What is to be made of the likely direction of the global economy as we head deeper into the first quarter of 2014? On the plus side we have the World Bank’s January 2014 flagship report Global Economic Prospects, which is about the most upbeat forecast seen since the 2008 financial crash. The World Bank takes the view that after several years of pronounced weakness developed markets (DM) are starting to grow again, adding, in its words, a second engine of growth to the global economy, and pushing forecasts of global growth up from 2.4% in 2013 to 3.2% in 2014, 3.4% in 2015 and 3.5% in 2016.
Steady growth for years ahead – now there is something we haven’t had a major institution say for a very, very long time. And it echoes some encouraging noises the International Monetary Fund (IMF) has been making in recent months. Since, as we all know, sales of executive jets are highly correlated to the economic cycle, this forecast might be expected to generate a warm glow in the hearts of everyone involved in the business aerospace sector. (OK, ultra long range sales have held up reasonably through five years of lacklustre growth, but sales in other categories have been poor to dismal.)
However – and unfortunately there is a very big ‘however’ to be worked around – the subhead to the World Bank’s report also demands our attention: “Coping with policy normalisation in high-income countries”. This subhead is a tad opaque for non-economists and those who do not watch markets particularly closely. What it refers to is that since the crash the US and Europe have reduced their interest rates to zero or near zero and have been trying to stimulate their sluggish economies through quantitative easing. The US is now returning to growth, as is the UK, with some encouraging signs in Europe, and obviously this period of wildly unconventional monetary policy strategy by key central banks can be expected to draw to a close. But you knew that, right? The deeper point is that a good deal of the money that has, over the last four years or so, flowed into emerging markets (EM) like India, Brazil, Turkey and South Africa, in search of higher returns, is now flooding back to developed markets in expectation that since growth is returning, interest rates will climb again and DM stock markets will rise (and rise they have, hitting record highs through December and most of January).
Does this outflow of money from emerging markets matter? The answer is not just yes, but hell yes. It matters hugely if it turns out that these outflows destabilise a sufficient number of emerging markets to disrupt the global economy. Remember, the World Bank report talks about two engines of growth. We very much still need the outperformance in emerging markets to continue in order for developed markets to get sufficient traction to start pulling their weight again.
In its report, the World Bank, being a sensible body, takes this outflow from emerging markets into account. But it argues that what we will see will probably be an orderly rebalancing across the investment spectrum. Yes, companies in developing markets will not be able to find US dollar denominated loans at the ridiculously low interest rates they have been enjoying so their cost of capital will go up. But emerging markets should still grow at a very handsome pace by comparison with developed markets. The World Bank’s forecast is that growth in developing economies will pick up modestly from 4.8% in 2013, to 5.3% in 2014, 5.5% in 2015 and 5.7% in 2016. However, the World Bank adds this caveat. If, instead of an orderly rebalancing, interest rates start rising sharply in developed economies and the marbles start to skitter around as companies in developing countries find themselves unable to pay back their dollar loans, then we are headed for a different scenario altogether.
As the report puts it: “… the rapid spike in long-term interest rates during the summer of 2013 suggests that a much more abrupt rise in long-term interest rates is also a possibility, if less likely. In such a disorderly adjustment scenario, capital flows to developing countries could decline temporarily by 50 percent or more for a period of several months – potentially pushing one or more countries into crisis. Evidence suggests that countries with large current account deficits or those that have had a rapid accumulation of credit in recent years could be most vulnerable to a precipitous tightening of international financial conditions.”
In fact, the world did not have to wait for any spike in long-term interest rates for at least a flutter of panic to set the wheels in motion for the potential start of an emerging market crisis. On Friday 24th January several emerging market currencies saw precipitous drops against the US dollar, beginning with Argentina’s peso, and spreading rapidly to the Brazilian real and the Indian rupee. This sudden collapse in EM values gave traders a case of the jitters in developed markets. Stock exchanges, which had been at record highs, went into correction mode, with their indexes losing hundreds of points by the close as people sold emerging market stocks and companies with exposure to emerging markets. Equities generally got hammered as money poured out of equities and into traditional defensive hedges for value such as gold and the US dollar. (As the deepest pool of liquidity on the planet the US dollar generally rises against all other currencies when a wave of fear hits the markets.)
Whether Friday 24th January turns out to be the start of another crisis or just a more or less normal market correction after a period of market exuberance, will become visible over the coming weeks and months. Of course, deals that are in process do not instantly slam on the brakes every time the markets stumble. As Cornelis Smaal, Head of Global Finance at PWC, one of the world’s top four accountancy firms, notes, deal-making picked up quite noticeably in 2013 and maintained, or even added to that momentum as we move deeper into the first quarter of 2014. Corporates buying and selling other corporates is a huge driver for business aviation since it is one of the major factors that gets company executives using private jets as they look to kick the tyres on potential acquisition targets all over the world.
“I would say that deal activity has recovered to the point where it is somewhere around 50% to 60% of the volumes we were seeing at the height of the boom in 2007, but there is no doubt that the market is still relatively fragile. However, there is now a very strong driver pushing companies to look for acquisitions. They have done as much as they can since the crash by way of pushing through efficiency gains and cutting costs. To improve their growth rates they cannot look to more internal growth. They have to get on the acquisition trail if they want to present shareholders with an attractive growth story going forward,” he comments.
The other factor helping to drive deals is that many companies are probably as cash rich right now as they have ever been. They have the money to make acquisitions, so it is a question of identifying the right targets. Every region is showing some deal activity, Smaal says. Even Europe, which has been very patchy, is on an upward trend in terms of numbers of deals done. In all of this, private aviation has a key role to play. “In deal-making, time is of the essence. In the wake of the crash many management teams were a bit cautious about being seen to be using corporate jets, but now, as M&A activity picks up, we are going to see management teams using corporate jets more and more to look at targets,” he says. If a company looks good to one potential buyer, you can bet that it will look equally good to half a dozen others, so speed is critical and hanging about waiting for scheduled airlines is not going to get the job done.
Marko Papic, Chief Strategist at the geo-political analysis house, BCA Research, says that while he and his team are pessimistic about emerging markets generally in 2014, they see growth markets being positive. “There are definitely some good signs about, despite the emerging markets weakness. We have been telling our clients to get out of emerging markets for over a year now, since developed markets are a much less risky story,” he comments. One very important factor to take into account, Papic says, is that while the US has moved to cut back somewhat on its quantitative easing programme, the dominant monetary policy is still very much geared to easing, rather than tightening through sharp rises in interest rates.
A second really important point is that inflation is low in Europe and the US and both are still producing well below their capacity. This means that there is still a big ‘output gap’ (the difference between what a country could produce and what it is actually producing), and output gaps constrain wages and help to keep inflation very much in check. This being the case there is little pressure on central banks to raise interest rates to combat rising inflation. So continuing accommodative, low interest monetary policy looks likely for some time to come, and that is growth positive for developed markets, Papic notes.
What worries Papic particularly about emerging markets, however, is that for the most part the huge dollar loans that companies in emerging markets went in for while rates were close to zero, have not been wisely used. “We do not see much evidence that companies used the loans to generate additional revenue or internal efficiencies. Productivity has been declining quite drastically in many emerging markets, with the year-on-year decline going all the way back to the 2008 crash,” he notes, adding: “You cannot get away from the fact that GDP growth equals productivity growth plus labour force growth. Emerging markets have generally not initiated the structural reforms required to improve productivity. Corporates and policy makers need to do some difficult things and do them quickly, if emerging market growth is going to be sustained,” he concludes.