We won't comment on the supreme imbecility of being able to predict something as amorphous as a recession in decile increments, but for what it's worth, here it is. Just out from the crack Goldman tag team of Hatzius and Dominic Wilson, who usually don't work together unless they have to make some big statement: "We now see the risk of a renewed US recession as around 40%." (this was 30% before - expect every other Wall Street idiot to follow suit with an identical prediction). Also, those wondering if Goldman is content with getting shut out on its IOER cut demand, we have the answer: no. To wit: "We expect additional easing of monetary policy beyond the ‘operation twist’ announced recently, although this may not come until sometime in the first half of 2012. In addition, the market’s focus on changes in the Fed’s guidance on future policies - including a greater emphasis on the employment part of the ‘dual mandate’ and/or a temporarily higher inflation target - is likely to intensify." Lastly, as relates to the saving grace in Europe, little surprise there - Goldman, whose plant Mario Draghi is about to take over the ECB, expects the very same ECB to open the spigots: "The increase in financial risk is likely to lead the European Central Bank to ease its liquidity policies further this month, and the economic weakness will probably result in a cut in the repo rate by 50bp to 1% by December." As for European economic prospects, well, sacrifices will be made: "we now expect a mild recession in Germany and France, and a deeper downturn in the Euro periphery." And with a former Goldmanite about to take over the European money issuance authority, we have a bad feeling about what will transpire in Europe after October 31, when Trichet finally exits stage left.
World Growth Slows as Europe Stagnates
The further deterioration in the economic and financial situation in the Euro area has led us to downgrade our global GDP forecast significantly, from 4.3% to 3.5% in 2012. Over the next few quarters, we now expect a mild recession in Germany and France, and a deeper downturn in the Euro periphery. The increase in financial risk is likely to lead the European Central Bank to ease its liquidity policies further this month, and the economic weakness will probably result in a cut in the repo rate by 50bp to 1% by December.
The increase in spillovers from the Euro area, primarily via tighter financial condition, is the primary reason why we have also downgraded our forecasts for the US further. We now see the risk of a renewed US recession as around 40%. We expect additional easing of monetary policy beyond the ‘operation twist’ announced recently, although this may not come until sometime in the first half of 2012. In addition, the market’s focus on changes in the Fed’s guidance on future policies - including a greater emphasis on the employment part of the ‘dual mandate’ and/or a temporarily higher inflation target - is likely to intensify.
Despite the deterioration in the advanced economies, Table 1 shows that our baseline global growth forecast for 2012 remains at 3.5%—a downgrade of 0.8ppt from our prior forecast and well below the pace seen in 2010-2011, but still decent by historical standards. The main reason is that we expect only a modest slowdown in China and other emerging economies. Although the recent Chinese policy tightening and the downturn in export demand are likely to weigh on growth in the next few quarters, we expect the waning inflationary pressures to lead to a renewed easing of policy later this year, and this should underpin a moderate reacceleration in 2012.
The downgrade to our growth forecasts has led us to lower our targets for bond yields, commodity prices and equity prices. While even the new targets are generally above the forwards, the downside ‘skew’ to our market views has increased notably.
The Euro Crisis Intensifies
On account of the intensifying financial dislocations in Europe, we have substantially revised down our outlook for economic activity in the Euro area over the next two years. The Euro area economy entered the year strongly, with first-quarter growth of 0.8%qoq, or 3.1% at an annual rate. A slowdown from this strength was expected, but the weakness in official and survey data through mid-year has gone further than we expected. The new forecasts embody significant downward revisions to Euro area growth for both 2011 and 2012. Our projections for year-on-year growth rates in 2011 and 2012 are 1.7% and 0.1% respectively, with a recession—defined as two successive quarters of negative growth—foreseen at the turn of the year.
On this basis, we expect inflation to moderate further in the first half of 2012, giving the ECB ample room to lower policy rates. We see the ECB lowering its repo rate by 50bp in December, with the risk that a cut may come earlier. With rates likely on hold in October, we think that the ECB will focus its immediate attention on bolstering its non-standard policy measures, aimed at supporting bank funding and peripheral sovereign debt markets where the current tensions are most acute. Given the current market situation, there seems to be little prospect of the ECB withdrawing significantly from these non-standard measures over the forecast horizon.
The rationale for our downward revisions varies across countries. Alongside a recession in the short term and stagnation next year, our new growth projections imply additional intra-Euro area cross-country divergence. We assume that financial dislocation in the periphery will persist into 2012, compounding the effects of fiscal consolidation on growth. We therefore project a more persistent downturn in peripheral countries. The impact of financial tension is less severe in most core countries, with sovereign yields low and corporate balance sheets strong. Nevertheless, the outlook for economic activity in the core has also deteriorated, on account of the expected weakness of demand from peripheral countries in recession and, at least temporarily, by decisions to delay investment in the face of elevated uncertainty stemming from financial market developments.
Will the US Avoid Recession?
We have downgraded our US GDP forecast for 2012 to 1.4% from 2.0%, and now see growth bottoming at ½% (annualised) in the first quarter of 2012. The reason for our downgrade is the larger financial and economic shock from the deterioration in the Euro area. We believe that this could take around 1ppt off US growth over the next year (although a small portion of this hit was already included in our prior forecasts.) There are three main channels of transmission:
- A tightening of financial conditions as measured by our GS financial conditions index, which we expect to take about ½ percentage point off GDP growth over the next year.
- Decreased availability of credit, which could take up to ½ percentage point off GDP growth, although there is not yet much evidence of a negative effect.
- Real economy spillovers via reduced exports (both to the Euro area and third countries), which might take another 10bp off growth. (For more details, see Andrew Tilton, “Will the European Storm Cross the Atlantic?” US Economics Analyst, 11/37, 2011.)
The obvious risk is that this hit will accelerate the labour market deterioration that is already underway, and will thereby push the economy into recession via the ‘stall speed’ effects that we have long noted. Indeed, our forecast now calls for a (very gradual) increase in the unemployment rate from a trough of 8.9% in early 2011 to 9.5% in late 2012. If this comes without an outright recession, it would be the first time in postwar history that the unemployment rate has risen more than 35 basis points without an outright recession.
However, we believe that the expansion might be somewhat less vulnerable to rising unemployment than it has been in prior cycles. The main reason for this is that the most cyclical sectors of the economy, such as homebuilding, durable consumption, business investment and inventories—which typically account for all of the decline in overall real GDP in recessions—are already at very low levels of activity and are unlikely to decline dramatically further unless there is another very large shock. (See Zach Pandl, “How Much Downside?” US Economics Analyst, 11/39, September 30, 2011.) We therefore believe that the risk of recession is ‘only’ 40% despite the upward trend in the unemployment rate. Moreover, if there is indeed a recession, we suspect it would be relatively ‘mild’ for the same reason. (The term ‘mild’ is in quotation marks because it refers only to the rate of change of activity and employment, recognising that the levels are already unacceptably low.)
Whether or not the economy enters another recession, a meaningfully above-trend recovery looks quite unlikely. A key reason for this is that monetary and fiscal policy is much less likely to make a positive contribution than in past cycles. In fact, we expect fiscal policy at the federal, state and local level to subtract about ¾ percentage point from growth next year, even assuming that Congress extends the 2011 payroll tax cut by another year and adds a hiring tax credit for small firms. On the monetary policy side, some additional easing is likely, and we expect a return to quantitative easing—defined as the financing of large-scale asset purchases by the creation of excess reserves—in addition to the recent ‘operation twist’ either later this year or in the first half of 2012. Moreover, the recent discussion about potential changes in the interpretation of the Fed’s dual mandate is likely to continue. But, on balance, we do not expect a big positive impulse from the policy side anytime soon.
Will China Keep Supporting Global Growth?
The stalling of economic activity in Europe and the US has further increased the importance of continued expansion in the emerging world—especially China—for the global growth picture. It is admittedly easy to worry about China’s resilience. For one thing, China is quite vulnerable to slower growth in its major export markets -as it is such an export-driven economy. We estimate that a slowdown in world GDP growth (ex China) results in about a 1-for-1 hit to Chinese growth, a much bigger number than in any other major economy.
In addition, Chinese policymakers have tightened aggressively in recent months, mainly via more stringent loan guidance to the banks.
The reason for this hawkish policy stance is twofold. First, inflation has stayed higher for longer than we expected. The main culprit is the surge in food prices, which have risen 13.4% over the last year and show only tentative signs of peaking in sequential terms. Second, the sharp increase in overall leverage in the Chinese economy—mostly in the local government sector—has probably made Chinese authorities more reluctant to respond to a deteriorating economic outlook by easing policy as early as they did in 2011.
But while the external drag and the policy tightening are likely to keep growth below trend in the near term, we do expect a modest reacceleration in 2012. At the most basic level, we do not believe that China is a ‘bubble economy’. And while inflation has stayed higher for longer, we still expect it to come down significantly in coming months, with the headline CPI down to around 4% by November from 6.2% in August. Combined with the slowdown in global activity, this is likely to prompt Chinese policymakers to ease policy anew, which should boost growth with a relatively short lag.
Outside China, we have also cut our growth forecasts across the bulk of the Asian and Latin American economies and made further downward adjustments to our EMEA forecasts.
A More Unfriendly Asset Market Environment
We have also adjusted our asset market forecasts, although less dramatically. In particular, we now see:
- Lower bond yields. Reflecting the shift in growth and policy rates, we have lowered our bond yield profile across the major markets. Those forecasts are now around 75bp lower for German and US bond yields. Given what are already quite stretched valuations, however, we still find it hard to generate forecasts for lower yields than current market prices without a broader shift into recession across the major markets. In EM, we are also forecasting more easing in Brazil and shifting to forecast rate cuts in Mexico and Chile.
- Lower equity index targets, with more pressure in Europe in the near term. With the shifts in growth views, our Portfolio Strategy teams’ earnings forecasts have also come down, particularly in Europe where we now forecast negative earnings growth in 2012, well below the consensus. Our revised targets still look for significant gains over 12 months in equity markets in our central case, but with low conviction on the near-term, particularly in Europe (see Strategy Matters: Risks deepen, stocks cheapen, also published today).
- A bit less Dollar weakening. Our mid-September issue of The Global FX Monthly Analyst already acknowledged some of the forces that have driven this latest round of economic revisions, and we cut our EUR/$ forecasts there, alongside some EM currency forecasts. We have made a further modest adjustment now, and given weaker global growth are also taking down our AUD and NZD profiles and forecasting a weaker path for the BRL given a weaker balance of payments outlook. But with a Fed still firmly in easing mode, markets pricing more rate cuts than we expect in most non-US markets, and a still-heavy US funding requirement, we still controversially show Dollar weakness persisting in the medium term.
- A flatter upward trajectory for commodities, but increasing risks to both the up and downside. The weaker global growth path translates into weaker global commodity demand but with our revisions falling hardest on European growth and our EM growth profile still relatively solid, our central economic view is still one that generates enough demand to continue to tighten the major commodity markets. As a result, our Commodities team now sees Brent crude prices ending this year at $112.5/bbl (previously $119.50) and ending 2012 at $122.5/bbl (previously $138.50), while we are pushing out the timing of a tight copper market and lower our 12-month price forecast from $11,000/mt to $9,500/mt. While we recognise the downside risk to our forecast from a potential European financial crisis, we also believe it is important to recognise that an event so widely anticipated will likely have an impact if it does not occur. The oil market continues to destock as prices anticipate a potential crisis. If the crisis does not occur, the oil market risks running into pressing supply constraints, requiring sharply higher prices than we currently forecast to force demand in line with supplies.
The question is why we are not shifting these forecasts more. Even after revisions, they still leave us—in our central case at least—bearish on the Dollar, bearish on rates and bullish on commodities and equities.
The answer is that our central forecast path is still one that looks more benign on average than the market is pricing. We have argued for some time that US rates markets and cyclical equities are pricing something close to a mild recession already; our view of the ECB, while now incorporating rate cuts, is still more hawkish than the forwards, reflecting our belief that the ECB still has a bias towards unconventional over conventional tools to deal with the periphery’s economic crisis; and without a sharper demand slowdown in China/EM than in our central case, we see commodity supply tightness still becoming a binding constraint.
But the market outlook continues to be complicated by the fact that many markets are priced for a scenario that is significantly worse than our central case—albeit still arguably better than a full global recession. In that sense, clichéd though it now is, the world remains essentially somewhat ‘bimodal’. Until we can be confident that the markets will be able to choose decisively in favour of one of these, we are likely to see a continuation of the high volatility that we have seen lately.
Because of that, as at other times of deteriorating economic momentum, we think it is dangerous to lean too heavily on point forecasts of asset markets. In this more fluid environment, we have emphasised instead the conditions for markets to manage a sustained improvement of the kind consistent with our central forecasts. In particular, we have emphasised that three sources of pressure—deteriorating data, tightening financial conditions and intensifying banking stresses—will likely need to reverse before markets can sustain an improvement. Until we see those conditions—and as yet we have not—we think it makes sense to take a cautious view of asset markets. Stability of some kind in these areas is certainly consistent with our revised economic forecasts, but in practice the point at which we may see it is hard to determine with much precision.
We are also watching carefully for any cracks in one of the most critical assumptions in our current outlook: the notion that financial transmission to the EM world will be limited. If economic pressures broaden, it is that assumption—and with it the outlook for commodities, and to some degree the Dollar—that will be most vulnerable. But if our central forecasts are closer to reality, then markets could relax significantly at the point where it becomes clearer that the threats are receding. We still see it likely that policy will play a major role in determining which of these outcomes dominates. A more rapid shift towards conventional policy easing in Europe, China and beyond and a quicker shift towards a comprehensive recapitalisation plan for Euro area banks would all be helpful on that front.