Policy Prop for BBB (Bumpy, Below-par and Brittle) expansion
This post is a guest contribution by Joachim Fels of Morgan Stanley.
The more things change… A lot has changed in the four months since our last global economic forecast update (see Global Forecast Snapshots: Outlook 2012: Policy Make or Break, November 28, 2011). US policy-makers finally agreed to extend the fiscal stimulus until end-2012. The ECB responded to the euro area debt crisis by flooding the banking system with more than €1 trillion of cheap three-year loans, thus making ‘LTRO’ the most frequently used acronym in investor conversations around the globe. Encouraged by falling inflation and worried about global recession risks, other central banks eased or ‘untightened’ policy in various forms, ranging from more subtle ones like dovish talk (the Fed in particular) and reserve ratio cuts (China, India) to blunter instruments such as rate cuts (ECB, Brazil, Indonesia and several more) and additional outright QE (BoE, BoJ). Encouraged by this second instalment of the ‘Great Global Monetary Easing’ (or GME2), stocks have rallied, risk premia in European peripheral government bond markets have eased, and credit spreads came in. Unsurprisingly, on the back of all of this, investor sentiment has swung from ‘winter depression’ back in November to ‘spring feelings’ now.
…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?
Source: Joachim Fels, Morgan Stanley, March 30, 2012.