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Advice on strategic issues for governments

On canaries in the mine and the dog that didn’t bark

David Skilling
26 March 2017

Another Sherlock Holmes series recently concluded on BBC, reminding us that things are seldom as they seem. In one of Sherlock’s previous cases, the key clue was ‘the dog that didn’t bark in the night’. Given the remarkable events of the past year, from Brexit to Trump and beyond, with rising risks to the functioning of the open global system, the behaviour of the global economy and markets is the contemporary non-barking dog.

The global economic recovery continues, with strengthening economic data around the world. World trade growth is showing signs of life after a very weak couple of years. And interest rate normalisation has started in the US. Similarly, global markets are shrugging off troubling political dynamics – with some localised exceptions, such as the GBP reaction to Brexit news or the pricing of the French presidential election. Despite some selling activity this week US markets remain close to record highs, European markets are travelling well despite political risks, and many emerging markets continue to move higher.

To get a perspective on the non-barking dog – and to mix animal metaphors – it is useful to consider the experience of small advanced economies, the canaries in the mine of the global economy.

Small economies are a good barometer of the health of globalisation and the global economy because of their high external shares. Small advanced economies have performed strongly over the past several decades of an open international economic system, and so an unwinding of globalisation could have a chilling effect. Indeed, there is palpable anxiety in small country capitals – from Singapore to Stockholm – on the potential for protectionism and big power politics. And a stream of commentary suggests that investors should avoid small open economies in favour of larger, more domestically-oriented countries.

And yet. Although sluggish global growth – and weak trade growth –clearly dragged on small economy performance over the past several years, small economy growth rates strengthened through 2016 – with resilience seen from Asia to Europe.

This week I prepared my quarterly small advanced economies tracker: across the 13 small economies I track, average growth in the year to Q4 2016 strengthened to 2.3% (even excluding rapidly-recovering Ireland), compared to 1.9% in the large economy benchmark group. More recent data (e.g. exports) and forward-looking measures (PMI data, confidence surveys) are also generally positive. And since early November (pre-Trump), small economy equity markets are up by about 10% and 10 year government bond rates are up by about 25bp.

Singapore is a good example, often cited as a bellwether economy. After a weak start to 2016, Singapore’s Q4 growth surprised positively at 2.9%; and export growth in the year to February was up by 22% on strengthening regional demand. And Singapore’s equity markets, which had been in a bear market in the early stages of 2016, are up over 20% since February 2016.

So although international developments made 2016 a year to forget for small economies, the economic and market performance of small economies is stronger today than 12 months ago. But – just as with Sherlock – we should not take things at face value.

In particular, it is important not to over-interpret the absence of an observed impact on small economy performance as evidence of the absence of a structural change in the global risk profile. Small economy performance is highly correlated to the strength of the global economy, and at its simplest level, the strong economic and market data is a reflection of small economies capturing value in this environment. Aside from localised events (such as Brexit), there are not yet major instances of change in the international order (border taxes, currency wars, and so on). However, there will likely be a bigger effect on the global economy if and when we move from a phony war into something more real: from weak G20 communique wording on protectionism, for example, to actual border protections being imposed.

But at least as importantly, the economic and market record of the past few years also shows that small economies are not as disproportionately exposed to the international environment as is sometimes supposed. Indeed, even over the past few years of lacklustre trade growth, and a challenging macro policy environment, small economy growth has continued to out-pace larger economies. The resilience of small economies to a less supportive environment is also apparent from market pricing over the past few years: it is hard to find a meaningful small economy discount.

Yes, small economies have high exposures to the global economy. But the way in which this international engagement is arranged (for example, a strong emphasis on outward direct investment; deep integration into regional institutions) provides a degree of resilience. Many small economies also have strong macro positions, areas of deep competitive advantage, well thought out economic policies, as well as high quality political institutions. Small economies work hard and creatively at managing their external exposures.

For these reasons, I expect that many small economies will continue to out-perform larger economies – although there will likely be a wider distribution of outcomes across the small economy group. I am not persuaded by the claim that small economies will systematically struggle. Small economy growth rates will weaken if protectionist risks manifest, but relative to larger economies it is likely that small economy growth will remain relatively resilient.

That said, small economies are good places to look for weak signals of change emerging. From trade flows to market pricing and policy debates, changes in the global economy often manifest quickly and cleanly in small economies. Indeed, small economy governments have been quick to identify the fundamental nature of the political changes over the past year. And there is some early indication in small economy market pricing that there is some weakness in the global growth outlook. In these respects, the small economy dog is already barking.

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