Global economy: Green shoots, weak roots

This is a summary of HSBC’s Global Economics Quarterly for Q2 2012

The foundations are weak

With the US stock market up around 30% from its lows last autumn, with eurozone periphery bond yields tumbling through much of the first quarter and with the green shoots of an economic spring emerging here and there, it might be tempting to believe we’re back to business as usual. That temptation should be resisted.

In a world of economic permafrost, markets have a tendency to move from despondency to euphoria and back again when little in economic reality has actually changed. And that’s exactly what we’ve been living through in recent years. Sentiment and reality, however, are not the same thing.

Western growth over the decade ending in 2010 was by far the weakest of any decade in the postwar period and lower than the average recorded in the first half of the 20th Century when nations had to cope with war, depression and other assorted difficulties. In per capita terms, US growth in the decade ending in 2010 was weaker than Japan’s performance in either of its two “lost decades”.

Far from avoiding Japan’s problems, the west appears to have fallen into exactly the same trap. Admittedly, this weakness partly reflects the impact of the financial crisis, a once-in-a-century event. That event, however, created two separate problems: first, an initial collapse in activity and, second, a lack of healthy recovery thereafter. In our view, the lack of decent recovery is the source of current confusion over the state of the economy. A year ago, economists and investors were optimistic about the outlook for the Western world and its financial markets, only to discover a far harsher reality. Consensus forecasts came down, risk assets disappointed and fears of double-dip returned.

The monetary spigots were then opened up – we’ve since had ‘Operation Twist’ from the Federal Reserve, a further round of quantitative easing from the Bank of England alongside a further dose of unconventional stimulus from the European Central Bank – giving financial markets yet another shot in the arm. With double-dip avoided, euphoria returned. Yet, all the while, economies remained on monetary life support.

The pattern is set to repeat itself in the Western industrialised world this year. Indeed, even as we put the finishing touches to this document, investor unease had resurfaced, reflecting fears of recession in Europe, worries about an excessive slowdown in China and concerns about the underlying strength of the US recovery.

This financial market bi-polar disorder should be familiar to seasoned Japan-watchers. Despite its twenty year economic malaise, Japan witnessed plenty of enormous stock market rallies, each of which ultimately ended up scattered on barren economic land. The problem can be simply put: stagnation leads neither to boom nor bust but only to grinding economic progress: investors, however, remain addicted to the old boom and bust model triggering huge – and ultimately unjustified – swings in asset prices in both directions.

Why stagnation is here to stay

We highlight five factors which are contributing to stagnation and, hence, a failure to achieve economic lift-off in the Western world:

4 Debt is too high, both absolutely and relative to very depressed levels of income. Across the industrialised world, income levels are around 10% lower than pre-crisis projections had suggested. Despite a huge monetary and fiscal stimulus, there has been no return to business as usual. For the most part, debt has merely been redistributed to the public sector rather than reduced.

4 The political landscape is more than usually uncertain, a reflection both of the 2012 political calendar – with elections in France, Greece and the US, a referendum in Ireland and a change of leadership in China – and the difficult fiscal choices forced upon governments as a result of excessive debt. And with a likely shortfall of growth in southern Europe, the eurozone’s problems are most definitely not over.

4 The gravitational pull of emerging nations is proving to be more destabilising than many had expected. The structural economic decoupling witnessed over the last decade or so – with emerging nations going from strength to strength while industrialized nations are left languishing – has shifted relative prices and wages: commodity prices are up, Western wages are stagnant and, as a result, real incomes in the west are not robust enough to allow smooth debt repayment.

4 Higher oil prices threaten to trip up the world economy this year in much the same way they did last year: Iranian tensions show no signs of fading any time soon while QE may have inadvertently led to higher commodity prices more generally.

4 The financial system is far from healthy. Money supply growth may have picked up in the US but for all the wrong reasons. The eurozone capital market is completely dysfunctional; interest rate spreads remain incredibly wide. And the volume of available credit continues to subside. Despite, then, all of the unconventional stimulus, there is little evidence that Western credit systems are returning to anything approaching normality. An observer from Japan would not be surprised.

Can the emerging world escape?

Compared with the developed world, the emerging world has plenty of advantages, at least from the point of view of economic growth. With much lower per capita incomes, many emerging nations still have many years of economic “catchup” ahead of them, suggesting that their growth rates – led more by rapid increases in productivity than is possible in the developed world – should remain significantly higher than in the west. They also enjoy a lot more policy flexibility. Whereas interest rates are down at more or less zero in both the US and Europe, matching Japan’s earlier experience, emerging nations still have plenty of available ammunition including rate cuts, reserve ratio cuts and, if necessary, fiscal stimulus.

The bigger problem for emerging policymakers is balancing the risk of too little growth against the danger of too much inflation. Rising commodity prices have the capacity to add both to inflation and, more worryingly, to income inequality, suggesting that the scale of stimulus likely to be seen in the months ahead will be a lot more modest than seen in, for example, 2009. One result is likely to be the weakest Chinese growth rate since 2001. Nevertheless, some countries have thrown caution to the wind, cutting interest rates much more quickly than expected: Brazil is the obvious example.

Our new forecasts

Consistent with our view on economic permafrost, we have resisted the optimism which, for a while, had begun to dominate sentiment in financial markets. To be clear, we are not suggesting a return to recession – other than for the eurozone’s periphery – but, instead, an absence of healthy recovery.

We have made marginal upward revisions to our forecasts for the US, the UK and the eurozone, in part reflecting a marginally stronger turn of the year than originally expected, but these changes are not really economically meaningful: they are the stuff of rounding errors rather than of major changes in the underlying narrative.

Thus, for the US, we now expect GDP growth this year of 1.7%, up from 1.5%, while the eurozone’s shrinkage is now limited to -0.6%, up from -1.0%, largely thanks to a more robust showing from Germany. China hangs on to growth of 8.6% this year, in part because we now expect a lot more policy stimulus than before in the wake of near-term weakness in exports and industrial activity. The outlook for 2013 is more or less the same as before, emphasising our view that recovery in the Western world remains a long hard slog. As before, the emerging nations continue to pull away.

While the euro’s problems bubble away, it is difficult to become excessively optimistic about the trajectory for the single currency. However, whatever the outcome of the ongoing fiscal machinations, at least Europe is making an attempt to deal with its excessive debts. The US, in contrast, looks set to delay debt reduction measures until beyond the Presidential Election.

Even then, prospects appear murky. To prevent long-term rates from rising, we expect the Fed will maintain its commitment to zero interest rates come what may, suggesting that the dollar’s medium-term prospects are even worse than the euro’s. Meanwhile, although we have rightly favoured a “risk-on” approach to asset allocation in recent months, favouring in particular equities over credit (The Allocator: Staying with the Risk-rally (for now), 20 March 2012), our growth outlook suggests doubts about the strength and sustainability of the recovery will soon resurface.

Ultimately, without decent growth, the risk of financial reversal remains high.