...the more they stay the same: And still, our baseline scenario for the global economy in 2012-13 has hardly changed since those dark November days. The reason is that we had assumed significant policy responses around the globe to help arrest recession and systemic risks, and policy responses is what we got. However, we were nervous about our base case policy assumptions and thus worried a lot about a much darker bear case scenario where further policy mistakes would plunge the world back into recession. Luckily, these worries haven't materialised, and to the extent that investors had similar fears, the risk rally simply reflects a collective sigh of relief because ‘bad stuff' that could have happened didn't. In short, by coming to the rescue once again, policy-makers, and central banks in particular, cut off the tail risks and helped the world economy to keep stumbling along rather than falling hard.
Main scenario remains BBB expansion... Our framework for looking at the world economy remains unchanged: Post-bubble economic expansions are different. Hence, ever since the credit bubble burst and policy-makers came to the rescue to prevent another Great Depression, we have been looking for only a Bumpy, Below-par and Brittle global economic expansion, particularly in the advanced economies. Three years after the Great Recession, strong headwinds to growth continue to emanate from ongoing consumer deleveraging in the US and other former bubble economies, and from banking sector and public sector deleveraging in Europe. The recent rise in oil prices on supply concerns is an additional near-term drag. Partly offsetting these headwinds are tailwinds from ongoing global monetary policy support, which has kept real interest rates in negative territory and asset markets supported, and from generally very healthy non-financial corporate balance sheets. Reflecting these opposing forces, we look for global GDP to grow by 3.7% this year (marginally up from our 3.5% forecast last November) and 4.0% (from 3.9%) in 2013, about in line with the long-term average growth rate, but about 1-1.5 percentage points slower than the previous expansion during the credit boom.
...propped up by ongoing policy support: Without ongoing monetary policy support, the BBB global expansion would long have faltered, as it did in the euro area, which is now in recession following ECB tightening last year which aggravated the debt crisis. Looking ahead, we think that the recent and prospective monetary easing will continue to prop up demand and keep global recession risks at bay. On our forecasts, virtually all of the major central banks, and many others, have some more easing in the pipeline this year. During the second quarter of this year, we expect the Fed to extend its Operation Twist and add (sterilised) MBS purchases, the ECB to cut rates one more time, the Bank of England to announce £25 billion additional QE, China to cut official policy rates by 25bp, India to begin embarking on rate cuts, and Brazil to deliver another (final) 75bp rate cut. Many other central banks both in DM and EM will likely follow suit with further easing. Thus, GME2 should continue to reign supreme in the near future. Only later in 2012 and in 2013 do we expect the easing trend to fizzle out and anticipate a few central banks to start undoing some of the easing. This is more likely to occur in EM rather than DM, as we expect EM inflation to trough out at still slightly elevated levels later this year, while DM inflation (provided the oil price roughly follows the futures path as we assume) should ease slightly throughout 2012-13.
Revisions? All about Asia: The only meaningful change in our 2012 GDP forecasts this time around is in China and Japan. In Japan, the upward revision from 1.1% to 1.8% largely reflects a better-than-expected ramp into the year and stronger capex assumptions. In China, where our previous above-consensus forecast of 8.4% 2012 GDP growth had become (published) consensus in recent months, we raise our forecast to 9.0%, one of the highest in the Street. As Helen Qiao and her China team explain in more detail in a companion note, this is essentially a call on additional macro stimulus being implemented in the very near term in response to somewhat disappointing results during the first few months of the year. In addition to further RRR cuts, OMO and window guidance intensification, we expect the government to support loan demand by lowering the benchmark interest rate by 25bp at least once, resuming infrastructure investment projects, as well as promoting first-time home purchase and developers' ‘regular commodity housing' construction to smooth the cycle.
Growth momentum: Up during 2012, dipping in early 2013: Annual average growth rates usually only tell half the story, or less, while markets focus more on cyclical momentum and potential turning points. The good news here is that we see global growth momentum accelerating from 2Q12 following the deceleration into 4Q11 and 1Q12. This mini up-cycle during the remainder of this year would reflect the dissipation of the euro crisis shock from last autumn, the effects of the policy easing that has already been put in place since, and the beneficial impact on consumers' purchasing power from the decline in inflation, especially in EM economies. However, the bad news is that this mini up-cycle won't last long, in our view: A pothole looms large for early 2013, when we assume a sizeable fiscal tightening in the US (to the tune of 1.5% of GDP) and Japan, and the lagged effects of the current monetary easing start to fizzle out.
What are the risks? Mainly oil and policy: And yet, despite the decisive policy action from central banks, we continue to worry more about the downside risks to growth than the upside risks - the distance between our bear case and our base case is 1pp, twice the distance between base and bull. One reason is that new policy mistakes simply cannot be ruled out. In the US, an obvious risk is the upcoming elections in November, which might produce policy gridlock. This could be so pronounced that, contrary to our baseline assumptions, much or all of the automatic tightening baked into current law from the expiration of the Bush tax cuts and the payroll tax cuts as well as the start of the automatic spending cuts actually kicks in early next year. In Europe, failure by governments to implement the agreed fiscal compact into national laws and/or increase the ESM/EFSF firewall might raise renewed doubts about the European project. However, the biggest risk in the near term is now the oil price. Hence, our new bear case for 2012-13 is built on: i) a lasting supply-induced oil shock to US$150 kicking in around the middle of the year; ii) a halving of world trade growth; and iii) significantly wider euro area bond yield spreads as debt worries flare up again. In this scenario, global growth falls below 3% in 2012-13, not far from the global recession threshold (2.5%). Note this is not a super-bear case, which could result for example from: i) total US fiscal gridlock with massive tightening; or ii) Greek euro exit with systemic knock-on effects.
Yes, there is a bull case, but it's not very bullish: Our bull case assumes that oil eases back to US$100, global trade is 2pp faster than in the base case, risk markets continue to do well (contrary to our base case assumption) and there is a little less US fiscal tightening in 2013. But even that only raises global GDP to 4.2% this year and 4.6% in 2013, below the 5.2% rebound in 2010 and below the growth rates seen during the credit boom.
Conclusion: All told, the world looks a less risky place right now: While our bull case for 2012 GDP growth hasn't moved at all since November, the bear case has come up by almost an entire percentage point (from 1.9% in November to 2.7% now). This has narrowed the spread between our bull and bear outcomes - a measure of the risks to our central case - by an equal amount. Thus, while risks remain decisively skewed to the downside, overall the world looks a somewhat safer place now. Famous last words?
While some incoming data - particularly the labor market indicators - have shown signs of improvement over the course of recent months, we still see a sluggish pace of growth in economic activity during 2012, along with risk of some slowing in 2013 tied to potential fiscal tightening. Thus, our outlook is little changed compared to the forecast published in late 2011. We still look for +2.25% GDP growth over the four quarters of 2012. For 2013, we see growth slowing to +2%, slightly higher than our prior forecast of +1.75%, reflecting a somewhat better outlook for US exports implied by our colleagues' updated global GDP forecasts (see Global Forecast Snapshots: Policy Prop for BBB Expansion, March 28, 2012).
Our tracking estimate for current quarter GDP has actually deteriorated since the start of the year. Specifically, disappointing readings on construction, capital spending and foreign trade have triggered a 0.5pp reduction in estimated 1Q GDP growth during the past few months (taking us down to +1.7%). In addition, improved income support tied to the recent pick-up in job growth is expected to be largely offset in the near term by the run-up in gasoline prices. So, consumption growth is likely to remain stuck at +2% or so for a while.
Turning to other sectors, growth in capital spending seems to have moderated a bit in response to the expiration of business tax incentives at the end of 2011. We may see some improvement as the year unfolds, but it appears that companies are still not seeing sufficient demand to warrant a significant pick-up in investment outlays. Meanwhile, sluggish global demand, combined with a strengthening in the trade-weighted value of the dollar since the lows in mid-2011, point to a negative contribution from net exports over the balance of the year. Residential construction is expected to continue to recover - primarily in the multi-family sector - but the impact on overall economic activity should be quite modest, given that this sector now represents a tiny share of the economy. Finally, government purchases should continue to be restrained in the near term by cutbacks at the federal level (particularly on the defense side) and restrained activity at the state and local sector. Looking to 2013, federal spending cuts will likely intensify, more than offsetting some encouraging recent indications that the worst is past for state and local spending.
The recent divergence between the GDP arithmetic and labor demand is unusual - but not unheard of. Most importantly, this combination implies a significant slowdown in productivity, which is somewhat troublesome, given the sub-par productivity performance that was already evident in 2011. A continuation of these trends would imply a significant deterioration in corporate profitability at some point in the not too distant future. However, we suspect that an eventual moderation in employment growth will help to reconcile things. In fact, we suspect that unusually mild weather across much of the nation has been helping to boost job growth. Our favorite proxy for weather conditions - the Heating Degree Days Deviation series published by the National Oceanic and Atmospheric Administration - shows that on a population-weighted basis, the US has experienced an unusual string of milder-than-usual temperatures this winter. Thus, we expect to see some payback in the job tally once spring arrives. This, together with a bit of a pick-up in GDP growth over the balance of the year, should help to limit the downside for productivity.
The Fed appears to be in wait-and-see mode at present, and the range of policy options over the next few months spans the spectrum from inaction to QE3. Based on our expectation of some deterioration in labor market data over the course of the spring and a belief that the overall economy will continue to expand at about a +2% pace, we still see a decent chance that the FOMC will opt for additional accommodation. The most likely path seems to be Twist 2.0 (or what some are calling sterilized QE, although, from our perspective, that is a terrible misnomer). Such a policy would represent a middle ground between inaction and full-blown QE. It would avoid the implicit tightening that would otherwise occur if the original Twist operation is allowed to expire and, since it involves sterilized asset purchases, would presumably carry limited ramifications for commodity markets and political blowback.
Since last autumn, Fed officials have been signaling that any additional asset purchases would likely include a hefty MBS component. So, the composition of further asset purchases would be somewhat different than the current Twist exercise, which is confined to long-dated Treasuries. Moreover, instead of selling short-dated Treasuries - which the Fed has just about run out of - the purchases would be sterilized via reverse repurchase agreements, term deposits and MBS rolls. So, although not identical to the current Twist operation, the basic thrust of the effort would essentially amount to an extension of what the Fed is doing now - thus, we call it Twist 2.0. Clearly, the hurdle for the Fed to act gets higher as the November elections approach. And, if it allows the current Twist operation to expire without taking action, that probably pushes up the bar a few more notches. So, while the Fed's hands aren't completely tied, the likelihood of action during the second half of the year seems relatively low.
We continue to fret about the fiscal cliff confronting the US at the end of 2012. Under current law, the start of 2013 will see expiration of the Bush era tax cuts, expiration of the payroll tax cut, imposition of a new round of spending cuts tied to Super Committee inaction in November, imposition of other discretionary spending reductions tied to budget appropriations legislation enacted in recent years, and imposition of some new taxes on individuals that were enacted as part of the 2010 Affordable Care Act. We estimate that all of this fiscal tightening would amount to about 4.5 percentage points of GDP in the aggregate - an unprecedented degree of restraint that could easily tip the US into recession. Of course, virtually no one in Washington believes that current law will prevail. Some tax cuts are almost sure to be extended, and spending reductions are likely to be restructured. Thus, we are assuming a more modest fiscal tightening of about 1.5 percentage points of GDP - still enough to trigger some slowing in economic activity next year. However, the degree of uncertainty surrounding all this is quite large, especially given the compressed timetable that will be confronting legislators after the November election and the potential for another debt ceiling debacle in late 2012 or early 2013.
Reiterating Headline Euroland GDP Growth Forecasts
Against a backdrop of a sea-change in market sentiment about Europe witnessed over the last three months, we are reiterating our GDP growth forecasts for the euro area. Despite the positive impulse coming from the ECB's 3y LTROs, eurozone fundamentals have not improved materially and, in our view, the sovereign debt crisis is not yet resolved. What's more, new downside risks, such as rising oil prices, have emerged in recent weeks.
Hence, we still believe that the euro area overall is likely to experience a mild recession, with GDP contracting an average 0.3% this year. A muted recovery that will remain vulnerable to adverse shocks starting in the second half of this year will likely cause next year's GDP growth to average a below-par 0.9%.
Our estimates are close to the market consensus, at present, but remain below official forecasters such as the ECB or the OECD, which we would deem to be too optimistic. However, the unchanged headline GDP estimates for the eurozone mask a wide range of changes that we have made to our country forecasts and to the different demand components.
Raising Core Country and Cutting Peripheral Estimates
In terms of our country forecasts, we raised our 2012 estimates for a number of core countries, notably the two largest euro area countries - Germany and France - but also upped our numbers for some of the smaller export-oriented economies such as Austria and Ireland. Post these forecast upgrades, which were mainly in response to a better-than-expected performance over the winter months, we are now close to consensus on Germany, Austria and Ireland. On France, which is under the market spotlight ahead of the presidential election, we are more bullish on the cyclical growth outlook than consensus - a view that is based on a more optimistic 1Q GDP estimate on the back of a better-than-expected run of survey data, especially towards the end of the quarter.
At the same time, we pared back further our below-consensus forecasts for much of the periphery, lowering further 2012 GDP growth forecasts for Italy, Spain, Portugal and Greece. These reductions are typically due to a combination of a worse-than-expected performance in late 2011 and additional austerity measures being announced since our last forecast update, which will likely cause these countries to continue to contract for much of this year. Outside the periphery, we also had to cut our estimates in the Netherlands and Sweden on the back of a worse-than-expected outturn in the final quarter of last year. Contrary to the peripheral countries, we did not make any downward adjustments to our growth estimates for the remainder of this year in these two countries.
As a result of these forecast changes, country discrepancies keep deepening. Even though the spread between this year's country GDP growth estimates is unlikely to be as wide as it was last year, in GDP level terms - a key variable for the unemployment rate, the capacity utilisation rate as well as the deficit and debt ratios - the discrepancies clearly deepen further. This discrepancy complicates the ECB's monetary policy decisions and could also give rise to mounting political tensions in Europe, which we would view as a key risk.
Weaker Domestic Demand, Better Net Exports
In addition to the changes in the headline country forecasts, we have also made some important adjustments to our forecasts for the different demand components in the euro area. In particular, we have become even more bearish on domestic demand, reflecting a cut in both our consumer spending forecast and our estimate of government outlays this year. Additional austerity measures that were announced over the last few weeks brought both estimates down. An additional dent to the consumer spending forecast came from a higher inflation forecast profile on the back of an upward shift in both actual oil prices and the oil futures curve, which weighs on real disposable income. A weak start to the year for both German and French consumers seems to support our more cautious stance on this front. Weaker domestic demand also means weaker import demand. Thus, net exports should make a slightly bigger growth contribution than before.
Shifting Our Risk Profile around Baseline Higher
Over and above the aforementioned tweaks to our baseline country and component forecasts, the most meaningful change to our views for financial markets is probably the shift in our risk scenarios summarised in our bull-bear cases. Back in November, we had warned about the risks to our forecasts being materially to the downside due to our concerns about a full-blown credit crunch pushing the euro area into a deep recession and towards deflation. Based on the joint assumptions that the global team has made in the latest Global Forecast Snapshots - Policy Props for BBB Recovery, March 28, 2012, and on the positive impact the ECB's 3y LTRO had on funding markets for both sovereigns and banks, we now see the risks to our forecasts being more symmetric around the base case, yet not completely symmetric, as we still see some considerable downside risks. Given that our bear case assumes a surge in oil prices, the deflationary pressures are less prominent than before - though the upward pressure from an oil price shock is not able to completely offset the domestic downdrift from a weaker economy and even more underutilised resources.
But Several Risks to the Recovery Remains
One of the key tail risks to the euro area growth has been removed since the start of year. In our view, this tail risk was a disorderly default in Greece, causing the domestic banking system to not only run out of collateral but also face large-scale capital losses. With the second bailout package providing up to €25bn to recapitalise the Greek banking system, the systemic implications of a disorderly default - which cannot entirely be ruled out for the future either - have become more manageable. Yet, there are still several hurdles that lie ahead for the European sovereign debt crisis in the remainder of this year. These include the French presidential election, the Greek parliamentary election and the Irish referendum, as well as a discussion about a possible programme extension for Portugal and Ireland, which both still aim to return to the bond market next year. Add to this renewed market concerns about the commitment to reforms and austerity in the two large peripheral countries and several narratives arise as to why higher risk premia could return to EMU sovereign debt markets.
Next to these political risks associated with the sovereign debt crisis, we also see three macro risks potentially emerging to our call for a 2H recovery in the euro area.
• The first risk is a sharp rise in the price of oil on the back of escalating geopolitical tensions in the Middle East. In our view, Europe would be particularly vulnerable to such an oil price shock, given that both households and companies are already squeezed by austerity measures and elevated credit constraints.
• The second risk is that - contrary to our FX experts' forecasts for a marked weakening - the EUR might continue to defy gravity and stay overvalued against the USD instead of easing towards 1.15 early next year.
• The third risk to our forecast is that the ECB will not follow the script set out in our forecast and, instead of cutting interest rates by another 25bp by the summer, stays on hold for an extended period of time. Based on the relatively hawkish tone at the recent press conferences, we see this as a distinct possibility.
Sovereign Debt Crisis and Budget Deficits
A combination of somewhat better budget execution in 2011 (notably in Germany), additional austerity measures announced in some of the peripheral countries over the last few months and falling funding costs across the euro area caused us to adjust our budget deficit forecasts for the euro area as whole. As a result, we now see the euro area-wide budget deficit at 3.5% of GDP - making it by far the lowest estimate across the major industrial economies globally, including the US, Japan and the UK. Next year, the deficit for the euro area as a whole might already be back below the 3% ceiling set out in the Stability and Growth Pact. Note that despite these better budget deficit forecasts, we don't believe that the sovereign debt crisis has been fully resolved yet. There can be no denying that some important steps in the right direction have been made. But lasting success of the new fiscal compact, the national adjustment programmes, the increase in the combined firepower of the EFSF and the ESM rescue mechanisms and the ECB liquidity injection is not secured yet.
Inflation, the ECB and Bond Yields
Upside surprises to inflation in early 2012 on the back of rising oil and gas prices as well as increases in indirect taxes and administrative prices, together with new set of assumptions for these external price pressures, have caused us to raise our inflation forecast materially to 2.5% for this year and to 1.8% for next year. While next year's inflation forecast is still in line with the ECB's definition of price stability, inflation is no longer undesirably low - thus weakening the argument in favour of an ECB rate cut. In reaction to these upward pressures, the noticeable impact of the 3y LTROs on funding and the more hawkish tone of the ECB, in early March we adjusted our ECB call (see EuroTower Insights: ECB to Do Less Later, March 1, 2012). Since then, we are no longer forecasting aggressive rate cuts and outright asset purchases in our baseline case. Instead, we are only forecasting one more refi rate cut in 2Q - and even that is subject to some risks. With the end of ECB easing being near (or even here already), we also expect bond yields to rise again in much of the euro area.
Outside the Euro Area: UK and Sweden Motor Along
Outside the euro area, we continue to be more optimistic on the growth outlook for the UK and Sweden than we are for the euro area as a whole. If anything, we see these two economies on par with the stronger core countries. In both cases, we expect the growth profile to be somewhat bumpy throughout the year though. In addition, we see scope for more expansionary policies from the central banks in both countries and expect additional QE of £25 billion by the Bank of England and an additional rate cut by the Riksbank in 2Q. As elsewhere, however, our conviction in these calls for additional easing is not as a strong as it used to be. In both cases, we also expect the monetary policy expansion to be reined in earlier and faster than in the euro area, with the first rate hikes already being pencilled in some time during the first half of next year.
For full details, see Europe Economics: Deepening Discrepancies, March 29, 2012.
The growth recovery has been rather muted so far. In addition to the official data on the lacklustre IP growth of 11.4%Y and retail sales growth of 14.7%Y in Jan-Feb, the recent HSBC-Markit flash PMI also showed continued weakness in sequential growth in March amid evidence of softer commodity demand. While the growth slowdown in 2H11 was much milder than during the global financial crisis and more ‘self-engineered', due to domestic policy tightening rather than external demand softness, it also seems to have taken longer than usual to see the impact of policy easing to support a strong rebound.
We believe that this is due to the ineffective delivery of policy easing. As we suggested in our recent reports, although policy untightening began in 4Q11, it has not yet translated the looser liquidity conditions in the interbank market to the real economy. In the absence of a notable decline in the funding costs faced by the corporate sector, the pace of bank loan extension has been slower than desired thus far. In addition, the legacy issues from the 2008-09 policy stimulus have prevented the government from adopting more measures to support domestic demand, contributing to a growth recovery that appears to be more painful than during previous policy-easing cycles.
However, the government is in the process of loosening financial conditions for the real economy and delivering more demand-supportive initiatives. In our view, policy-makers have already realised the need of removing the excessive constraints on credit supply, by cutting the RRR, raising the loan-to-deposit ratio (LDR) targets, and adjusting the macro-prudential measures adopted during policy tightening. But in addition to further RRR cuts, OMO and window guidance, we also expect them to support loan demand by lowering benchmark interest rates by 25bp at least once this year, resuming infrastructure investment projects, as well as promoting first-time home purchases and developers' "regular commodity housing" construction to smooth the cycle.
We have raised our baseline GDP growth forecast to 9.0%Y for 2012, up from 8.4%Y. Our out-of-consensus call is based on our view that the slow recovery so far is conducive to more effective policy easing, most of which will still come in small installments in a low-profile fashion. As a result, we expect a stronger rebound in growth in 2Q-3Q12. Meanwhile, we have lowered our 2013 GDP growth forecast slightly to 8.6%Y, from 8.7%Y, in expectation of more structural reforms to take place next year, once China is assured of its foothold in short-term growth stability in the near future.
1. Things Have to Get Worse before Getting Better...
Market sentiment on China has taken a dive recently on the back of a series of events. First, policy-makers appeared to be more hawkish than expected, with the Premier's announcement of a lower GDP growth target at 7.5%Y (lowered for the first time in the last eight years) and the suggestion of no policy easing in the property market. Second, commodity demand from China does not seem to have recovered from recent lows, according to both overseas raw material producers and domestic bottom-up sources. Third, despite the monetary easing so far, the newly increased bank loans in Jan-Feb combined has been lower than in 2011 by Rmb127bn. If demand growth fails to accelerate notably in March, investors' concerns about a China hard landing will likely recur soon.
We agree that the growth recovery is seeming to take longer than usual this time. In our view, Chinese policy-makers have taken actions to untighten the policy stance early in the cycle since late 4Q11 (see Premier Wen Signals Near-Term Policy Easing in China, October 26, 2011, and Liquidity Conditions Might Be Looser than Monetary Aggregates Suggested, February 10, 2012). However, the economy did not deliver a sharp rebound immediately, due to a delay in financial condition easing. We argued that although the RRR cuts and various monetary policy tools have improved the liquidity condition in the interbank market, funding costs faced by the corporate sector remain high.
The binding constraints on loan supply rather than the lack of loan demand is the crux of the problem. During the last round of policy tightening that began in 4Q10, regulators resorted to a series of non-market-oriented policy measures to slow down bank lending and informal credit creation. Some of these measures, such as the direct control on loan disbursement and high-frequency reinforcement of LDRs, have remained in place for too long and started to cripple banks' capability of deposit creation and loan extension. Since Chinese banks have to resort to their own deposits and cannot use the interbank market to fund new loans, the dislocation of liquidity abundance in the interbank market with the cash-strapped real economy has held back the pace of growth recovery.
In addition, the legacy issues from the 2008-09 policy stimulus and the continuation of the property market policy tightening have also prevented the government from adopting more measures to support domestic demand, contributing to a growth recovery that appears to be more painful than during previous policy-easing cycles.
2. More Room for Effective Policy Easing as Inflation Subsides
We expect Chinese policy-makers to deliver more effective policy easing in the immediate future to smooth the cycle since they see fewer obstacles for relaxation, as CPI inflation continues to trend downwards, and the recent trade deficit and remaining uncertainties in external demand strength still loom large.