UBS On "How Bad Might It Get" And Why "Sooner Or Later Intense Instability Will Resume"
Despite the very short term bounce in markets on yet another soon to be failed experiment in global liquidity pump priming, UBS' Andrew Cates refuses to take his eyes of the ball which is namely preventing a European collapse by explaining precisely what the world would look like if a European collapse were allowed to occur. Which is why to people like Cates this week's indeterminate intervention is the worst thing that could happen as it only provides a few days worth of symptomatic breathing room, even as the underlying causes get worse and worse. So, paradoxically, we have reached a point where the better things get (yesterday we showed just how "better" they get as soon as the market realized that the intervention half life has passed), the more the European banks will push to make things appear and be as bad as possible, as the last thing any bank in Europe can afford now is for the ECB to lose sight of the target which is that it has to print. Which explains today's release of "How bad might it get", posted a day after the Fed's latest bail out: because instead of attempting to beguile the general public into a false sense of complacency, UBS found it key to take the threat warnings to the next level. Which in itself speaks volumes. What also speaks volumes is his conclusion: "Finally it is worth underscoring again that a Euro break-up scenario would generate much more macroeconomic pain for Europe and the world. It is a scenario that cannot be readily modelled. But it is now a tail risk that should be afforded a non-negligible probability. Steps toward fiscal union and a more proactive ECB, after all, will still not address the fundamental imbalances and competitiveness issues that bedevil the Euro zone. Nor will they tackle the inadequacy of structural growth drivers and the deep-seated demographic challenges that the region faces in the period ahead. Monetary initiatives designed to shore up confidence can give politicians more time to enact the necessary policies. But absent those policies and sooner or later intense instability will resume." So what exactly does UBS predict will happen in a scenario where the European contagion finally spills out from the continent and touches on US shores?
We stressed that the most obvious downside risk to our new forecasts would be a further intensification of the European debt crisis and an even greater degree of regional and global financial instability, alongside perhaps even a break-up of the euro. But what would those risks invoke for the world economy?
There are of course no easy answers to this, partly because there are a number of possible scenarios for the Euro zone in the period ahead, each of which would have different financial market and macroeconomic consequences. At one extreme is the ‘break-up’ scenario which would have devastating consequences and potentially invoke a ‘depression’ for the Euro area and perhaps even the world. At the other extreme is a ‘muddle through’ scenario where policymakers continue to introduce additional measures on a piecemeal basis to contain the situation. In doing so they would keep market risk premiums higher for longer with more negative consequences for global financial stability and the world economy. But, assuming that a meaningful policy response that addresses some of the deep-seated challenges is eventually forthcoming, there need not be a devastating European recession in that scenario.
Our European team’s baseline scenario is closer to the latter than the former. The key difference concerns the assumption of more strident steps toward fiscal integration in the region over the coming weeks. That, combined with a greater willingness from the ECB to offer liquidity and monetary accommodation, ought to help fend off financial instability and a more entrenched European – and global – economic downturn.
But what might that latter scenario of ‘muddle through with higher risk premiums’ formally imply for the world economy relative to our current baseline forecasts? Again there are no easy answers. But to address the question we ran a simulation on the NiESR’s (the UK’s National Institute of Economic and Social Research) global econometric model. Specifically we assumed that risk premiums in European equity and credit markets climb much further from here, to levels exceeding those seen in the region during the 2008 global financial crisis. Risk premiums on all government bond markets in Europe, including Germany’s, are also assumed to rise from here.
Implicit in this scenario is a Europe-wide tightening of credit conditions and a generic across-the board increase in corporate and household borrowing costs. We also set the simulation to “infect” the rest of the world by generating some global financial contagion. The simulation generates an increase in equity and investment risk premiums in other economies proportional to their trade linkages with Europe.
The impact of this on GDP levels is shown in the charts below. In this simulated scenario, Euro area GDP falls by 1.3 percentage points relative to a baseline scenario after one year as domestic demand contracts more severely in response to tightening financial market conditions. In other words instead of a 0.7% contraction in the region’s GDP, which is our current forecast for the Euro area next year, we should expect a contraction closer to 2%. Other major economies would be hit as well, although the US is still simulated to escape a formal recessionary phase. Our forecast for US growth would drop to about 1.5% from our baseline forecast of 2%.
The impact of the simulation on emerging economies is on the whole less pronounced, partly because the model assumes proactive policy responses but also because the degree of financial contagion is less severe relative to most major economies. Those factors help cushion the blows.
All in all, though, this scenario would bring the world economy much closer to recession. Global growth would be close to just 2% in 2012 under this scenario. Most official bodies (including the IMF) typically regard a global growth rate of less than 2% as being consistent with a recession phase.
And here comes UBS, admitting what happened on Wednesday is nothing, and the ECB better print soon or else.
Finally it is worth underscoring again that a Euro break-up scenario would generate much more macroeconomic pain for Europe and the world. It is a scenario that cannot be readily modelled. But it is now a tail risk that should be afforded a non-negligible probability. Steps toward fiscal union and a more proactive ECB, after all, will still not address the fundamental imbalances and competitiveness issues that bedevil the Euro zone. Nor will they tackle the inadequacy of structural growth drivers and the deep-seated demographic challenges that the region faces in the period ahead. Monetary initiatives designed to shore up confidence can give politicians more time to enact the necessary policies. But absent those policies and sooner or later intense instability will resume.
And the "models"