Hamish McRae: Shares are up, confidence is in the air, but it's still going to be a slog of a year

Economic View
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The Independent Online

A happy New Year? Well, on balance, probably a happier one than last year in the sense that the global recovery is more secure now than it was a year ago, and that will inevitably pull the UK up along with the rest of the developed world.

But it will be a year of tension, of dissent, and not just in Britain, for the early part of any economic recovery always feels scruffy and even a year from now the UK will still not have regained the level of output it reached at its last peak.

So what is going to happen? Let's start with the world and then come back to Britain later. I have been looking at the various economic forecasts for this year and the general view is that global growth will be somewhat faster in 2011 than it was in 2010.

You can already catch some feeling for the impact of that from the news of the past few days. For example, energy and food prices have been strong, a sign of demand from China and the rest of the emerging world. You could see that as a negative for us – higher inflation, more pressure on living standards and industrial costs – and in a way it is. But it is also a practical boost for companies throughout the developed world. There was a story last week about Land Rover, showing that global sales were up nearly one-third under their new Indian owners and that they were going to start assembly in China.

There are two other big things happening in the world economy: in northern Europe and in the US. Germany in particular but also Sweden, the Netherlands, Denmark and so on have been benefiting directly from global demand. Germany is doing astoundingly well. To take just one measure, its unemployment has been falling for 18 months and despite the impact of the bad weather, which nudged the numbers a bit last month, was at 7.5 per cent. In the US the recovery has been more of a jobless one, and that is causing a lot of distress, but growth has been quite good and looks set to be well over 3 per cent this year.

Global share markets have picked up the mood, becoming more and more confident about the recovery from the second half of last year onwards. The left-hand graph shows what has happened to share prices worldwide over the past two years, and in particular the way in which the medium-size and smaller companies have started to share in this recovery of confidence. Equities are a lead indicator of sorts, for in their incoherent way they managed to "predict" the turning point in the world economy about three months before it took hold in the second half of 2009. The fact that they have retained their optimism is encouraging as a sign that investors seem confident the recovery is broadening and deepening.

None of this is to play down the very real problems in the year ahead.

Take Europe. Yes, northern Europe is doing fine, but the southern fringe is not. Expect further rescues to be necessary this year. Or take the US. The big growth numbers are encouraging but the debts, both local and national, are dreadful. Some large cities are likely to default on their debt and the housing market remains dire.

So we can expect a year where the big numbers for economic growth are reasonably satisfactory but where there will be a lot of residual bad news – residual in the sense of leftovers from the recession, things that have yet to be sorted out.

From the point of view of financial markets, this is positive. Jim O'Neill of Goldman Sachs pointed out in a recent paper that the world economy was at something of a sweet spot at this point in the cycle. Policy was still expansionary and there was still plenty of slack in the economy.

But companies worldwide were benefiting from the growth. As a result he was bullish on equities for a while yet. It is worth remembering that UK shares have gone sideways for a decade.

As the right-hand graph shows, the FTSE 100 index is still more than 10 per cent off its high, reached at the beginning of 2000. Now you say that prices then were absurdly overvalued and you would be right, but I do find it an intriguing possibility that this year the Footsie might regain its end-1999 peak. Remember that this index reflects what is happening to the world economy rather than the British one, for at least two-thirds of the profits of its companies come from overseas.

Now come to the UK economy. We have a huge amount of sorting out still to do. Most people don't realise that, for all the talk of cuts in spending and the increases in taxation, we are still running a fiscal deficit that is almost identical to that of the previous year. It is going to be around £150bn this financial year, close to 12 per cent of GDP. We have hardly begun.

I must confess that I find the accusation that the Government is going too fast in cutting the deficit quite absurd – cloud cuckoo-land absurd. Even the previous government admitted that it had to correct the deficit, though it said it would do so over seven years instead of five.

So that debate seems to me to be a sterile one. The much more interesting issue is how the economy will respond. Here my instinct is that we will be surprised on the positive side by growth but on the negative side by public accounts. In other words, growth will turn out to be something over 2 per cent and there will not be the surge in unemployment that many fear.

That growth will be strong enough to withstand the first increases in interest rates which will come though before the summer is out. But the deficit will not narrow as quickly as it is forecast to do, largely because tax revenues will fall short of target.

We have to wait and see. What we can, I fear, be sure about is that this will be a year of dissent, a bumpy year, a work-in-progress year, a slog. But growth is better than no growth, even if the benefits of the growth have to go to cutting debts.

Britain must prepare for the inevitable: China's rise to economic superpower

The "when will China's economy pass the US?" debate got further legs last week with two new studies on the shift of economic power from the developed world to the emerging one. You may recall that when Goldman Sachs did its most recent calculations of that passing point, it came up with 2027. There have been others giving dates as early 2020.

Now two reports, both coincidentally entitled "The World in 2050" have come up with some other predictions. One, from HSBC, suggests that the shift in power will be rather slower than previous estimates. By 2050, China will indeed be the world's largest economy but it will pass the US some time in the 2040s, so still quite a way off. The other report, by PwC, thinks the passing point could be 2032, though if the exchange rate calculations are done at purchasing power parity, rather than market exchange rates, it would be 2018.

Which form of exchange rate conversion is more relevant? It depends a bit on what you are interested in. If you are looking at trends in trade, for example demand for natural resources, market rates are the ones that matter. If, on the other hand, you want to compare living standards, purchasing power is more appropriate. But I do wonder whether the very big divergences in these will persist.

There will be massive pressure on China and India to permit a rise in their currencies as their economies grow and there is already a lot of inflation in both countries – particularly from increases in wage rates. And on one point, anyway, there is unanimity: at some stage in the foreseeable future, China becomes the world's largest economy. There is no getting away from that.

All this leaves open the question of what the UK should do to benefit from this known and inevitable shift. Play to our strengths? But what are they?