Global economy – dangerously close to recession
This post is a guest contribution by Joachim Fels and Manoj Pradhan of Morgan Stanley.
Ever more BBB: We are cutting our global GDP growth forecasts by a combined full percentage point in 2011-12, to 3.9% from 4.2% in 2011, and to 3.8% from 4.5% in 2012. We now see growth in the developed market (DM) economies averaging only 1.5% this year and next (down from 1.9% and 2.4% previously) – markedly more sluggish than the 20-year trend growth rate in DM of 2.3%, and more than a full percentage point below the 2.6% rate in 2010 when the world rebounded from the Great Recession. While we had been calling for a BBB recovery in DM all along, the path now looks even more bumpy, below-par and brittle than previously thought.
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.
Source: Joachim Fels and Manoj Pradhan, Morgan Stanley, August 19, 2011.