Substantially more sanguine than their two key strategists Albert Edwards and Dylan Grice, SocGen's Cross Asset research has come out with a report looking at the future of the world, and the various scenarios that may end up taking us there (although the actual reality will of course be something unforeseeable). So while we play predictive games, here is how SocGen believes the upside/neutral/downside cases could look like across asset classes, and across the globe.
First, a summary of alterantive economic scenarios and the probability of each one occurring. Our advice: invert the probabilities for a realistic approximation.
Next, SocGen looks at what are the key drivers (and non-drivers) of assorted metrics, including monetary policy rates, bond yields, and FX.
SocGen then present and analyzes the core themes it believes will dominate over the next year. These are as follows: i) New 5-yr plan to prioritise reform favouring the Chinese consumer, ii) Firm growth in dynamic emerging driven by domestic demand, iii) Firm capital flows to emerging markets, but mounting financial protectionism, iv) The discussion on exit begins, but
will come very slowly, v) Fixing public finances and peripherals competitiveness will take time.
In a move that will certainly piss of Albert Edwards, the cross asset team has reduced the downside probability risk from 25% to 20%. Here is how the downside risks are quantified:
As seen in our 2011 Global Tails, we see advanced and emerging economies’ risks as near mirror images. In Asia and Latin America, the risk is to see inflation and asset price bubbles. In the advanced economies, the risk is biased to the downside on growth and sovereign risks. The common risk factors globally are found in protectionism, geopolitical risks and in global liquidity. In the event the vast pools of global excess liquidity are withdrawn too quickly, the risk is to see a sharp sell-off on risk assets. Conversely, if liquidity remains too generous, asset price bubbles will result (with the subsequent risk of a painful bust).
Summarising our risk factors at the aggregate level of the global economy, we still see the bias to the downside but have reduced the probability to 20% from 25% previously. We have subsequently increased our upside risk scenario to 10%. On the downside, we continue to split the risk scenarios into two. The first is “double-dip”, which requires a trigger event such as a sovereign debt crisis, abrupt policy tightening, or a sudden sharp decline in asset prices. The second is “drift to deflation”. This scenario has a distinctly more Japanese lost decade feel with a continued slow spiral down in the advanced economies. The latter will be much harder to pinpoint. On the upside, our scenario of “stronger policy multipliers” offers faster-than-expected repair of transmission channels. In particular, we note the possibility that cash rich corporates will regain their appetite to hire and invest. German households may offer the upside surprise in Europe.
The report does acknowledge that for global growth to continue, just shifting relative power between currencies (i.e. competitive devaluation) will not be sufficient, and a "new growth engine is required."
Currency movements on paper are essentially a zero sum game, and do little to boost aggregate global growth. Reducing the US current account deficit by 1% of GDP over two years would as a rule of thumb require a 20% depreciation of the US dollar, all else being equal. To reduce China?s current account surplus by 1% over a two-year period would require a 30% appreciation of the yuan. Moreover, such currency movements would do relatively little for global aggregate growth, and could even be damaging if large currency movements were to come about quickly and abruptly. A much better option for global re-balancing is clearly to see stronger growth in the emerging economies (here represented by non-OECD).
A lynchpin assumption behind our 2015 outlook is that China can successfully steer the economy towards domestic growth engines, building on the policy framework outlined in the new 5-year plan (2011-2015). As we detail in our Asia editorial, we see investment (and notably infrastructure) as the initial driver, with household consumption then becoming the relay as a higher share of Chinese national income is shifted from profits to wages. It is important to emphasise that the process of changing to new growth engines is far from automatic, but is highly dependent on the success of structural reform. Of particular importance is the speed at which China is able to rebalance between the corporate and household sectors. Reform of the state-owned enterprises (SOEs) is encouraging, with higher dividend payments and a reduction of monopolies and oligopolies. Also good news is the initiatives directed at encouraging bank lending to SMEs and reforms to allow greater mobility of labour and land reform (cf. Asia editorial for details). This process of growth transformation is not without risks. One reassuring factor is that China has room to adopt additional policy stimulus should downside risks materialise, and enjoys short policy lags.
In the US, businesses will need to look to new markets to secure stronger export growth. On the domestic front, moreover, the US needs to reduce reliance on energy imports. Again, this is a process that will require some effort. In the very short term, it is important that US companies regain confidence to hire and invest. Our central scenario (cf. US editorial) assumes that the US consumer will increase spending by around 2% p.a.
And while the bulk of the report is pretty much regurgitated stuff we hear most days, here are some other cool observations.
First the global leverage chart which we presented recently. It bears presenting again.
Next, a chronological look at the components of the US Economy. These are the five components that must be jiggered to generate growth.
A more detailed look at what happens to GDP during recessions:
And some good observations on whether "this time it is different," courtesy of the massive current account deficit.
Is this time different?
Might this CA adjustment be different to the previous ones? One reason to think so is the fact that the latest cycle was driven not just by cyclical and currency factors, but also by massive structural changes that may be more difficult to unwind. On the one side of this structural shift is the trade deficit with China, now at over 50% of the total. On the other side is the US savings rate which in our view continues to be suppressed by the massive buying of Treasuries by Asian central banks and artificially low bond yields.
The deficit with China is a problem because it is not subject to market forces which would normally work to eliminate it. Indeed, the deficit with China has grown even as the overall deficit has shrunk. The US deficit peaked in late 2006 and ? outside of the big swings following the financial meltdown ? has been correcting gradually since then. This was largely driven by dollar weakness that triggered adjustments versus flex-currency economies (Canada, Australia, Japan, France, etc.). This adjustment was not a deliberate policy choice as the dollar was being pushed down by market forces; however it represents an interesting opportunity for the future. If the US can not fix its deficit with China, it could try to offset it by building surpluses against other flex-currency economies. This ?currency war? scenario may be a positive for the US, but is not a positive for the global economy. It would merely reshuffle imbalances rather than addressing them at the core.
Can the dollar help?
The dollar can help to a certain extent, but it must be noted that the real trade-weighted dollar index is already at the low end of its historical (post Bretton Woods) range. In the past, with the dollar at these levels the current account would have been largely eliminated. So why is the US deficit still stubbornly stuck at 3% of GDP? Perhaps because what?s left in it are structural components: China and oil.
In modelling the external balance, we can improve the fit significantly by including the savings rate as a proxy for structural issues. The dollar explains the timing and direction of CA cycles, while the savings rate explains why they have gotten progressively larger over time.
So how do we get back to a sustainable current account level? To answer this question, we have created a matrix of various CA values which are a function of the trade-weighted real dollar index on one axis and the savings rate on another (see chart 2.11). If we assume -1% of GDP as a sustainable level of US deficit (consistent with the US income balance), then a 7.5% savings rate would put us right at that target. This would be a largely import-related adjustment triggered by lower levels of domestic demand. In the absence of such a structural savings adjustment, reducing the external imbalance purely via currency depreciation would require a further 25% in the value of the dollar (inflation adjusted). This would push the dollar well outside of a ?normal? range and would effectively constitute a dollar crash scenario.
What SocGen thinks is the endgame:
Orderly vs. disorderly rebalancings
What if structural changes fail to materialise? What if China fails to revalue the yuan or to restructure its economy away from an export-led model? This would imply ongoing large purchases of Treasury debt which should keep bond yields low and which should continue to discourage US dis-saving (either private or public). This status quo could continue for a few years, but markets have a way of ultimately forcing the necessary adjustments. One way in which this scenario could play out would be a period where private savings are offset by further fiscal expansion which ultimately leads to a loss of confidence and a Treasury market crisis. The recent steepening of the Treasury curve in the 10yr-30yr segment may be an early warning signal from the market. In this scenario, the dollar would suffer as well. The net effect would be a much higher savings rate, much lower imports, and slightly higher exports. Needless to say, this rebalancing is in no one?s interest.
Back to policy – what can the US do?
We see three potential scenarios developing over the next several years:
1) The US closes the output gap by rebalancing successfully vis-à-vis China;
2) US-China deficit remains unchanged, but the US builds offsetting surpluses with flexcurrency economies (?currency wars?);
3) There is no rebalancing, in which case the US will have a difficult time avoiding a deflationary scenario.
We have adopted the first, orderly rebalancing, as our baseline scenario. We do acknowledge that there are significant risks to this view and the recent backlash over QE2 does not inspire much confidence. Yet, underneath political postulating and harsh words, we see reasons for optimism. China will no doubt do what is in China?s interest, but its interests are ultimately aligned with the US. Having recognised the limitations of its export-led growth model and now the limitations of investment-driven growth, China is making real efforts to stimulate consumption growth. In the meantime, China?s growth remains sensitive to US exports and it has no choice but to protect the Treasury market from undue volatility.
Pretty charts and fancy theories aside, the bottom line is that nobody has any idea what will happen in a world so globalized that every non-US decision actually matters now. Where before the "ROW" was a simple category, that is no longer the case. And to assume that anyone has any grasp over the infinity of variables that determine the reality of the 95% of world population not residing within the US (which in addition to their own unique financial and economic uniqueness, also has a distinct culture, tradition and history) is beyond naive.