2012: Jeux Sans Frontiers – Markets With Tears

The good news is that the global economy will avoid recession during 2012.  The global economy will avoid a double dip recession by a whisker, growing by just 2.25%, significantly below its productive potential of 3%, which in turn means that the world economy will experience a growth-recession. Growth recessions occur when an economy’s growth is less than productive potential.  Productive potential is measured by the sum of productivity growth and working age population growth.  If growth is below productive potential, the level of unused capacity within the economy increases, widening the output gap and putting downward pressure on price increases. 

The major industrial economies have been experiencing a growth recession since the inventory bounce that followed the Great Recession that began in December 2007. History tells us that these economies can expect several years of volatile and sub-trend growth after a major financial crash as they reduce their excessive consumer/corporate and financial sector leverage.

However, we believe that the major developing economies will experience contagion through trade and financial linkages from these major industrialised economies and these developing economies will therefore experience their own growth-recessions. Growth-recessions for the developing economies will still produce considerably higher growth than the developed economies; we expect Chinese activity to expand by 7% during 2012.  Nevertheless, this is less than required to absorb the economies’ growing labour forces or satisfy consumer aspirations, thus increasing political risk.

This creates the first of our three prisoners’ dilemmas* of 2012.  The developing economies have already begun to ease policy in response to slower economic growth, but they are playing a game of chicken with the major industrialised economies, afraid that if they ease aggressively and repeat the stimulus of 2008, it will lead to faster inflation.

The second prisoners’ dilemma will be in the US where the forthcoming Presidential election creates a dilemma between the Republicans and the Democrats/Obama over fiscal policy. The lack of agreement will produce a sub- optimal outcome for the economy, consigning the economy to growth of 1-1.5% over the next few years and forcing the Fed to add further quantitative easing during this election year.

The exception to the global growth-recession will be Europe, where the peripheral economies as well as France and Belgium are expected to experience full blown recessions during 2012. More fiscal austerity is not the solution to the region’s dysfunctional monetary union. We expect the ECB to ease policy further and the central bank to expand its balance sheet through more liquidity and increased bond purchases but this will not be sufficient to offset the paradox of thrift.  Europe’s prisoners’ dilemma is therefore that the central bank is not in a position to pursue unlimited quantitative easing, there are not sufficient sanctions to ensure that peripheral governments meet their austerity targets and therefore there is a clear risk of cheating. In addition, the ECB does not have the legal mandate to pursue unlimited QE for peripheral government bonds or support common Eurobonds.

Britain’s dilemma is that it is a prisoner of these other dilemmas. Recession in Europe and growth recessions in the rest of the world will subtract 1% from UK growth, while the deleveraging of government, consumer and financial sectors will drain another 1% producing growth of just 1% and requiring the central bank to add another £150bn to the economy during 2012.
However, to quote the Duke of Wellington’s famous epitaph on the Battle of Waterloo; “the global economy will be a damn close run thing”. We expect France’s triple AAA sovereign credit rating to meet its Waterloo during 2012. We also expect Austria to lose its triple AAA status as Central and Eastern Europe follow the €urozone into recession during 2012.

These moves will further emphasise the shortage of triple AAA, safe haven government assets. This will be an important driving force behind the performance of government bond markets over the next twelve months and in particular the shape of forward curves. We expect long dated forward rates in the triple AAA government bond markets to fall further than short-dated forward rates, while in the non-triple AAA markets these forward yield curves are expected to steepen with the ECB’s 3yr LTRO in February exacerbating this trend.

We believe that the economic outlook in the first couple of months of the year will be better than consensus expectations and coupled with bountiful ECB liquidity and some modest PBOC easing of reserve requirements suggests that the consensus assumption that the worst of the global problems will take place during the first quarter. Indeed, this period is likely to be the phoney war ahead of a sharper slowdown in the global economy over the second and third quarters. This sharp slowdown is expected to coincide with further deterioration in the European Sovereign Debt crisis.

We believe that it is impossible to devise a voluntary private sector haircut of sufficient magnitude to put Greek government debt to GDP ratio on a sustainable path. Europe is faced with another substantial bailout package for Greece in March or allowing it to default. We believe that default is the logical option. However, contrary to consensus, we do not believe that this will provide the catalyst for the ECB or Germany to abandon their constitutional framework and pursue unlimited quantitative easing. In the absence of unlimited QE, the peripheral nations will be forced to continue with internal devaluation and deflation.  This will lead to calls for creditors to share the pain with debtors.

 PDF Download