Three Big Questions To Decide Fate Of The World: Invesco

For 18 months the markets have been grappling with the Eurozone sovereign debt crisis. The crisis took a distinct turn for the worse from March 2011 when the failure of the first Greek bail-out (of May 2010) became evident. Since then there have been a series of meetings of Eurozone leaders, culminating in the statement at the conclusion of their fifth crisis summit on December 9 when the heads of government pledged to strengthen EMU (the Economic and Monetary Union) in two broad ways. 

First, the leaders committed their countries to a greater measure of fiscal discipline than in the past. Specifically they agreed to pass constitutional amendments in each country to enshrine maximum structural budget deficits of 0.5% of GDP instead of the previous 3% general budget deficit limit contained in the now discredited Stability and Growth Pact. This new ‘Fiscal Compact’ is intended to be achieved according to timetables for each member state proposed by the European Commission, enforced with a greater degree of automaticity than previously and ultimately subject to the jurisdiction of the European Court of Justice.

Second, the leaders agreed to boost the ‘stabilisation tools’ or rescue funds. By this they meant that leveraging of the EFSF ‘will be rapidly deployed’; the creation of the permanent rescue fund to be known as the European Stability Mechanism (ESM) will be brought forward to July 2012, but the combined lending capacity of the two institutions would be limited to €500bn; and the members would subscribe €200bn to the IMF for use in bilateral loans.

While these aspirations are laudable, financial markets are likely to require far more tangible measures implemented according to a more urgent timetable. The problem is that these measures may help to avoid the next crisis, but they are not capable of solving the current crisis. For example, in the face of a tightening credit crunch in the banking system there is no promise of any immediate injection of liquidity by the ECB or any other entity. Even though the ECB's latest liquidity measures – a reserve ratio cut, the provision of three-year refinancing and the expansion of eligible collateral -- will enhance liquidity and are intended to assist bank funding stability in 2012 and 2013, it is by no means clear that these measures will be enough.

Banks and sovereigns in the euro-area are locked in a mutually destructive embrace -- if sovereigns default then banks could face runs, higher financing costs and the need for capital infusions, but if private markets refuse to recapitalise impaired banks, only sovereigns with no fund-raising power remain. Yet as announced by the European Banking Authority on December 7, the euro-area banks are in desperate need of €115bn of new capital.

The plan contains no vision or clarity on the final destination, and provides no bridge to get there. In fact the tool-kit proposed contains only one tool – more austerity. Proposals to revive growth are notable only by their absence. Finally, there is no attempt to address the underlying problem of the loss of competitiveness in southern Europe as reflected in the intra-eurozone external payments imbalances – the surpluses in the north and the deficits in the south. The conferees meekly adopted the essentially German view that this is a crisis that must be resolved by internal adjustment by the debtors – i.e. years of deflation -- rather than a payments imbalance within a fixed exchange rate area requiring adjustment by creditors as well as debtors (1).

Even taken at face value, the proposals from the summit lack credibility in the markets. With respect to fiscal discipline, the previous Stability and Growth Pact was persistently broken, above all by Germany and France in 2003-04 when they each refused to pay the penalties incurred. It seems almost certain that this time ways will be found to escape the discipline of the 0.5% structural budget constraints and to avoid the supposedly automatic sanctions. In the end this form of fiscal union will prove to be too weak.

With respect to the stabilisation tools, instead of capping the combined rescue funds at EUR 500bn, the leaders ought to have rolled out a much bigger ‘bazooka’, and provided it with firepower immediately. Already, too, there is widespread opposition – e.g. from Japan, the United States and China -- to the use of IMF funds for further bail-outs of wealthy European economies. As British Chancellor George Osborne commented, the summit proposals represent necessary, but not sufficient conditions to solve the crisis. Sadly, too little too late has been the consistent pattern of the Eurozone leaders in the face of these momentous problems.

All this means that the eurozone debt crisis will persist through 2012 and even beyond, exacerbated by the deepening recession among the heavily indebted southern Eurozone members. In financial markets that spells heightened uncertainty and increased volatility. Among the major currencies, the euro is beginning to lose its appeal, and will probably decline further against the US dollar, the yen and the pound. With central bank policy rates in the developed world remaining very low for an extended period, the emphasis should still be on quality assets that generate safe and sustainable yields such as corporate and high-yield bonds in the fixed income area, ‘bond-like’ equities, i.e. stocks whose dividend are insulated by steady earnings growth and solid dividend cover against a muted economic backdrop, or real estate funds that can assure strong and stable flows of rental income. Commodities will be vulnerable to slowdowns in Europe and Asia.

UNITED STATES

The sharp falls in the stock market in August and September were triggered by an economic ‘soft patch’ in the summer, the impasse over the US debt ceiling and the consequent downgrade of the US sovereign debt rating from AAA to AA+ by S&P. Since then the economic data reported by government agencies as well as by survey sources has improved.

Before discussing the extent of the improvement, it is worthwhile remembering that the soft patch in economic activity came despite the fiscal stimulus passed in December 2010 (extending the Bush tax cuts, lengthening unemployment benefits and reducing the payroll tax) and despite the second programme of quantitative easing conducted by the Federal Reserve between November 2010 and June 2011. In this sense, both fiscal and monetary policy had failed to revive the economy. Traditional macroeconomic tools proved impotent when confronted with the greater forces of private sector deleveraging.

Balance sheet repair was thus one of the main headwinds holding back the economy in 2010 and 2011, and is likely to continue to be a major pre-occupation of the household and financial sectors over several more years. We should therefore moderate our expectations of any sudden snapback to economic normality.

A second major headwind in 2010 and 2011 was the adverse shift in the terms of trade – the price of exports relative to the price of imports. Specifically this took the form of strong rises in imported energy, metals and food prices driven largely by strong demand in China and India as well as by

other emerging economies. The principal effect was to drive up consumer prices from an average of 1.6% in 2010 to an average of 3.2% in 2011, eroding nominal wage and salary growth, and causing real after-tax incomes to fall. This phenomenon was by no means restricted to the United States, and was evident in many other developed economies. In 2012 I expect the rise in commodity prices to ease, with some prices declining -- particularly under the influence of the recession in Europe and the slowdown in China. This would imply that US consumer spending in real terms could recover moderately as consumer price increases in the US slow from 3.2% in 2011 to 2.1% (the current consensus forecast) or less in 2012.

The third headwind for the US economy in the past two years has been the continued slump in the housing market. It is still the case that over 22% of mortgage borrowers are in negative equity, implying that their ability as consumers to spend freely in the shopping malls is constrained by the need to pay down their debts. Equally, the large overhang of unsold homes means that house prices have remained under downward pressure for much of 2011. Consequently new single family home sales remain in a slump, running at about 300,000 p.a. compared with 1-1.3m p.a. in 2003-06. At the same time employment in construction and purchases of raw materials for home building are obviously constrained. Historically the housing industry was a bellwether for the economy as a whole, featuring prominently in the leading indicators of the GDP. The best that can be said is that affordability has improved, but access to credit is difficult, reducing the number of potential buyers.

Compared with the soft patch in the summer the US economy performed better in the final four months of the year. Real GDP in the third quarter recovered to 2.0% (annualised) compared to 0.4% and 1.3% in the first and second quarters respectively, while non-farm payrolls improved, rising by an average of 143,000 per month in September-November compared to only 76,000 per month in May-August. Durable goods orders excluding volatile transportation orders – a key indicator for business investment – has continued to strengthen, and the trade deficit has narrowed. These are all signs that the economic recovery, although not vigorous, is at least on a consistently positive trajectory.

An important question is why US debt and deficits are not the same crisis-inducing issues in the US as they are in the Eurozone. The answer is that the US enjoys what is known as the ‘exorbitant privilege’ of having the world’s premier reserve currency. As long as China, Japan, the smaller East Asian economies and OPEC choose to prevent their currencies appreciating while they run current account surpluses, they inevitably accumulate foreign reserves that must be held somewhere. But their options are limited. They will be reluctant to buy euros as long as the euro sovereign debt crisis continues, and their appetite for Japanese yen, pounds or Swiss francs will be small. Effectively that leaves only the US dollar. For this reason alone the US can rely on more financing of its domestic debt by foreign investors, and at lower interest rates, than (say) Greece or Italy. The risk for the US is that high levels of indebtedness will make the economy more vulnerable to balance sheet recessions. This is why it is so important to reduce the ‘global imbalances’ before another credit bubble begins.

Given the deep-rooted nature of two out of three of the headwinds mentioned above – the overarching need for balance sheet repair, and its impact on credit-sensitive sectors like housing – it is simply not feasible for the US economy to experience the sort of rapid bounce-back to strong 3-4% growth rates that typified many of the post-war recoveries. The current economic upturn is therefore likely to remain sub-par. I expect just 2.0% real GDP growth in 2012 with CPI inflation falling to 1.4%.

CHINA

The Chinese economy has been losing momentum in 2011 and will weaken further in the first half of 2012. There have been two main contributors to the slowdown: weaker domestic demand in response to the progressively tighter monetary policy of the past eighteen months, and a distinct slowing of export growth as key overseas markets such as Europe and the UK have edged closer to recession. However, overall, I do not expect a hard landing in China.

On the domestic side the authorities embarked on a programme of monetary tightening mainly in order to cool the overheated residential property market. However, the composition of the Chinese housing market is undergoing a fundamental shift. While private housing is cooling, public sector housing is being energetically promoted under the new Five Year Plan which seeks to build 36m subsidized housing units by 2015. The scale of that lower-income housing expansion means that the weakness in the private sector will be largely offset by strength in the public sector. In the materials market – e.g. for concrete and steel – while the private sector will be weaker, the public sector-driven demand will be stronger.

Another area where growth has slowed is on the external side as exports have moderated from over 23% growth in the first half of 2011 to 13.8% by November 2011. Mostly this has been driven by the slowdown in the developed world. Overall I expect Chinese economic growth to slow to between 7% and 8% in 2012, but if the authorities take the view that the slowdown is becoming more serious – perhaps because of a recession in the Eurozone – then they will have no hesitation in introducing further expansionary measures. As in 2009-10, these would be likely to succeed thanks to the fact that balance sheets in China remain in good shape, and households, firms and local authorities are therefore still willing to borrow and spend. 

On the inflation front consumer price changes peaked in July at 6.2%, and have since moderated to 4.2% in November as food prices and energy markets have softened. I expect inflation to average 3.5% in 2012. Fundamentally China remains excessively dependent on external demand and investment spending, and hence acutely vulnerable to the deepening downturn in Europe. Hence even though further domestic stimulus will almost certainly be employed in 2012, China’s overall growth is likely to be lower than in 2010 or early 2011.

THE EUROZONE

The outlook for the euro-area remains clouded by the failure of the leaders to resolve the region’s sovereign debt crisis. This is casting a shadow over business and consumer confidence. Real GDP growth for the Eurozone was only 0.2% quarter-on-quarter in each of 2011 Q2 and Q3. This subdued growth was due to the drag from the crisis economies which offset stronger growth in Germany and France. Based on survey data so far, such as the Purchasing Managers Index which remained below 50 for the three months September- November, the euro-area economies are almost certain to have shifted to negative growth or recession in Q4. I expect growth to be negative again in 2012 Q1 and very low for the balance of the year, resulting in growth for the year as a whole of 0.3%.

Inflation in the eurozone averaged 2.7% in 2011, but will fall below 2% in 2012, depending on the depth of the recession. I am forecasting 1.8% CPI inflation for the year as a whole.

UNITED KINGDOM

Both the Office for Budget Responsibility’s (OBR) Fiscal and Economic Outlook and the Chancellor’s Autumn Statement were very gloomy about prospects for 2012 and 2013. However, both documents at last displayed a welcome sense of reality in contrast to the persistent tendency in the past of Whitehall to overestimate growth prospects and hence overcommit to government expenditure.

The framework the OBR uses to forecast growth depends on two concepts that are both very hard to measure – the output gap in the economy, and the underlying growth of productivity. Both of these have been problematic recently. The amount of excess capacity is inherently hard to measure, especially in a service economy, while the OBR argues that productivity growth has taken a permanent hit due to the recession and will take many years to recover. On this basis the OBR is forecasting only 0.7% real GDP growth in 2012 and 2.1% in 2013.

I believe one can come to the same conclusion more directly. Much recent research has shown that economic growth is significantly impaired in the aftermath of a financial crisis. The reason is that financial crises do great damage to balance sheets across the economy, and it takes a long time for the household and financial sectors to repair them. Consequently I would say that essentially the official Whitehall view has at last come into line with my forecast of sub-par, 1.0% real GDP growth in 2012.

On the inflation front, commodity prices were pushed up strongly in 2009-10 on the back of the strong recovery in the emerging economies, especially natural resource-importing economies such as China and India. The feed-through to consumer prices in very open economies such as the UK was rapid, exacerbated by weak sterling and higher VAT and fuel duties. But essentially this recent episode of inflation was a one-off event rather than the start of a sustained, continuing inflation. In 2012, the recession in the eurozone together with weak growth in the US and the UK will mean that these one-off effects will largely fall away so that rising inflation will be replaced by slowing inflation. I expect CPI inflation to fall to 2.4% for the year as a whole.

NB: The recent UK veto of the proposal to make changes to the Lisbon Treaty in order to secure a ‘Fiscal Compact’ for the eurozone member states has drawn both criticism and praise in abundance. With the UK not being a member of the eurozone, it is hard to see why the UK should accept compromises to national sovereignty (e.g. in respect of

financial sector regulation) where the central purpose of the Fiscal Compact is to impose discipline upon and possibly rescue weaker members of a currency union in which Britain does not participate. In that regard, David Cameron’s veto seems understandable, even though it has not won any immediate concessions.

JAPAN

Economic activity has continued to recover from the devastating Tohoku earthquake in March. In 2011 Q3 real GDP growth surged by 1.5% quarter-on-quarter following three successive quarters of negative growth. In October industrial production increased by 2.4%, confirming the industrial recovery. Business sentiment has been encouraged by the passage of the third supplementary budget of JPY 12 trillion (equivalent to 2.5% of GDP) by the Diet. The Bank of Japan has maintained its extremely loose monetary policy stance, assisted by the authorities’ aggressive intervention in the foreign currency market in October to keep the yen from appreciating.

While the recovery from the earthquake has demonstrated Japan at its most resilient, I nevertheless expect the economy to resume its trend pattern of the past decade by 2013 – weak domestic demand growth partially compensated by strong export performance. Meanwhile I expect real GDP growth to be 2.4% in 2012, mainly due to base effects. Growth will be artificially lifted by flattering comparisons with the earthquake-affected performance in 2011. Prices continued to decline in Japan with the CPI (excluding food and energy prices) registering negative year-on-year readings ever since January 2009. In 2012 I forecast that prices will creep above zero, but essentially the same deflationary conditions will prevail.

NON-JAPAN ASIA

The momentum of growth among the East Asian economies has slowed with real GDP growth reduced to 2.5% quarteron- quarter in 2011 Q3, down from 2.8% in Q2. The common factor was the moderation in export growth, while domestic demand, particularly household consumption, has generally held up well. Data for October and November point to further weakening of external demand, while forward-looking indicators show that consumer confidence has continued to stay firm, even though business confidence is showing signs of weakening. In 2012 the subdued growth prospects for the advanced economies and increased volatility in financial markets will continue to weigh on prospects for the region.

Inflationary pressure has begun to ease thanks to softening commodity prices and weaker aggregate demand pressure. For the region as a whole inflation remained at 4% year-onyear in October. The central banks in the region have generally taken a wait-and-see approach, although Indonesia, Singapore and Thailand have lowered interest rates or taken other easing measures during October and November. After remaining firm for most of the year, currencies in the region showed some weakness in November and December, driven by concerns about weaker export prospects in 2012.

LATIN AMERICA

Like the export-oriented economies of East Asia, Latin American economies have shown a distinct slowdown during the second half of 2011. In Brazil industrial production and broad retail sales both declined in October, and a widely followed proxy for monthly GDP growth in October was also negative. Demonstrating that the slowdown is largely externally induced, preliminary data for November suggest that consumer confidence, auto production and sales, energy consumption, road cargo, and imports have recorded positive readings for the month. To counter the slowdown the authorities have lowered interest rates, postponed taxes on imported vehicles, and reduced taxes on some consumer goods.

Economic activity across the region is likely to slow down in 2012, with real GDP growth slowing to around 3% from an estimated 4.1% in 2011. I expect inflation to decelerate, but only slightly. Nevertheless, most central banks will loosen monetary policy in 2012 as they continue to grapple with the external downturn. Political considerations will come to the fore with presidential elections in Mexico (in July) and Venezuela (in October).

COMMODITIES

The major drivers of commodity prices in 2012 will be the extent of the recession in the euro-area and its knock-on impact on the leading emerging economies such as China, India, and Brazil. Although oil prices have held up remarkably well during the intensification of the euro-area sovereign debt crisis, base metals and soft commodities have weakened, led by a number of agricultural products. This in turn has led to the decline in food prices in roughly two thirds of the emerging economies, and implies a significant easing of headline inflation both in the advanced and in the emerging economies in 2012. 

CONCLUSION

In the developed world the normal recovery process after a recession has not materialised during the three years since the Lehman bankruptcy. The reason, of course, is the overindebted or impaired state of balance sheets, particularly in the household and financial sectors. This means that large parts of the developed economies must focus on debt repayment by restraining consumption and postponing new investment, leading to sub-par economic growth. In response, governments initially stepped up their fiscal support programmes, but since debt levels were already high, the additional burden of official sector debt has now triggered a sovereign debt crisis across much of Europe and threatens to do so even in the US and the UK if deficit spending is not curtailed. This implies that 2012 will be another year of balance sheet repair by the private sector, austerity by governments, and slow growth in most of the advanced economies. One bright spot, however, will be that inflation rates will generally be declining.

In the emerging world there was initially a strong bounceback of economic activity but this is now faltering due to the failure to decouple from the developed economies. The continued heavy dependence of growth in these economies on exports to the developed world means that in most cases domestic demand growth will not be vigorous enough to offset external weakness. In turn, this implies slightly slower real GDP growth rates in 2012 than in 2010 or 2011, but – unlike the eurozone - by no means a recession. As in the developed economies, headline inflation rates, which are already slowing across much of the emerging world, will fall further in 2012.