Over the next 12 months, expect unsettling developments. The global crisis is still unfolding, and it could escalate
Weakening growth, rising systemic risks, and contagion-prone markets are likely to enhance economic and financial fragility. We are entering a perilous new phase.
First, growth will remain below potential, hindered by excessive debt. Since 2000, the debt globally held by governments, corporations, and households doubled to 63 per cent of global output, fuelling international growth. To avoid a structural deceleration of global activity, the balance is now due.
In 2012, the world economy is expected to grow at a frail three per cent. In advanced economies fiscal austerity in Europe and much-needed in the US, and a credit crunch, will curb recovery.
Europe will undergo a ‘double-dip’ recession, short-lived in the core, France and Germany, deeper in the Mediterranean. The sovereign debt crisis will continue. Greece will default. Italy’s rising bond yields (now at six to seven per cent) will amplify fiscal challenges. France will lose its AAA status, and Germany might follow. The European Central Bank (ECB) has made clear it will not rescue any government before shared fiscal rules and competitiveness-restoring reforms are agreed upon and approved. Quantitative easing (QE) is unlikely in the near term. Recession and deflation will prove costly ways to achieve relative devaluation. EU rescue vehicles (EFSF and ESM) will fall short: €1 trillion is needed and is not readily available. The banking sector is fragile. Direct exposure to peripheral sovereign bonds will entail capital losses. Greek private sector involvement has already bankrupted Dexia and – probably – Commerzbank. An orderly adjustment is the base case scenario, but disorderly developments (Italy and Spain losing market access, additional sovereign defaults, banks runs, and Euro zone breakup) are possible.
In the US, despite fiscal and monetary expansion (deficit at nine per cent, benchmark interest rate at 0.25 per cent) and a positive business outlook, the economy is unlikely to grow above two per cent. To sustain growth, incomes need to improve, but unemployment is structurally high and a quarter of mortgages are above house value. At $60 trillion, the net present value of future liabilities (social security, Medicare, Medicaid) is eroding the dollar’s ‘reserve currency’ status. A gridlocked political environment will weaken recovery, limiting the administration’s ability to approve a medium-term fiscal consolidation plan aiming at public debt sustainability while injecting additional fiscal stimulus. Policies in support of the labour and housing markets (i e extension of payroll tax cuts and unemployment benefits, Obama’s job-creation plan) might face headwinds. A European banking crisis is likely to impair US credit supply and, in case of major bank failure, induce a recession. Further downgrades are possible if – after the failure of the ‘debt-reduction Super Committee’ – the $1.2 trillion automatic budget cuts are suspended.
Emerging markets (EM) will grow at about six per cent, and for the first time will purchase more than half the world’s imports. Still, given their trade and financial links with the developed world, EM will suffer from the global slowdown. Lower EU and US demand will reduce export growth and commodity prices. A pullback in lending by European banks will make EM borrowing harder and more expensive. Asia will play a key role in sustaining world growth, but will not reverse ongoing deceleration. Currency depreciation and capital flight will pose intertwined risks, and enhance volatility. China, in a year of leadership change, will aim at strengthening its safety net – via social housing and healthcare spending – and household income. Because of the ongoing correction in property prices, developers will suffer. Non-performing loans will rise and the financial system will need recapitalisation. As real estate investment accounts for about 13 per cent of GDP, government revenues will decline. Still, if growth were to weaken significantly, Beijing is likely to loosen its prudent monetary policy and increase fiscal expenditures.
Second, downside risks are rising: too many issues remain unresolved, and policy is out of steam. The massive stimuli – fiscal injections, interest rate reductions, QE – that kick-started recovery in 2009 are to be progressively withdrawn. Global demand could be weakened further by negative feedback-loops between high debt, fragile sovereigns and banks, fewer jobs and social grievances, insufficient rebalancing, higher uncertainty and lower confidence. Over the course of the year, a few negative shocks are to be expected.
To clean up balance sheets, debt needs to be paid down or restructured. Political and economic considerations will determine who will pay. The private sector will face tax increases. Workers will suffer high unemployment and declining wages. In absence of sustained growth, creditors will face debt restructuring, a wealth transfer to their debtors. In the EU, Germany will have to forgive peripheral debt and guarantee central government debt of core countries. In the US, negative-equity mortgages will need to be written down.
Banks are likely to maintain high liquidity, tight lending, and suffer a rise in non-performing loans. The Euro zone will suffer financial instability and banking sector stress. The risks of sovereign default and bank bankruptcy are rising. Banks need to recapitalise and – to reach a nine per cent Tier-1 ratio – will shrink their balance sheet. As private capital is unlikely to show appetite, government-takeovers or partial nationalisation are on the cards. As a result, the US banking industry might suffer contagion and credit disruptions. Still, the US will continue to benefit from deep bond markets and credible liquidity conditions. Central banks will support the financial system if conditions worsen.
Rising social grievances will be left unanswered. Massive protests at the global level are likely to persist, fuelled by unemployment, budget cuts, and high food prices. In the Middle East, evolution is unlikely to replace revolution. Worryingly, financial markets might not allow time for individual nations to work through the political process.
Third, global markets will operate in a jittery landscape. Europe’s challenges will keep investors worried. Concerns about sovereign debt and banks’ balance sheets, widespread downgrades of earnings and credit ratings, rising systemic risks and elevated correlations will restrain financial flows and spark periodic sell-off of risky assets. The strong corporate sector’s financial position and economic weakness will favour mergers and acquisitions (M&A). In bond and equity markets, a “home bias” will persist. US Treasuries will remain a refuge, with yields at two per cent or below. If further stimuli measures are not enacted, equity performance will suffer economic stagnation, underperforming bonds.
As inflation will continue to ease globally, central banks will cut rates, but will not significantly grow the monetary base. Budget constraints and political impasse will hamper fiscal expansion. In the EU, the ECB will walk the fine line between moral hazard (printing money and buying bonds would lift pro-reform pressures from the periphery) and financial instability (markets dislike unsustainable rises in bond yields). In the US, further QE is possible to buy financial assets.
Against this backdrop, where to invest? Capital preservation and prudent risk management are priorities. Deflationary pressures (due to unused capacity in goods and labour markets), high downside risks and a fragile upside will push investors into cash. Also, cash allows taking advantage of both low valuations and the volatility inherent to a highly liquid post-crisis environment. However, in the medium-term holding liquidity will not pay off. Cash and bond investments will see their purchasing power eroded by inflation. Indeed, negative real interest rates will produce massive transfers from those who play safe (depositors and lenders) to risk-prone investors (borrowers). A sustained equity rally is possible, but would depend on clear and decisive public policies. In Europe, the ECB should backstop sovereign bonds, and governments provide an unambiguous map towards the introduction of Eurobonds. In the US, the approval of the stimulus bill is essential to uplift growth. In China, fiscal expansion, monetary easing, and currency appreciation would need to tackle current account imbalances.