A tale of two worlds: We forecast 4% global GDP growth in 2010, up only marginally from three months ago (see the previous Global Forecast Snapshots: ‘Up' Without ‘Swing', September 10, 2009). True, if this turns out to be about right, it would be a fairly decent outcome, especially compared to the widespread doom and gloom earlier this year. However, it falls short of the close to 5% growth rate in the five years prior to the Great Recession, and it will be the product of unprecedented monetary and fiscal stimulus, which poses substantial longer-term risks on various fronts. Moreover, our 4% global GDP growth forecast masks two very different stories. One is a still fairly tepid recovery for the advanced economies - the ‘triple B' recovery we discuss below. The other is a much more positive outlook for emerging markets, where we forecast output to grow by 6.5% in 2010 (China 10%, India 8%, Russia 5.3%, Brazil 4.8%), up from 1.6% this year. A rebalancing towards domestic demand-led growth in EM is well underway. Moreover, as our China economist Qing Wang has been pointing out for a while now, the official statistics are likely to vastly underestimate the level and growth rate of consumer spending in China. In short, we think that the theme of EM growth outperformance has staying power and has even been bolstered by the crisis.
A ‘triple-B' recovery in G10: In contrast to our upbeat EM story, we forecast barely 2% average GDP growth in the advanced G10 economies in 2010 - a triple B recovery where the three Bs stand for bumpy, below-par and boring. On our estimates, GDP growth has averaged around 2% in the G10 in the second half of this year and won't accelerate much from that pace next year - hence our ‘up' without ‘swing' characterisation from three months ago remains valid. The two reasons why we think the recovery in advanced economies will be of the ‘triple B' type are that it is likely to be creditless and jobless. Creditless recoveries - defined as a situation where banks are reluctant to lend and the non-bank private sector is unwilling to borrow - are the norm following a combination of a credit boom in the preceding cycle and a banking crisis; and creditless recoveries typically display sub-par economic growth as credit intermediation is hampered. Moreover, we expect a jobless G10 recovery, with unemployment in the US declining only marginally next year and rising further in Europe and Japan. Unemployment may well stay structurally higher over the next several years in the advanced economies as many of the unemployed either have the wrong skills or are in the wrong place in an environment where the sectoral and regional drivers of growth are shifting.
More growth differentiation within the G3: Beneath the surface of what we call a lacklustre ‘triple B' recovery in the advanced economies lies a differentiated story for the three largest economies within this block - the US, the euro area and Japan. We expect significant growth differentials between these countries in 2010, which may well become a topic for currency, interest rate and equity markets again. We see the US as the growth leader among this group next year, with output expanding by 2.8% in the annual average of 2010. The euro area economy looks set to grow by less than half that rate (1.2%), while Japan should hardly grow at all (0.4%) next year and is forecast to actually fall back into a technical recession in 1H10. One reason for relative US outperformance is that the creditless nature of the recovery affects the US private sector by less because banks (as opposed to capital markets) play a smaller role in financing the economy than in Europe or Japan. Another reason is that US companies have been much more aggressive in shedding labour this year than their European or Japanese counterparts, so the US labour markets looks set to recover (albeit slowly) next year, while we expect unemployment to rise further in both Europe and Japan. Further, European and Japanese exporters should feel the pain from this year's currency appreciation, whereas US exporters should benefit from this year's dollar weakness.
Crawling towards the exit, but triple A liquidity cycle remains intact: As stated above, we expect the beginning of the exit from super-expansionary monetary policies and its implications to be the dominant global macro theme in 2010. We will discuss details of the likely monetary exit strategies across countries in next week's year-end Global Monetary Analyst. Here, it suffices to say that we expect the Fed, the ECB and the PBoC to move roughly in tandem and raise interest rates from 3Q10, with the Bank of England following in 4Q. Some, like the central banks of India, Korea and Canada, are likely to move earlier, while others, such as Japan, will lag behind. Generally, given the remaining fragility in the financial sector, central banks are likely to approach the exit in a cautious, gradual and transparent manner, so any hikes will likely be telegraphed well in advance, partly through appropriate twists in the crafted language, and partly through some cautious draining of excess bank reserves. Importantly, while the end of easing and the beginning of the exit can be expected to cause wobbles in financial markets, and this is one reason why we see bonds selling off sharply next year, we point out that official rates are likely to stay well below their neutral levels (even factoring in that these themselves are likely to be lower now than they have been in the past) throughout 2010 and, probably, also in 2011. Hence, monetary policy is only expected to transition from super-expansionary to still-pretty-expansionary. This would leave what we have dubbed the ‘triple A' liquidity cycle (ample, abundant and augmenting), which we have identified as the main driver behind this year's asset price bonanza and economic recovery, fairly intact next year. The metrics we follow to validate or refute this view is our global excess liquidity measure depicted in the chart below, which is defined as transaction money (cash and overnight deposits) held by non-banks per unit of nominal GDP. This measure exploded this year and we would expect it to rise further, though at a much lower pace, through 2010.
Sovereign and inflation risks on the rise: Fifth, but not least, we think that sovereign risk and inflation risk will be a major theme for markets in 2010. The current issues surrounding Greece's fiscal problems are only a taste of things to come in many other advanced (note: not emerging) economies, in our view. We note that fiscal policy looks set to remain expansionary in all major economies next year, as it arguably should be, given the ‘triple B' recovery which still requires support. However, markets are likely to increasingly worry about longer-term fiscal sustainability, and rightly so. Importantly, the issue is not really about potential sovereign defaults in advanced economies. These are extremely unlikely, for a simple reason: most of the government debt outstanding in advanced economies is in domestic currency, and in the (unlikely) case that governments cannot fund debt service payments through new debt issuance, tax increases or asset sales, they can instruct their central bank to print whatever is needed (call it quantitative easing). Thus, in the last analysis, sovereign risk translates into inflation risk rather than outright default risk. We expect markets to increasingly focus on these risks in the year ahead, pushing inflation premia and thus bond yields significantly higher. Put differently, the next crisis is likely to be a crisis of confidence in governments' and central banks' ability to shoulder the rising public sector debt burden without creating inflation.
This year's Pre-Budget included a few eye-catching tax rises and economic support measures. The figures also provided a reminder that issuance will be very large over the next few years. We had also assumed that the Pre-Budget would show additional fiscal tightening for future years. That is not apparent in the projections - the deficit figures are largely unchanged.
Alongside the Pre-Budget, the government also published the details of its Fiscal Responsibility Bill, which promises that the government will at least halve the deficit over four years. The Treasury's Pre-Budget 2009 forecast shows a slightly revised 2009-10 deficit at 12.6% of GDP (£177.6 billion, from 12.4% and £175.4 billion previously) and by 2013-14 this is still as high as 5.5% of GDP, unchanged from its forecast in April. However, we had thought that given widespread pressure for additional fiscal tightening than already incorporated in the Budget, the 2013/14 deficit might be lower than the numbers presented in April's Budget 2009.
However, interpreting these figures is complicated slightly by the Treasury now using a different definition of the deficit. This new measure excludes ‘temporary effects of financial interventions' and appears to raise public sector net borrowing by about £7 billion compared to what it would otherwise have been in 2009-10, for example, and by £6 billion in 2010-11. That suggests that without the definitional change, the deficit numbers might have looked a little lower, although there is no effect as it appears on the central government net cash requirement (CGNCR) and therefore on issuance.
2009/10: PSNB Broadly Unchanged. Gilt Issuance Up
Including the definitional change, the Treasury's projection for Public Sector Net Borrowing (PSNB, effectively the UK's measure of its fiscal deficit) was broadly unchanged (£2.2 billion higher than the number in the April Budget). Looking at the numbers for central government spending and receipts where we can track the monthly data, the Treasury has left its estimates of both growth in receipts and expenditure between 2008-09 and 2009-10 largely unchanged.
We got a smaller-than-expected upward revision to the central net cash requirement (CGNCR) and gross gilt issuance. We had expected around a £10 billion upward revision following recent announcements of capital injections into the UK banks. Gross gilt issuance was instead revised up by £5 billion.
2010/11: PSNB Revised Up Slightly
The forecast for public sector net borrowing in 2010/11 was also broadly unchanged at £3 billion higher than April's £173 billion. We had expected a downward revision (as in a smaller deficit), partly given that some of the assumptions built into those April projections looked overcautious. The Treasury has revised up its underlying assumptions for the level of the FTSE and revised down the unemployment estimates used for example (and the level of nominal GDP in the forecast for 2010-11 is higher). However, as pointed out earlier, without the definition change, this deficit projection might have come in a few billion lower. These forecasts still look consistent to us while expecting around £215 billion gross gilt issuance in 2010-11.
New Policy Announcements
As expected, there were a few new eye-catching measures, including further raising of national insurance contributions from April 2011 (expected to raise around £3 billion in 2011-12). There was a near-term tax on bank bonuses (the Chancellor announced this would be a one-off levy of 50% on any individual discretionary bonus above £25,000 paid by the bank rather than the employee). The government also announced plans for a 1% cap on public sector pay settlements in 2011-12 and 2012-13, which is estimated to raise £3.4 billion per year by 2012-13. Some economic support measures were extended, including extending the temporary increase in the threshold for empty property rate relief and further deferring the increase in the Small Companies' Rate of corporation tax.
Despite the revenue raising and cost saving measures mentioned above, these aren't enough to change the current budget forecasts in 2011-12 and 2012-13 once other discretionary and forecasting changes are taken into consideration.
Disappointing Pace of Deficit Reduction
We think the government should aim to reduce the debt/GDP ratio faster.
These PBR forecasts do already embody a significant fiscal tightening. The structural deficit is estimated to decline from 9.0% in 2009/10 to 3.6% in 2013/14, broadly the same percentage point decrease as was incorporated into April's Budget projections (although the level of structural deficit has been revised lower on the back of an increase in the estimated output gap). Average real spending growth between 2011/12 and 2013/14 still looks set to be roughly flat: between 2011/12 and 2013/14 average real spending declines 0.1%Y on average. Once you take another year of the Treasury's projections, that calculation shows flat average real spending.
However, the deficit on these forecasts will still be at 4.4% of GDP by 2014-15 and public sector net debt, as a percentage of GDP, still does not start declining until 2015-16 (from a level of around 77% of GDP and, on a Maastricht basis, debt - general government gross debt - declines in 2014-15 from a peak of 91.6%). Such high debt levels would leave the UK vulnerable to being unable to boost fiscal spending significantly when the next crisis hits. The government might also want to build in more ‘room' in case a large proportion of the contingent liabilities built up over the financial crisis materialise. Further, the Treasury's forecasts for GDP growth, particularly beyond the next couple of years, still look optimistic to us.
What does this mean for gilts? Issuance will be large over the coming year, and we continue to think that yields will rise over the next two years. Our central case is a gradual not a violent re-pricing, with a weak economic recovery and regulatory incentives for banks to hold gilts helping to offset upward pressure on yields from a gradually rising policy interest rate and high net supply (and likely in the absence of BoE purchases). Since we are close to an election, the incumbent government's forecasts also need to be probability-weighted, and the election could have significant impacts for fiscal policy and yields.
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