In its "pre-Christmas" note, it is somehow appropriate that Goldman's Jose Ursua reprises the role of Ebenezer Scrooge, and explains how, in this contemporary Christmas Carol, "The world economy is struggling: to begin with. There is no doubt whatever about that" and, logically, gets a visit from the three ghosts of the world's past, present and future. However, while the narrative is similar for the most part to the Carol morality play, where it diverges is in the Hollywood ending: "As in Dickens’ story, avoiding this outcome will require decisive actions. Unlike Ebenezer Scrooge’s overnight redemption, however, we believe the solution to the current global problems will potentially take much longer. So, although some steps are clearly visible in the right direction, the post-holiday environment will likely continue to be challenging for both policymakers and markets alike." And that's only for the macro; the "micro", as Morgan Stanley explained yesterday, is already slipping regardless of how long the US pretends that Europe is irrelevant for the big picture. The only question is whether the macro follows suit (which in Morgan Stanley's case was left as the optimistic case with full resolution), in which case the ghost of the coming "Great Stagnation" will be one scary dude.
From Goldman Sachs: A Markets Carol
As we head towards the long weekend, we describe the current global situation by referring to the opening line from Charles Dickens’ book (“A Christmas Carol”): ‘The world economy is struggling: to begin with. There is no doubt whatever about that.’ As in that story, we look at how the world economy is being visited by the “ghosts” of its past, present, and (possible) future: ‘Great Recession’, the ‘Great Eurozone Crisis’ and the ‘Great Stagnation’, respectively. We see each of these three issues as part of the current landscape even if some seem more immediate, while others are not yet clearly established.
These three themes have radically affected the economic landscape since 2008, when the ‘Great Recession’ began. As Dominic Wilson highlighted recently, we are now receiving mixed signals from different parts of the world (Eurozone pressures vs US data: a tricky balance). While the ‘Great Eurozone Crisis’ is an ongoing source of concern, data has been more encouraging in the US and parts of EM. But overall, we believe the struggles of the world economy are likely to linger well into 2012. If deeper recessions are avoided both in Europe and internationally, the potential threat the markets will continue to face is the materialization of a prolonged period of sluggish growth, which we have labeled before as the ‘Great Stagnation’ (From the ‘Great Recession’ to the ‘Great Stagnation’?). As in Dickens’ story, avoiding this outcome will require decisive actions. Unlike Ebenezer Scrooge’s overnight redemption, however, we believe the solution to the current global problems will potentially take much longer. So, although some steps are clearly visible in the right direction, the post-holiday environment will likely continue to be challenging for both policymakers and markets alike.
The Ghost of the Past: the ‘Great Recession’
At the global level, the ‘Great Recession’ saw a contraction of about 0.8% in 2009, and a slowdown in growth rates from approximately 4.0% (2000-07) to 2.3% (2008-10). The global performance hides huge regional disparities: advanced economies contracted by 3.6% in 2009, while emerging markets actually grew by 3.5%. The contrast is also visible in the growth rates between 2000-2007 and 2008-2010: from 2.6% to -0.1% in the first group, and 6.9% to 6.0%, in the second case. Thus, one of characteristic features of the ‘Great Recession’ was the resilience of emerging markets in face of a severe shock coming from the developed world.
A second feature was that equity markets across the world showed a strong rebound from their early-2009 troughs to their peaks in early-2010. For example, in terms of MSCI share prices (in US$ ex-div.), trough-to-peak recoveries were as follows: World (60%), EU-27 (66%), UK (58%), US (48%); EMs (104%), India (144%), and Mexico (117%). Although the degree to which those moves have been unwound now varies significantly, it is still true that most markets are a long way above their early 2009 lows.
Finally, the ‘Great Recession’ is also regarded as an episode of relatively rapid and forceful policy intervention--unconventional monetary expansions, countercyclical fiscal deficits, and effective policy coordination at the global level--that can be fairly credited with having averted a much worse outcome in the style of the Great Depression.
While the ‘Great Recession’ itself is in the past, we have argued that its legacy is still very clearly with us. The post-bust headwinds from deleveraging, the strains on public sector balance sheets, the constraints on conventional monetary policy, the sharp differences in excess capacity across different countries and sectors: these are all parts of the ongoing impact of the 2008-2009 crisis. And many of those features are likely to help to define the broad landscape still in 2012.
The Ghost of the Present: the ‘Great Eurozone Crisis’
While the post-bust legacy is part of the broader backdrop, we think the most immediate issue weighing on the outlook is the ongoing Eurozone crisis. While not the only shock that the global economy has encountered this year, nor the only one that will matter in the year ahead, it is front and center in our own forecasts.
Both in economics and markets, the Eurozone is finding itself more quickly back into its second recession in three years after a rebound that has proved relatively weak and short-lived. 2011 was the year when the crisis spread widely. With Italy moving more decisively to the forefront of sovereign debt woes, the issue took on a scale and intractability that became increasingly clear. Unlike 2010 where core Europe by and large shrugged off the economic impact in the periphery, the broadening crisis alongside a global slowdown has meant that core European economies are also slowing sharply, the ECB has shifted from tightening in the first half to easing in the second. And outside Germany, almost all other Eurozone economies have endured at least some challenge to their sovereign credit risk.
Our central forecast is that the economic and market position may get worse before it gets better. Recent ECB action to alleviate bank funding stresses (evidenced by the large take-up in this week’s 3-year LTROs) has been positive. But while the recent EU summit has laid out a potential path for an institutional solution to sovereign problems (exchanging tougher fiscal rules for some risk-sharing on existing debt), there are still important pieces of the puzzle missing (see Global Market Views: Post-Summit Blues). And it is hard to see how the economic pressures, particularly in what we see as the potentially riskier sovereigns, abate quickly given a shared commitment to fiscal austerity.
2012 is likely to be driven to a significant degree both by whether a lasting institutional solution can be carved out, but also by how much Europe’s own problems transmit to the rest of the world. On the first issue, the intensifying stresses have put risks on the table (like an eventual break-up) that seemed farfetched initially. At the same time, however, the risk of extreme scenarios also increases the chances of policy response, making markets more volatile. On the second, we expect the shock to be transmitted to a degree to the rest of the world, particularly those with close links to Europe (as we discussed last month in Transmission of the Euro-zone Shock; and as Jan Hatzius recently discussed for the US: European Banks—A Drag on US Growth?). However, we are less sure about the degree of transmission than about the problems in Europe themselves, and the distinction matters. It is banking linkages that remain the most challenging and concerning channel. But so far, US data in particular has been better than expected. Whether that is a function of resilience or simply of delayed reaction is yet to be seen.
The Ghost of the Future: a ‘Great Stagnation’?
Early in the Fall, we posed the question of whether the ‘Great Recession’ would turn into a ‘Great Stagnation’, which we defined as a prolonged period of sluggish growth. We looked at the global history of these experiences to asses their likelihood, both in general and conditional on the impact form the ‘Great Recession’. One of our findings was that GDP trends in Europe and the US were tracking along typical stagnation paths, with an uncomfortably high probability of stagnation lasting at least eight years in Europe and the US. Since then, the deepening of the Eurozone crisis has made it even more likely that growth in the region will remain stagnant (at 1.5% for 2011 and -0.8% for 2012), while growth in the US still struggles to go back to potential (at 1.7% in 2011 and 1.5% in 2012; Our 2012/2013 Outlook: Still Mired in a Post-Bubble World). If these forecasts materialize, both the Euroland and the US will have accumulated five to six years of stagnant growth by the end of our forecast horizon.
A stagnant economic landscape has important implications for asset prices, especially equity valuations. As David Kostin and team have signaled for the US, economic stagnation will likely imply a stable P/E multiple ahead and equity returns driven mainly by earnings growth (2012 US equity outlook: Strategies for stagnation). For Europe, Peter Oppenheimer and team have shown that recent market action in the region is consistent with the view of a prolonged stagnation (2012: Despair into Hope).
As we have stressed before, the scenario of a ‘Great Stagnation’ is only that--a scenario. While the current global economic environment is still consistent with that trend, it is by no means certain that it will materialize. And while we see the risks of stagnation in the major developed markets as high, our models show that the risks in EM--and so for global growth--are much lower. But we think it is likely enough to warrant particular attention; especially by policy makers, who operate the tools to fix it, and by investors, who must continue to find ways to navigate difficult waters. And even the best scenarios we can imagine plausibly in the US and Europe are likely to involve recoveries that remain sluggish by historical standards.
The End of It?
At some point in the story, Scrooge asks the third ghost (in our case, the ‘Great Stagnation’) whether the scenes it was showing were “the shadows of the things that Will be”, or the “shadows of things that May be.” Scrooge gets no clear answer, but sets about to change his future. There is nothing deterministic in the path for the world economy either. How policymakers react will perhaps be more critical to the outlook than at any point since early 2009. Unlike Scrooge, an overnight change is not possible for the world economy. But we hope that 2012 is a year where eventually we see things move back in the right direction.