Vol 9 (2012) - Issue 2

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Risks Better Balanced

We see risks as being better balanced this year relative to 2011, with global central bank liquidity providing a powerful safety net, thereby protecting the global economy from potential financial shocks and contagion.

US economy: more balanced risks
Recent data have been positive though should not alter the view that US economic growth will probably average 2–2.5%, up from 1.8% in 2011, headline inflation will slow (from 3% in 2011 to roughly 2%) and the unemployment rate will gradually decline.
The headwinds that plagued growth last year are still in place, notably housing weakness, de-leveraging, joblessness and government cutbacks at the state and local level. But they are likely to be less intense this year. The housing sector appears to have bottomed but remains hampered by foreclosures, de-leveraging continues but at a slower pace, the labor market shows signs of improvement, consumer confidence and small business sentiment have improved moderately, and commercial and industrial loans are on the rise, as is consumer credit. Illustratively, credit conditions for auto loans coupled with underlying demand for cars have brought a recovery in unit car sales.
The combination of jobs growth and lower inflation should keep consumer spending on a moderate growth trajectory (roughly 2–2.5% inflation adjusted, down from the pre-crisis 3.5% trend growth rate). Investment spending growth should remain robust. Corporation reacted aggressively to the crisis by slashing spending and the investment share to GDP is still low. This suggests that the replacement cycle still has room to expand.
The risk remains centered on fiscal policy. The expiration of the payroll tax cut appears averted, but the outlook for next year is challenging. Across-the-board spending cuts remain the likely scenario and the Administration is looking to raise taxes on dividends and capital gains.

Europe: mild recession
The 'muddle-through' scenario remains intact. We do not believe in the break-up/serial default scenario. The challenge resides on the policy making front, as has been the case for the past two years. This means bouts of market euphoria driven by hope for some tangible resolution of the debt crisis (during which sovereign yields decline – Exhibit 1) followed by moments of severe doubt. But adjustments are taking place, even if more slowly than the markets are willing to tolerate.
Cyclical indicators underscore the mild recession outlook for this year, a surprising outcome given the fiscal consolidation programs put in place. It may partly reflect the divergence of growth between the core and periphery, with the core performing better, partly the timing of the fiscal bite and partly the resilience of the corporate sector, thanks to the ECB liquidity injection and the moderately positive global growth environment.

China: modest slowdown in growth
We maintain our view of a soft landing in China. The January PMI of 50.5 and the latest 50 basis point cut in the reserves requirement ratio reinforce this view. The risk this year is the changeover of the government leadership and the latter’s ability to steer the economy on a slower and sustainable path.

Emerging markets: more balanced risks
We believe that global growth will post a mid-cycle slowdown this year (3.5% rate vs. 3.7% in 2011). Such an outcome is very favorable for risk appetite. South East Asia’s outlook depends on trade and the positive reports out of the US render the risks more balanced. The outlook for Latin America have also surprised to the upside, with steady growth seen in Mexico, Chile and a gradual pick-up seen in Brazil. Activity in EMEA has surprised to the upside, with industrial output momentum gaining traction, particularly in Poland and Turkey.