Whether it is strong-USD-based forward revenue reductions for US corporations, rear-view mirror-based fuel-cost implicit tax-cuts, or unsustainable savings rate reductions, the recent US data has created a plethora of 'this time is different' decoupling theorists. We discussed David Rosenberg's perspective on this unsustainability last week and now his old employer (Bank of America) is notably out with a rather negative note on the chances of this 'local' European problem becoming a global issue and impacting US growth through both trade and financial linkages. In their view, we will see a steady deceleration in growth this year while the consensus sees a pick up and by the spring these negative revisions (from sell-side economists) will weigh heavily on stock markets and support bonds. They sum it up succinctly: 'Enjoy the recent price action while it lasts.'
BAML Economics: The odd decouple, Neil Dutta
Over the last several weeks, US economic data has almost uniformly surprised to the upside. The employment report is a case in point. In December payrolls rose by 200,000, the unemployment rate ticked lower, and the work week ticked higher. Against this firmer growth backdrop, we are marking to market our Q4 GDP forecast to 3.5% from an initial forecast of 3.0%. Roughly one-third of the growth contribution comes from inventories, which leaves final sales at 2.4%.
Moreover, we now expect legislators to stumble toward a full-year extension of the payroll tax cut and unemployment insurance, with only limited fiscal offsets. A temporary payroll tax cut is a relatively weak stimulus measure because only about a third is spent. Be that as it may, our original forecast assumed an expiration of both measures; we now see an extension of both. As a result, we are revising up Q1 to 2.2% from 1.8% and Q2 to 2.0% from 1.8%, but leave Q3 and Q4 unchanged at 1.3% and 1.0%, respectively. The confluence of these changes takes 2012 GDP to 2.1% from 1.9%.
With this less pessimistic forecast, we see the unemployment rate averaging 8.5% in Q4 2012, down from 8.8%. This level will still limit wage growth, and so we are leaving our inflation forecast untouched, looking for a drop to 1.5% YoY in core CPI by year-end from slightly above 2% now. Finally, the probability of QE3 gradually builds as growth drops to 1% in H2. Our “point estimate” is that they restart QE in September, slightly later than we initially thought.
Despite the near-term revisions, our longer-term view remains the same: we still see a steady deceleration in growth next year, while the consensus sees a pickup. We believe that the consensus continues to misread the lag pattern in the economy’s response to shocks. Europe is sliding slowly into recession and it will take time for that recession to dampen US data. The impacts of US fiscal tightening will also build over the year. And a significant post-election uncertainty shock awaits at year end, with the threat of major tax increases and major spending cuts, and more squabbling over the debt ceiling.
Hot topic: Europe’s crisis will hit the US with lag
In recent months the US economy has picked up, even as Europe has weakened and many forecasters expect this decoupling to widen further. In our view, the consensus is misreading the timing and underestimating the magnitude of the shock from Europe to the US. The consensus forecasts Europe contracting in Q1 with slow growth thereafter, but sees the US economy accelerating steadily over the course of the year. In contrast, we expect Europe’s crisis to have a lagged, longer lived impact on the US (Figure 1). This is one reason why we expect a steady deceleration in US growth in 2012.
Historically, economic activity in Europe lags the US by roughly 2 to 3 quarters. Figure 2 illustrates the economic cycles in the US and Euro area. Economists generally attribute this phenomenon to a less flexibility in Europe’s economy, particularly in the labor market. When a global shock hits—such as a spike in oil prices—US firms are quicker to cut workers, causing a more immediate shock to income and a faster feedback loop between declining demand and incomes.
However, this cycle should be different. This time the shock is not global or US in origin, it is coming from Europe. Hence, it should take time first for Europe to slide into recession and then for the US economy to contract. We expect the consensus to ultimately come around to our second-half growth view for the US economy. By the spring, we expect these negative growth revisions from sell-side economists to weigh on the stock market and support bonds. Enjoy the recent price action while it lasts.
Europe has a local problem that can go global
Conventional wisdom holds that because of increased trade and openness between nations, business cycles across nations should be more synchronized.
Indeed, one reason for the synchronized global upturn has been the sharp recovery in global trade. However, that has generally not been the case. One reason national economies were less synchronized, at least until recently, is that global economic shocks had been smaller in the 1980s and 1990s than they were in the 1960s and 1970s. The absence of global shocks reduced volatility over time, allowing economic performance to be more differentiated across countries.
By extension, if nations were subject to more global shocks, then economic conditions across countries would be more synchronized. The nature of the shock matters. Historically, three kinds of shocks have driven the business cycle:
- Regional shocks that have limited spillover to other countries. Examples include the European Exchange Rate Mechanism crisis in the early 1990s, the “Tequila crisis” of the mid 1990s, and the Asian crisis in the late 1990s. Each of these events sparked recessions in the regional economy with minimal spillover to the rest of the world.
- Global shocks that impact many countries simultaneously. Oil production disruptions are a good example since every nation on earth consumes oil.
- A regional shock that can go global. The US subprime crisis is the best example. The reason the crisis was so debilitating was because of the unique position of the US in the global capital markets and the heavy global exposure to toxic assets from the US.
In our view, the current crisis in Europe is an example of a local economic problem with a high risk of going global. While we do not expect the magnitude of this crisis to match the US financial crisis of 2008, we do think the transmission process will be similar – namely through confidence and trade.
Trade linkages are relatively easy to measure. Generally, what drives cross-country trade is a “gravity model”. This theory posits that countries closer in distance and similar in income levels tend to trade more with each other. The US is a fairly closed economy to begin with; exports are roughly 15% of GDP (mostly to Canada and Mexico) and exports to Europe are just under 15% of that. So, a 1% decline in Europe’s GDP would shave US GDP growth by 0.02pp.
The key linkage to US is through the financial market
The financial and confidence linkages are more important but also harder to measure. In 2008, global financial institutions posted large losses on US mortgage-backed securities. US bank exposure to European peripheral debt is low relative to the rest of the world. Instead, the principle risk to the US stems through the increase in risk aversion in the capital markets and corresponding tightening in interbank funding markets.