 is provisional and will not be confirmed until April 2013.  The annual peaks in the forecast are in the first quarter of each year – Spring Tides, maybe.


Figure 1 | WTO forecast for World trade growth vs Actual growth: October 2011-January 2014

Source | DeltaMetrics 2014

The reason for the peaks in the forecast in the first quarter of each year are evident from a closer scrutiny of world trade data on a monthly basis, as illustrated in Figure 2.


Figure 2 | World trade growth: 2001-December 2014, actual and yeay-on-year

Source | DeltaMetrics 2014

NOTE: Data is actual IMF data up to September 2013, is Delta Economics estimates to January 2014 and thereafter forecast

Figure 2 unsurprisingly shows the big year-on-year drop in trade in 2009, but it is the time after that, especially since October 2010 that helps us explain why the IMF and WTO are optimistic at the start of every year.  There are cyclical upticks in trade in each year in Q3 and Q1 which, when examined as part of a “Net export” effect in GDP forecasts, have a multiplier effect.  However, what is clear from the analysis of year-on-year changes in Figure 2, is that the momentum has been downwards (both actual and estimated) since mid 2011 and that the pattern of post-crisis trade is actually substantially different to pre-crisis trade.

The other reason why the WTO and IMF may be over-optimistic in their start-of-year forecasting is because of the seasonal volatility in China’s trade data presented in Figure 3. Each year, a major drop in Chinese trade, visible throughout the period between December and January is upwardly adjusted by March leaving the trend trajectory one of growth.  These swings have been particularly obvious since the financial crisis and although there are similar seasonal patterns in Germany, the US and the UK but the swings are less marked.


Figure 3 | Selected Countries’ Export Growth, June 2001-December 2014

Source | DeltaMetrics 2014

Based on the IMF’s own data up as far as the end of September 2013 as these charts are, it is easy to see why Roberto Azevêdo might be cautious about trade growth in 2013.  However, historical growth is of interest only to economists attempting to establish the scale of the damage that is currently being done by the slow-down in world trade.

What is more worrying is that the lessons from past trends seem to be buried in the past as well and that more recent analysis of what is happening with trade is focused simply on a dogmatic assumption that world trade growth has to return to a multiple of GDP growth (often taken to be 2.5 times GDP growth) if the world economy as a whole is to reach an “escape velocity” growth.

Trade since the crisis exhibits different patterns, more volatility and much slower year-on-year growth than pre-crisis.  Evidence from sectoral analysis of trade suggests that this is because global supply chains are using local content to service local markets and that global regional analysis yields more insight into how this fuels trade within regions rather than between regions.  While trade between emerging economies, which is highly commodity focused, remains flat because of the current economic challenges they face, the effects of export-led growth will be limited.

The temptation is nevertheless to watch trade growth and assume that, if it picks up, it will lead automatically to an increase in GDP.  We can expect a market rally during March when, if past trends are replicated, the tide really does rise and Chinese trade data for Q1 is corrected.  While the Delta Economics’ forecast suggests only modest trade growth in 2014 at around 1.6%, and while this is substantially below the current WTO forecast, as Brutus said, “There is a tide in the affairs of men, which, taken at the flood, leads on to fortune.”  This may only be short-lived, and all forecasters (whether economic or weather) should beware the Ides of March.