[ipagelist tag=notablereport num=10]
- A tale of two worlds. Growth in the emerging world becomes more balanced and will by far outpace growth in the advanced economies this year.
- ‘BBB recovery’ in the G10. We expect the recovery in the advanced economies to be creditless and jobless, making it bumpy, below-par and boring.
- G3 growth differentiation. We see the US as the growth leader among the G3, the euro area to lag behind, and Japan to double-dip.
- ‘AAA liquidity cycle’ remains intact. Central banks will crawl rather than rush towards the exit, so global liquidity continues to be ample, abundant and augmenting.
- Sovereign and inflation risks on the rise. 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.
Last year was all about the exit from the Great Recession – and it worked courtesy of massive global policy stimulus, as expected. This year will be all about the exit from super-expansionary monetary policy. As we laid out in more detail in the final issue of The Global Monetary Analyst on December 16, we expect the major central banks to start exiting around the middle of this year.
Yes, they will likely be cautious, gradual and transparent, but the prospect and process of withdrawal may have unintended consequences: We think that government bond markets will be the first victim. While the exit will be the dominant macro theme next year, we identify five important economic themes in our global economic outlook that should be highly relevant for investors in 2010.
1. A Tale of Two Worlds
We forecast 4% global GDP growth this year, which would be a fairly decent outcome, especially compared to the doom and gloom that prevailed for much of last year. However, it falls short of the close to 5% average annual GDP 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. Importantly, our 4% global GDP growth forecast masks two very different stories. One is a still fairly tepid recovery for the advanced economies, the other a much more positive outlook for emerging markets, where we forecast output to grow by 6.5% this year (China 10%, India 8%, Russia 5.3%, Brazil 4.8%), up from 1.6% in 2009. A rebalancing towards domestic demand-led growth in EM is well underway. Moreover, as our China economist Qing Wang has pointed out, 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.
2. ‘BBB Recovery’ in the G10
In contrast to our upbeat EM story, we forecast barely 2% average GDP growth in the advanced G10 economies this year – a ‘BBB recovery’ where the three Bs stand for bumpy, below-par and boring. On our estimates, GDP growth averaged around 2% in the G10 in 2H09 and won’t accelerate much from that pace this year. The two key reasons why we think the recovery in the G10 will be ‘BBB’ are that it is likely to be creditless and jobless. Creditless recoveries – 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. 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 this 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.
3. G3 Growth Differentiation
Beneath the surface of a lacklustre ‘BBB recovery’ in the advanced economies lies a differentiated story for the three largest economies – the US, Europe and Japan. Significant growth differentials between these economies in 2010 may well become a topic for currency, interest rate and equity markets again. We see the US as the growth leader among this group, with output expanding by 2.8% (annual average) in 2010. The euro area looks set to grow by less than half that rate (1.2%), while Japan should hardly grow at all (0.4%) and is forecast to actually fall back into a technical recession in the first half of this year. One reason for US outperformance is that the creditless nature of the recovery affects the US 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 last year, so US labour markets look set to recover (albeit slowly) this year, while we expect unemployment to rise further in both Europe and Japan. Further, European and Japanese exporters should feel the pain from last year’s currency appreciation, whereas US exporters should benefit from last year’s dollar weakness.
4. ‘AAA Liquidity Cycle’ Remains Intact
The beginning of the exit from super-expansionary monetary policies will likely be the dominant global macro theme in 2010. We expect the Fed, the European Central Bank and the People’s Bank of China to move roughly in tandem and raise interest rates beginning in 3Q10, with the Bank of England following in 4Q. Some, like India, Korea and Canada, are likely to move earlier, while others, such as Japan, will lag behind. 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 twists in the crafted language and partly through cautious draining of excess bank reserves.
The end of easing and beginning of exit can be expected to cause wobbles in financial markets – one reason why we see bonds selling off sharply this year. However, official rates are likely to stay well below their neutral levels 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 the ‘AAA liquidity cycle’ (ample, abundant and augmenting) – the main driver behind last year’s asset price bonanza and economic recovery – fairly intact this year. The metric we follow to validate or refute this view is our global excess liquidity measure, which is defined as transaction money (cash and overnight deposits) held by non-banks per unit of nominal GDP. This measure exploded last year, and we expect it to rise further, though at a much lower pace, through 2010.
5. Sovereign and Inflation Risks on the Rise
We think that sovereign risk and inflation risk will be major themes for markets this year. Greece’s fiscal problems are only a taste of things to come in other advanced (not emerging) economies, in our view. Fiscal policy looks set to remain expansionary in all major economies this year, as the ‘BBB recovery’ still requires support. However, markets are likely to increasingly worry about longer-term fiscal sustainability. The issue is not really about potential sovereign defaults in advanced economies. These are extremely unlikely, for a simple reason: Most 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, their central banks can print whatever is needed (call it quantitative easing). Thus, sovereign risk translates into inflation risk rather than outright default risk. We expect markets to increasingly focus on these risks, 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.
Source: Morgan Stanley
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