EM isn't immune, but generating 80% of global growth: The great EM-DM growth divide continues, but EM economies won't be immune to the DM slowdown, in our view. We now see EM growth decelerating from 7.8% in 2010 to 6.4% this year (6.6% previously), and further to 6.1% (6.7%) in 2012. While this keeps EM GDP cruising above its 20-year trend rate of 5%, it implies a significant further cooling of growth compared to last year's bonanza. Remarkably, despite slowing growth, EM economies - which now account for half of global GDP (using PPP weights) - will generate fully 80% of global GDP growth we are forecasting for 2011-12.
A policy-induced slowdown: There are three main reasons for our downgrade. First, the recent incoming data, especially in the US and the euro area, have been disappointing, suggesting less momentum into 2H11 and pushing down full-year 2011 estimates. Second, recent policy errors - especially Europe's slow and insufficient response to the sovereign crisis and the drama around lifting the US debt ceiling - have weighed down on financial markets and eroded business and consumer confidence. A negative feedback loop between weak growth and soggy asset markets now appears to be in the making in Europe and the US. This should be aggravated by the prospect of fiscal tightening in the US and Europe.
US and Europe dangerously close to recession: Our revised forecasts show the US and the euro area hovering dangerously close to a recession - defined as two consecutive quarters of contraction - over the next 6-12 months. The US growth disappointment in 1H11, when GDP advanced by an annual average rate of less than 1%, illustrates the brittleness of the US recovery in the face of external shocks (oil, Japan earthquake), despite ongoing QE2 and fiscal stimulus at the time. While the current quarter should still show some rebound in growth to around 3% from the very low bar in 1H, much of this rebound is likely due to temporary factors such as the ramping up of auto production as supply disruptions from the Japan situation ease. The most critical period for the US economy will likely be 4Q11, when we may see some fallout from the heightened volatility of risk markets, and 1Q12, when we get an automatic tightening fiscal policy if, as our US team currently assumes, this year's fiscal stimulus measures will expire.
Europe's woes to continue: The ECB's past rate hikes and, more so, the sovereign crisis and the additional fiscal policy tightening as well as the banking sector funding stress it produces, will take an additional toll on growth, in our view. Our European team now sees euro area GDP broadly stagnating later this year and in early 2012. Thus, it won't take much to tip the balance towards recession, especially as a final resolution of the debt crisis (in the form of fiscal transfers or common bond issuance) is likely to be very slow in coming. Against this backdrop, our European team has slashed its already below-consensus 2012 euro area GDP forecast from 1.2% to a mere 0.5%. In our view, despite the problems in the US, the euro area is clearly the weakest link in the global chain.
Dangerously close to recession, but not our base case: While we think that the US and the euro area will be dangerously close to recession over the next several quarters, we are not making recession our base case, for three reasons. First, companies are sitting on a pile of cash and display healthy profit margins. Second, the decline in oil prices from the peaks earlier this year should act as a partial stabiliser, lowering headline inflation over the next 6-12 months and supporting household real disposable incomes. Third, we expect the major central banks to lend additional support, with both the ECB and the Fed cutting interest rates and possibly implementing additional non-standard easing measures.
Why this is not 2008: Initial conditions are better now. Back then, household, corporate and bank balance sheets were much weaker, employment in the US was already falling and unemployment rising, monetary policy was tight, and the Lehman collapse meant that the financial system, including trade finance, totally seized up. Against this, fiscal and monetary policy have less (though not zero) room for manoeuvre now. So, while a freefall of the economy similar to 2008 looks very unlikely, policy also has less potential for a shock-and-awe response, if needed. Surely, we should not take too much comfort from saying that this is not 2008 - after all, the recession that followed was the deepest since the Great Depression. However, it is important to point out that a plausible recession scenario in 2011-12 would be much shallower than the 2008-09 experience. To get a 2008-type recession, one would have to assume a major Lehman-type policy error, such as the default of a European sovereign, which could bring the whole financial system down. While this is not impossible, we currently attach a very low probability to such an outcome. We will elaborate more on bear and bull scenarios in the coming weeks as events evolve.
EM policy-makers to cushion the blow: The current slowdown in EM growth, caused by a run-up in inflation and the monetary policy response, now looks set to be prolonged into 2012 by the weaker DM outlook. However, with inflation at or close to a temporary peak, some policy easing in EM looks likely to provide a cushion for growth. EM policy-makers should be able and willing to help their own economies avoid a hard landing, but they won't be able to bail out the world, in our view. Absent the kind of tail risks that were present in the world in 2008, and having barely emerged from a battle with inflation and overheating, EM policy-makers at this point will likely signal that they want to use just enough policy stimulus to help their own economies. In fact, given the constraints on DM policy-makers, EM policy-makers should really be ready to act relatively more aggressively, but this is unlikely to happen, given lingering inflation risks. If neither aggressive nor pre-emptive action is forthcoming, then a DM shock to growth could slow down EM economies significantly. Any policy action would then have to be aggressive. The good news? We believe that weaker DM growth will reinforce many EM policy-makers' resolve to support the rebalancing towards domestically led EM growth and allow more rapid exchange rate appreciation.
The early signs are encouraging if the recent moves in the renminbi are anything to go by, and they will be welcome relief for a slowing EM economy. Our AXJ team now expects further downside, particularly in 2012, to its below-consensus growth forecast. Latin America and CEEMEA growth is now forecast to be 1% and 0.6% lower than previously expected. Regional giants China, India and Russia all show better resilience than their respective regions, with growth now lower by 0.3%, 0.4% and 0.3%, respectively than previously expected. Growth in Brazil, however, has been marked down from 4.6% to 3.5% in 2012, a little lower than the downgrade for the region as a whole.
Inflation, not deflation: While near-term inflation expectations have eased, reflecting weaker growth and lower commodity prices, longer-dated forward measures of inflation expectations (such as five-year five-year-forward breakevens) have remained elevated during the recent turmoil. This is good news as it suggests that a Japan-type negative feedback loop between weaker growth and deflation expectations can most likely be avoided. The difference to Japan, despite other similarities, is that monetary policy has acted much more aggressively much earlier in this crisis, thus nurturing expectations of positive inflation and pushing real interest rates into negative territory.
Consumer and business confidence appears to have been shaken by the debt ceiling debacle and the S&P downgrade. This results in yet another headwind for an economy that was already experiencing a woefully subpar pace of recovery. So, we are once again downgrading our growth expectation for the US. We now see GDP expanding at a sub-3% pace during the second half of 2011 and moderating to about a +2.25% pace over the four quarters of 2012. We believe that the odds of a recession starting prior to the end of our 2012 forecast horizon have risen to about 30%.
The bulk of the 2012 forecast revision reflects a slower pace of growth in domestic consumption, but some of it is tied to lower exports in the face of lackluster global demand (see Global Economics: Dangerously Close to Recession, August 17, 2011).
First, the good news. We were encouraged by the results of the July employment and retail sales report. In particular, we would highlight the rebound in aggregate weekly payrolls - a comprehensive measure that incorporates moves in employment, hours and wage rates. Second, we were impressed by the forward momentum in ‘retail control' - a spending gauge that feeds directly into the calculation of personal consumption. Also, weekly industry figures suggest that motor vehicle assemblies are now ramping higher, which continues to point to significant upside for 3Q GDP. Thus, we still believe that the economy will show better performance during the second half of the year, and we see 3Q GDP at +3.0% and 4Q at +2.5%.
Moreover, we would not get too carried away by the unusually sharp downward adjustments to previous quarters' GDP growth in the recent benchmark revisions. In particular, the sizeable downward adjustment to 1Q11 GDP (from +1.9% to +0.4%) appears somewhat suspicious. The Chicago Fed produces a National Activity Index (NAI) that incorporates all available economic data for the relevant time period and is therefore an even more comprehensive measure than GDP. We estimated a simple OLS (ordinary least squares) equation for the relationship between GDP growth and the NAI and found a reasonably good fit. For 1Q, the NAI-implied GDP figure for 1Q is +3.3% - much higher than the reported +0.4%. Other developments during 1Q - such as the sharp drop in the unemployment rate and strong corporate earnings - would also point to significantly stronger growth than seen in the official GDP data.
Finally, we disagree with those who emphasize the need for further household deleveraging. Household debt service has been plummeting, and within the next few quarters it should reach levels not seen since the mid-1980s! Also, it's worth noting that much of the build-up of household leverage over the past decade merely reflected a rising homeownership rate. As homeownership rates continue to return to a more sustainable level, household indebtedness should move steadily lower. This trend is related to a powerful housing market correction, rather than a balance sheet adjustment. Consolidation of high interest rate non-mortgage debt has already been very large, with revolving consumer credit, mostly credit cards, down 18% from the 2008 high to the lowest levels since 2004.
Onto the bad news. Our 4Q GDP estimate has been downgraded from our previous estimate of +3.7% largely because the recent benchmark GDP revision fixed the net export seasonal quirk that we had expected to provide a sizeable boost. The simplest way to describe this situation is that the pre-benchmark data showed the average GDP contribution from net exports during the 2006 to 2010 timeframe was approximately 0 in 1Q through 3Q and +2 full percentage points in 4Q. Up until the release of the benchmark revision, all signs pointed to a similar pattern in 2011, but in fact the seasonal distortion has largely disappeared in the revised data. In their write-up of the benchmark revision, the Commerce Department called special attention to adoption of a new seasonal adjustment methodology for net exports that was aimed at addressing the bizarre bias in the old data. The bottom line is that there is no longer any reason to expect an unusually sharp boost to 4Q GDP from net exports. On an underlying basis, we still expect relatively much stronger growth in major emerging market economies going forward to support robust US exports. But recent softness in monthly real exports points to much more sluggish performance in the near term. And we've reduced our expectation for real export growth in 2012 a point to near +6% in line with downward adjustments to our global growth estimates, which would be a significant downshift from the 11% annualized growth in the first two years of the recovery.
While we continue to expect some improvement in US economic activity during the second half of 2011, this largely reflects temporary factors - specifically, the aforementioned turnaround in motor vehicle production and support from lower fuel prices. Eventually, these special factors will give way, and the underpinning for sustained economic growth will depend on job creation. At this stage of the recovery, the economy is simply unable to sustain the rapid productivity gains seen earlier. And, with significant slack evident in the labor market, we are far away from the point at which rising wage rates will provide meaningful support for household incomes. So, both the income and production sides of the economy are largely dependent on employment gains.
While it took Wall Street only a few trading days to fully recover from the turmoil that was set off by the debt ceiling debacle and subsequent ratings downgrade (with an intensification of problems in Europe thrown into the mix), the negative ramifications for consumer confidence and business hiring and investment decisions may be more long lasting. Consumer attitudes towards government economic policies in the University of Michigan survey collapsed to their most negative level in the survey's decades-long history during early August, with the report noting an unprecedented "sense of despair and pessimism about the role of government". Business sentiment also seems to have taken a significant hit, as seen in our Morgan Stanley Business Conditions Index survey this month (see Business Conditions: Reversal of July Surge, August 16, 2011). There seems little prospect of much improvement here, with the recent debt limit fight likely to be repeated in November and December when the so-called Super Committee releases its budget recommendations. Meanwhile, corporate profit margins have surged to record highs, and corporate balance sheets are in unusually strong shape. But, deteriorating sentiment means that investment and hiring will be more subdued than previously thought.
So, an economy that is highly dependent on job growth and consumer demand is now being buffeted by a potentially significant negative shock to the demand for labor. Previously, we expected average job growth of about 200,000 per month (quite close to where we were running during the first four months of the year). Now, we assume that employment growth will be closer to +125,000 per month, leading to slower income and spending growth. Despite this downgrade, we believe that this level of job growth is still sufficient to lead to a slight decline in the unemployment rate over the next year or so because we suspect that the labor force participation rate will continue to decline, for three reasons: 1) long-term demographic factors, 2) continued reverse immigration of construction workers, and 3) expiring jobless benefits for long-term unemployed (some of whom were probably only marginally attached to the labor force to begin with).
Outlook for fiscal and monetary policy. Obviously, there is considerable uncertainty with regard to both monetary and fiscal policies. Here are our assumptions:
Fiscal policy. We are still assuming expiration of the 2011 payroll tax cut, unemployment benefit extension, and the accelerated depreciation provision of the December 2010 stimulus legislation. Also, we look for some flattening out of discretionary spending (especially defense) in 2012, reflecting the very modest near-term impact of the debt ceiling deal and the budget resolution that was approved back in the spring. All of this implies a swing toward significant fiscal restraint in 2012. If the December 2010 stimulus measures are extended, we would boost our 2012 GDP forecast by 0.5-1.0pp. Other initiatives aimed at providing stimulus are also possible - e.g., new job tax credit, broad tax reform, profit repatriation, etc. Any or all of these measures would likely have some impact on the outlook, but the magnitude of the effect depends on the details. By the way, whether the so-called Super Committee, established as part of the recent debt ceiling deal, gridlocks or succeeds in identifying the required amount of deficit reduction is relatively unimportant in terms of the economic forecast for 2011-12, since no meaningful changes are likely to be implemented until 2013.
Monetary policy. We are making some changes to our Fed outlook. First, we are assuming that the Fed soon implements a modest portfolio extension program along the lines that Bernanke and other officials have publicly discussed. Specifically, we expect the Fed to begin to concentrate its MBS reinvestments in the 7-12 year sector of the Treasury market. Also, we look for the open market manager to gradually liquidate $150 billion or so of short-maturity Treasury coupons and reinvest the proceeds into the 5-20 year sector. By lengthening the duration of the System Open Market Account (SOMA) portfolio, the Fed would be trying to achieve lower borrowing costs for the private sector - particularly via the mortgage market. While some have called this an ‘Operation Twist', such terminology is not really appropriate because the Fed is actually trying to achieve a lower structure of yields across the curve. In contrast, the original ‘Operation Twist' exercise conducted in the early 1960s involved an attempt to push up short rates (in order to support the dollar) while depressing longer-term yields.
In any case, we believe that the impact of a duration shift in the SOMA portfolio will be relatively limited and look for only a slight decline in 10-year Treasury yields (compared to current levels) once it is implemented. We also now assume that the interest rate on excess reserves (IOER) is reduced to 0% later this year and thus expect the effective fed funds rate to hold near 0bp through the end of our forecast horizon in 2012. Moreover, we are intrigued by the idea that the Fed might eventually adopt a negative IOER along the lines proposed by Alan Blinder, in an effort to stimulate bank lending and/or securities purchases. Indeed, even the threat that such a policy might be implemented could have a potentially beneficial ‘unlocking' effect. With the 10-year TIPS yield having plunged to zero, high long-term rates are certainly not restraining the economy. An extremely high liquidity preference by banks and other companies continues to stymie Fed stimulus efforts, so directly attacking this with penalty rates could prove effective. We believe that concerns related to the Fed's authority to enact such a change and regarding the incentive to convert reserve positions to vault cash under a negative IOER regime could be easily addressed. However, we are not yet adopting this assumption and believe that the Fed would provide plenty of guidance in advance of actually implementing such a significant change.
We assume that the Fed will not restart large-scale purchases of Treasury securities - and even if it does, it probably would not have any significant impact on our growth or inflation forecasts. However, other, more creative policy measures could have a meaningful impact on the outlook. In particular, we believe that efforts to unclog the mortgage refinancing pipeline would have the most bang for the buck, since it could repair an important transmission mechanism for monetary policy (see Slam Dunk Stimulus, July 27, 2010). With 30-year fixed mortgage rates closing in on 4%, compared with Commerce Department data showing that the average rate on outstanding mortgages is currently 5.25%, a massive refi wave should be underway. But mortgage prepay speeds are currently running at only 8 CPR (conditional prepayment rate), while our mortgage strategist Janaki Rao estimates that prepayment speeds should be in excess of 20 CPR given the current rate environment.
Obviously, many borrowers continue to have difficulty qualifying for a refinancing because of a high loan-to-value ratio (LTV) or other constraints. A streamlined refi program that recognized it makes no sense to requalify borrowers for a mortgage that is already guaranteed by the Federal government would help lower borrowing costs and save taxpayers' money via a lower default rate. However, a streamlined refi initiative combined with a Fed MBS purchase program would have to be undertaken in conjunction with the Treasury Department, and we still see no indication that Secretary Geithner and other officials are anxious to move in this direction.
Finally, core inflation continues to move steadily higher. Most Fed officials still appear to be attributing this to temporary factors, and the FOMC appeared to deemphasize inflation concerns in the official statement issued after the August meeting. However, we don't see anything on the near-term horizon that is going to put a stop to the underlying acceleration in core inflation. In particular, the pass-through of prior hikes in food and energy prices still seems to be in the early stages. For some time now, retailers and apparel makers have been warning that price hikes will hit later in the summer and fall. And, while the pace of auto price hikes should eventually moderate as inventories are gradually rebuilt, the industry has dramatically restructured its fixed cost base. Thus, we don't anticipate a return to the days of overproduction and heavy discounting.
Most importantly, the run-up in the shelter category is still gathering momentum (see Have We Seen a Bottom in Core Inflation, December 22, 2010). Indeed, stock prices of apartment REITs got hit hard during the recent market sell-off but have rebounded strongly in recent days. This reflects the very favorable supply/demand characteristics of the rental market, which is leading to dramatic increases in rents across the nation. Given this backdrop, it will probably take either a further significant deterioration in the economic environment or a meaningful downshift in inflation expectations before the Fed would implement another round of large scale asset purchases.
We are revising down our growth forecasts for 2011 and 2012. Disappointing data for the first half and a deteriorating outlook cause us to cut our below-consensus GDP estimates by a full percentage point for this year and next. Instead of 2%, we now expect the euro area economy to expand by only 1.7% on average this year. In addition, we are lowering our forecast for next year to just 0.5%, down from 1.2% before. If accurate, this would put the coming winter on a par with the 2002/03 period, which was initially considered a mini-recession in Europe based on the first set of GDP data reported. Today, however, after several rounds of revisions, the data no longer show two subsequent quarters of negative GDP growth - the standard recession definition. But we still consider it to have been a very meaningful downturn.
There are several reasons for the downward revision to our growth numbers: First, over the last few days we had a series of disappointing 2Q GDP outturns in the euro area. Between April and June, domestic demand softened meaningfully in the core countries, with consumer spending contracting noticeably both in Germany and France, raising questions about the ability of the core countries to act as a locomotive for the euro area as whole. True, there are some special factors to account for this weakness, such as the expiry of the French car-scrapping scheme earlier this year and the warm winter weather boosting German construction. However, it remains to be seen whether households in core countries will loosen their purse strings again, as consumer price inflation is starting to come down and falling energy prices boost real disposable incomes.
Second, manufacturing indicators are showing a marked deceleration heading into 3Q throughout the region, suggesting that there is a slowdown in global trade momentum underway. Several of our proprietary indicators, including our surprise gap index, are signaling a turning point in the business cycle at present. In part, this slowdown in the industrial sector might be reflecting some of the disappointing growth outcomes seen in the US earlier this year (see Should we worry about weak U.S. growth? August 8, 2011). But the downturn in manufacturing seems to be broad-based across the region, hitting both the core countries (which are still operating at a higher level) and also the peripheral economies (which are already in the doldrums) as both reported a sharp fall in current output in July and have lowered their output expectations for the next three months.
Third, as documented extensively by our banks team, currently many banks cannot access term funding markets at reasonable rates. As a result, commercial banks continue to tighten their credit conditions, albeit marginally, to both their corporate and retail clients (see European Banks: ECB Survey highlights the challenge for bank lending, July 29, 2011). Looking ahead, if these term funding stresses continue well into the fall, the risks are rising that a lack of credit availability could dent domestic demand growth further. Note that low or negative credit growth by itself is not necessarily an indication of a credit crunch, given that we are also in a period of deleveraging in the euro area, which causes credit demand to be rather sluggish as a result.
Fourth, a renewed escalation of the sovereign debt crisis over the summer brought two larger euro area countries - Italy and Spain - into the spotlight. The rising risk of contagion towards the core pushed funding costs higher, caused the ECB to extend the scope of its bond purchase program, and induced the Italian, Spanish and French governments to commit to additional austerity measures. While the bold ECB action has managed to contain the rise in bond yields for now, the genuine uncertainty about the eventual policy response from governments will likely weigh on the propensity of companies and consumers to go ahead with larger investment projects, we think.
These four factors come on top of the headwinds the euro area was already facing and which led us to lower our forecast for the first time back in April (see Clouds Gathering over Growth Outlook, April 7, 2011). Back then, we took on board the headwinds created by elevated commodity prices, an overvalued currency, rising ECB policy rates. It now turns out that our forecasts were still too optimistic and that a period of outright stagnation over the winter seems more likely than a below-consensus trend-growth rate of around 1%. With the euro area as a whole teetering on the brink of recession territory, the risks of another shock pushing the region over the edge are significant, in our view. Parts of the euro area, notably several countries in southern Europe (Italy, Spain, Portugal and Greece), will likely find themselves back in recession.
Alas, the sovereign debt crisis will not allow governments to use fiscal policy proactively to fend off a decline in economic activity, we think. Instead, the shortfall in growth compared to government projections might even necessitate further fiscal tightening to ensure that stated budget targets are met. Such a pro-cyclical policy stance might be necessary to regain market confidence - in a way similar to central banks having to regain credibility in the 1980s by pushing economies into recession to break the engrained inflation habit.
In terms of the different demand components, we lowered domestic demand across the board in the next few quarters, reflecting the tightening in financial conditions in the euro area on the back of widening credit spreads, falling equity markets and tighter bank lending conditions. Consumer spending will likely bear the brunt of the additional fiscal austerity, be negatively affected by labor market prospects deteriorating and face the ongoing need for households to deleverage. Investment spending, notably capex on machinery and equipment, will likely be most affected by the slowdown in global trade, the tightening in credit conditions and the increase in uncertainty. Construction investment will likely shrink as well, due partly to the ongoing need to correct past excesses and due partly to falling corporate investment, government cut-backs and sluggish residential activity. Government spending should also weaken on the back of the fiscal consolidation effort across the euro area. Last but not least, export demand will likely reflect weaker global demand and an overvalued currency.
In terms of the different euro area countries, we have made very meaningful reductions to both the core and the periphery. In fact, the largest cut we made was to our Spanish GDP forecasts, which we cut by 1.8 points over 2011/12 combined, followed by our German and Greek GDP forecasts, which we lowered by 1.5 points over the same timeframe. Note that about one-third of the German downgrade was due to the disappointing outcome in 1H 2011. Other countries were cut less, e.g., France and Italy only came down by 1.1 points each.
On the fiscal policy side, several countries have announced additional austerity measures recently over and above their initial plans. Others are likely to follow in due course. While cutting the budget deficit is almost a necessity to regain credibility as a sovereign borrower, given market focus on fiscal discipline, this will negatively affect GDP growth. In particular:
• France will announce at the end of August further fiscal adjustment measures in order to achieve its fiscal deficit target of 4.6% in 2012. These additional measures are likely to focus on spending cuts but also on revenues, especially through further cuts in tax expenditures and exemptions on social security contributions. On our estimation, the overall fiscal effort should amount to about €10 billion, i.e., about 0.5% of GDP.
• Italy has recently announced a further round of austerity measures (60% spending cuts and 40% revenue-raising measures), worth around €20 billion in 2012 (~ 1.3% of GDP) and €25 billion the following year, in order to achieve a budget close to equilibrium in 2013. Along with the other factors (e.g., slowing global demand and tighter credit conditions) mentioned previously, this will likely trigger an outright recession next year, in our view.
• Spain has not yet specified the mix of extra deficit reduction measures it aims to announce soon. Yet various government officials have already mentioned the goal of achieving extra savings of €20 billion (~2% of GDP) or so - at least half of the money is likely to come from additional privatization measures. An extraordinary cabinet meeting is scheduled for August 19, followed by another one the week after. An announcement is likely to follow.
• Greece and Portugal will continue to implement their austerity programs, which now include further belt-tightening measures in Greece relative to our previous update following the finalization of the medium-term fiscal plan, and some corrective actions in Portugal due to some slippages in 1H11, as highlighted in the first review by the EC/ECB/IMF. We think that both economies will continue to contract sharply next year.
Slower growth, falling capacity utilization and rising unemployment will likely put a dampener on underlying inflation in the euro area. A marked drop in oil futures across the curve shaves several tenths off our headline inflation forecasts, such that our 2012 HICP number eases to 1.7%, compared to 2% on the previous forecasts (and to 2.5% this year). Especially in early 2012, we see inflation easing meaningfully such that there is a risk that inflation could fall below the ECB inflation tolerance of "below, but close to 2%".
With risks to growth tilting to the downside, such benign inflation outlook would allow the ECB to reverse the course of its monetary action and start to cut interest rates in early 2012 when inflation falls meaningfully below 2%. Thus far, we had expected the ECB to be hiking further from the present policy rate of 1.5%, probably at the October meeting, and then staying on hold for most of 2012. We now think that the next ECB policy move will likely be a refi rate cut, rather than a hike.
That said, the possibility of the ECB raising rates once more in October cannot be completely dismissed yet. Not only did the bank sound very much in tightening mode at its last press conference (something that we expect to change at the September meeting when the bank publishes a new set of staff projections). But also ECB President Trichet stressed the importance of the separation principle, as he hinted at the reopening of the SMP bond purchasing program, announced the continued unlimited tender operations and offered a new six-month long-term refinancing operation (LTRO). Hence, the fact that the ECB is reacting swiftly to market tensions is not necessarily an indication that it will also change its monetary policy stance. On balance, however, we expect the refi rate to stand at 1% at the end of next year, instead of 2% on our previous forecast.
Still having some fire-power left on its conventional policy tools, such as the policy rate, and still offering unlimited liquidity to euro area banks against a very broad range of collateral, we don't think there is an urgent need for the ECB to adopt additional non-conventional policy measures. If needed, the ECB could reactivate its one-year LTROs, thus embarking on another round of indirect QE via the banking system. In our view, the impact of new one-year LTRO is likely to be less powerful than when it was first offered in the summer of 2009. Instead, the bank could, if it deemed such a step appropriate, decide to stop the sterilization of its bond purchases and make its SMP outright QE. While this is certainly a possibility, the hurdle for the ECB to embark on such a step is probably quite high. The same applies to a medium-term funding facility, we think, given the bank's concerns about "addicted banks" and the slow progress in restructuring and recapitalizing them. As long as the economy does not slide into a full-blown recession, we don't expect the ECB to pull any of these levers.
An important wildcard in our growth outlook and for the ECB policy path is the evolution of the sovereign debt crisis and the policy responses that it might trigger. Our base case for the purpose of our growth projections is that the sovereign debt crisis won't be allowed escalate further - say by spreading to the core - and that it also won't dissipate quickly (see Sovereign Debt Crisis - A Roadmap for Investors, February 7, 2011). Hence we also don't assume that the sovereign debt crisis will be addressed in a meaningful way in the near term through some major policy innovation, such as the joint issuance of euro bonds. Hence, in the interests of providing a ‘clean' reading of the likely cyclical dynamics in the quarters ahead, muddling through remains our base case. We are, of course, aware that this strategy of piece-meal policy reactions is increasingly challenged by financial markets. However, as policy-makers will likely remain reactive rather the proactive, because they need to demonstrate to their electorates and parliaments that there is no alternative to the chosen policy path, we view the risk to our forecasts as being asymmetrically tilted to the downside.
Our bear case scenario is that of a full-blown recession (similar in terms of its depth and duration to the one Europe experienced in early 1990s when GDP contracted on a full-year basis by 0.7% in 1993). At this stage, though, monetary policy should be able to fend off such a serious outcome. In our book, additional discretionary tightening across the euro area in 2012 of around 0.5% of GDP would be outweighed by the ECB rate reductions we are now forecasting. The weaker EUR exchange rate that our FX team is forecasting in the quarters ahead should add to the easing in financial conditions in the euro area, thus providing a further cushion for growth. Alas, there isn't much more room left to absorb any additional negative shocks that could potentially hit the euro area economy over the next 18 months.
The growth outlook for our key trading partners has deteriorated substantially... Our euro area and US colleagues now anticipate much weaker growth in 2012, with both areas coming close to recession over the next 6-12 months. That's not good news for hopes of an ‘export-led recovery' in the UK. Faced with a significantly weaker outlook for export demand, we anticipate much slower growth in exports (and have cut our forecast for 2012 from 6.0% to 4.6%).
There are two main reasons for expecting a slower recovery in the US and euro area. The first is recent policy errors, namely Europe's slow and inadequate response to sovereign stress and the drama around lifting the US debt ceiling. The second is the prospect of further fiscal tightening in both areas. Our euro area team has cut its growth forecast by more than half, and now looks for just 0.5% in 2012, after 1.7% in 2011; the euro area takes almost half of all UK exports (goods and services). Our US colleagues have cut their growth outlook by almost an entire percentage point, to 2.1% for 2012. The US is our single largest trading partner and takes around 17% of all UK exports.
In addition to weak demand, several other factors may weigh on the export recovery. First, constraints on trade finance are unlikely to fade. A survey by the British Chambers of Commerce conducted earlier this year found that nearly one-third of exporting companies surveyed believed that they have lost more than 10% of their export sales due to difficulties obtaining trade finance and export credit insurance. Second, exporters may receive less government support, as the UKTI (which assists UK exporters) faces a 20% cut in funding to its current services and a 19% reduction in its trade advisers.
...and so we now look for weaker growth in 2012. In light of our revised outlook for a weaker recovery in exports, our GDP growth forecast for 2012 is now four-tenths lower at 1.4% (our outlook for 2011 is unchanged at 1.2%). For 2012, we are now further below consensus (1.9%), the Bank of England (around 2%) and the OBR (2.5%). Net exports remain a key driver of the recovery, but now make a smaller contribution. The main reasons for our weak growth outlook are fiscal consolidation and a weak recovery in investment.
Despite our below-consensus outlook for growth, we do still expect a small acceleration in activity in the UK over 2012 (in contrast to some of our trading partners). That improvement comes from a recovery (albeit modest) in the domestic picture, particularly from the consumer. Our reasons are i) we anticipate positive growth in real disposable income owing to less weakness in real wage growth, and ii) we assume a small fall in the savings rate, as households deleverage and credit constraints ease. The Olympics should also provide a one-off boost to activity in 3Q12. For more detail see Better Times Ahead, but Still Likely to Disappoint (page 3), August 1, 2011.
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