COVER STORY: THE NEW RISKS
By Laurence Neville
Last year the global economy dodged some scary-looking bullets. This year it might not be so lucky.
As volatile and unnerving as it was, 2010 provided a welcome respite from the turmoil of the previous two years. Many of investors' and corporate executives' worst fears failed to be realized—thankfully—but the underlying causes of those fears are far from being resolved. If anything, 2011 is going to be even more of a roller coaster ride. After last year's minor bounce in the wake of the financial and economic crisis, growth rates in the developed world and emerging markets are expected to fall. Moreover, the world will have to cope with two novel and potentially disruptive scenarios—a likely climax in the eurozone debt crisis and the consequences of quantitative easing (QE)—as well as other potential risks.
Even without a cataclysmic upheaval, the coming year threatens to be a tough one. ING Investment Management expects global GDP growth to slump by roughly a fifth, to 3.8% from 2010's 4.8%. Emerging markets' GDP expansion is projected at 6.5% for 2011, down from 8.1% in 2010, while the developed world will grow just 1.6%. As Ted Scott, director of UK strategy at F&C Investments, explains, although even developed economies are recovering, the policies being pursued by many governments and the ongoing trauma of the debt crises "are creating headwinds that will be hard to overcome."
The unprecedented challenges facing the world, though, mean that any assessment of its economic prospects must take into account the potential for extreme events. One such possibility is a significant economic downturn, the probability of which, according to ING IM senior equities strategist Patrick Moonen, is around 25%. Jerome Booth, head of research for the Ashmore Group, paints a bleaker picture: "There may be a 65% likelihood [that] the US and Western Europe achieve recovery without catastrophe. But that leaves maybe 35% likelihood of some very unpleasant scenarios."
It also means, however, that the most likely outcome in 2011 is a continuing—but sluggish—recovery in the developed world and further strong growth in major emerging markets. "It is important to consider the 15% likelihood of outperformance in 2011," Moonen points out. "Earnings growth should continue, liquidity remains abundant and corporate spending and M&A could increase. Certainly, it's a minefield of risks but, provided we don't step on a mine, the outcome could be positive."
“There may be a 65% likelihood the US and Western Europe achieve recovery without catastrophe”
“But that leaves maybe 35% likelihood of some very unpleasant scenarios” – Jerome Booth, Ashmore Group
Similarly, Jeff Applegate, chief investment officer at Morgan Stanley Smith Barney, says that its "outlook is optimistic for markets because we don't think any of the worst-case scenarios will come to pass." However, for the sake of preparedness it is vital to be aware of the potential hazards threatening the global economy: No one can predict with certainty how each risk will play out—or even whether individual risks will be significant—but some of the scenarios described below may well occur.
Europe's Sickness Worsens
Europe's serial debt crises—Greece received €110 billion ($145 billion) in loans at the beginning of May, and Ireland got €85 billion from a range of lenders, including the European Financial Stability Facility (EFSF), the IMF and Sweden, in November—have demonstrated that bailouts conform to a law of diminishing returns. "The EU authorities have been reactive, not proactive, during the eurozone debt crises, and as a result their actions have had less impact in each successive intervention," notes F&C's Scott. "The rally following the Irish bailout lasted just a few hours."
It seems almost certain, says Scott, that other EU periphery countries such as Portugal will have to ask for help, as markets are now dictating events. Based on fundamentals, there is no reason for Spain—the next likely target after Portugal—to be in difficulties. "Greece and Ireland had clear default risk" says ING IM's Moonen. "Spain does not: Its interest payments are below its long-term GDP growth rate; its debt-to-GDP ratio is just 60%—lower than France's; it has implemented reform measures; and a general election is not expected until 2012."
However, as 2010 has shown, fundamentals are just one element in determining outcomes, and markets can be irrational—sometimes, alarmingly so. Consequently, many observers believe a crunch point will be reached in 2011 at which the fundamental tenets of the eurozone project will have to be rethought. Should there be a need for a bailout of Spain, which would require more funds that the EFSF's currently committed €440 billion (or €421 billion now that Greece and Ireland are no longer contributors), or of Italy, which alone represents 17% of EU GDP, compared with a combined 12% for Spain, Portugal and Greece, it is likely to prompt a crisis unparalleled in European history—one that would likely reshape the eurozone. As of early December, not a single European politician has been brave enough publicly to broach this possibility.
A New Eurozone
The eurozone might need reshaping because monetary union has linked creditor and debtor countries without adequate institutions to manage their problems, according to George Magnus, senior economic adviser at UBS and author of Uprising: Will Emerging Markets Shape or Shake the World Economy? "Moreover," he says, "the debt crisis has become an extension of the banking crisis: The contingent liabilities of banks in Ireland, for example, are of a scale that they undermined the credibility of the state to guarantee all the banks' liabilities."
The apocalyptic scenario is that the euro breaks up, prompting a banking crisis as credit default swaps are unwound, or alternatively that the eurozone is split in two. "A more likely outcome is that the euro authorities will create new arrangements that start to address the lack of economic and fiscal coordination in the eurozone," says Scott. "Fiscal union [which would remove the ability of national legislatures to set budgets and raise taxes] is the inevitable long-term solution, but politically it will prove impossible in the short term as it requires a rewrite of the constitution."
Instead, the eurozone could choose the least-bad option and adopt QE, which would provide sufficient sums to increase confidence and recapitalize banks, says Scott. "The barriers to adopting QE remain huge: Psychologically, it will require a major shift by Germany, which publicly views the US policy as madness." At the beginning of December, there was growing speculation that the European Central Bank will be charged with buying huge quantities of eurozone debt. The use of QE could be a pain-free way to finance such a move. The ECB, however, was still resisting the idea.
Julian Callow, chief European economist at Barclays Capital, says that hopefully efforts will be made in 2011 to address the fundamental gaps that exist in the eurozone project, such as a lack of financial integration and the absence of deposit insurance (along the lines of the FDIC in the US, where a levy on banks is used to protect depositors). However, he adds, the broader question is whether eurozone economies will be able to recover on their own—the Baltics moved from current account deficits to surpluses and lived to tell the tale, for example—or whether they will need German reunification–style large-scale transfers of wealth. "If it is the latter, it is unclear where that wealth will come from," he says.
Applegate says that although it is easy to get caught up in the drama of the eurozone crises, ultimately the issue in Europe is about whether the euro will survive. "Our call is that there is a fundamental commitment among its strongest members to ensure it does," he says. "Down the road Greece or Ireland or other countries might need to restructure, but the currency will continue, and the main problem—that the eurozone has no common fiscal policy—will be addressed in some form."
Of course, there remains the risk that markets get carried away with their success in forcing eurozone countries to capitulate. "The crisis could spread outside the eurozone," says Magnus at UBS. Japan is likely to be insulated, as 90% of its debt is owned domestically; and the UK currently seems secure, given the radical fiscal moves made by the government and the average maturity of UK debt, which is twice as long as many European countries'. "If investors perceive there to be policy inertia in the US—53% of whose debt is owned by foreigners—as a result of gridlock in Congress, confidence could be undermined," he says. "That is not to say there is any question that the US can't pay its bills—simply that it will be paying them in a devalued currency. That's great for US exporters but poison for financial stability: If Treasuries become unhinged, other assets will follow suit, and the cost of borrowing for corporates and the housing market will rise."
QE: Fear of the Unknown
The financial crisis of the past few years has given rise to perhaps the greatest financial experiment in history—the use of QE in the UK, the US and Japan (which used QE to little effect earlier this decade). QE effectively involves the creation of money to buy bonds with the aim of inflating asset values, stimulating economic growth, buoying confidence and lowering borrowing costs. The risk of quantitative easing is that it is too successful and inflation is created.
"QE1 worked well from March 2009 and prompted a sharp rebound in markets and a reopening of capital markets to corporates," says Callow. Moreover, as Moonen says, inflation is not a 2011 or even a 2012 risk in developed markets, given that output gaps—the level of underused human and industrial capacity—remain high.
Debate still rages, though, over whether QE is working—and whether it is storing up problems for the future. "Some argue that QE2 [the second $600 billion program of QE begun in November by the Federal Reserve] won't help and point out that corporates already have $1 trillion on their balance sheets and aren't using it. But insofar as it will maintain loose financial conditions and increase asset prices, QE2 will be beneficial," says Moonen.
Others remain circumspect. "It will be more difficult than [Federal Reserve chairman Ben] Bernanke envisages to use QE to stimulate lending and economic activity: Disinflation is high, given high unemployment and a weakening housing market," Scott comments. "Consequently, banks are cautious and are reluctant to lend, especially to those who most need funds. QE doesn't work as a transmission mechanism: It creates liquidity but doesn't get it into the real economy. At some point, when the economy does recover, the huge levels of liquidity in the system could lead to high inflation, which will require rapid rises in rates."
Indeed, Moonen concedes that the broader benefits of QE, other than boosting asset prices, are hard to spot. "In the US, housing prices have stabilized, but there is no sign of a significant upturn," he says. "The housing market is important for consumer confidence—and it is important to remember that consumption represents 70% of US GDP. If consumption remains weak, then corporates will have little confidence—PMIs [an indicator of confidence where a figure above 50 shows the economy is expanding] will remain in the mid-50s—and consequently firms won't invest or hire, and sustaining the recovery becomes more difficult."
There is also disagreement about QE's impact on the rest of the world. "There is likely to be an escalation in currency and trade disagreements, primarily between the US and China, which sees QE as creating hot money that puts its own economy under pressure," says F&C's Scott. In the US, debate is focused on whether currency controls in China amount to protectionism by boosting the competitiveness of Chinese exports. However, Chinese—and other global—politicians believe QE is a ruse to devalue the dollar and boost US exports.
Applegate: We don't think any of the worst-case scenarios will occur
Applegate at Morgan Stanley Smith Barney dismisses this suggestion. "Clearly, the yuan needs to appreciate further to reflect China's role in the global economy—and also to help control domestic inflation," he says. "But the idea of currency wars is just a fiction created by the press, as can be seen by the rise of the dollar over several weeks [to the end of November.] Quantitative easing was directed at strengthening US growth, not devaluing the dollar."
Regardless of the merits of either case, the fear is of a repeat of the beggar-thy-neighbor situation in the 1930s. "In the US, the House of Representatives has already passed a bill enabling tariffs, and the political atmosphere has changed significantly with the rise of the Tea Party movement and the gains by Republicans," says Scott. "The level of unemployment in the US is politically unacceptable—10% is high for this stage in the cycle—and the pressure that creates could [mean] President Obama waves through protectionist measures. The inevitable outcome will be a decline in world trade."
Magnus at UBS agrees that there is a latent protectionist sentiment in Western countries and that currency, trade and corporate protectionism are growing. "There are increasing trade restraint measures in Europe, such as product specifications designed to favor local companies," he says. "There have been 480 incidents of trade restraints in the past two years. The problem is that if the climate between the world's two most important powers worsens—especially in a two-year period that includes a US presidential election and a change of leadership in China—it will make it harder to address the problems affecting the global economy."
Despite moves in the House of Representatives, there is little likelihood of a trade war, according to Applegate. "The President would veto any such policy." Callow adds: "Despite plenty of talk, the idea of protectionism never really gains traction because it is unambiguously negative for asset prices and growth. In contrast, the more subtle current US policy of creating inflation rather than imposing trade barriers enables the US to pass its inflation on through currency pegs and forces the issue of currency appreciation onto rapidly growing emerging market economies."
The Motor of Global Growth Stalls
Callow: Growing inflation in emerging economies is a potential problem
Many of the world's problems stem from the financial crisis and are therefore more prevalent in the developed world. However, emerging markets, which are widely credited with being the new drivers of the global economy, are not without their problems. "Growing inflation in emerging economies, especially India and China, is potentially problematic for the global economy," says Callow. "Much of the inflation is being driven by food prices, which in turn are being driven by climatic changes and changes in demand and demographic patterns, which are not easily managed. Inflation could lead to monetary tightening and dramatic shifts in policy and has the potential to restrict or even kill growth."
Chinese inflation in October hit 4.4% prompting a 50-basis-point increase in bank reserves and talk of price controls. Some observers believe that rates may have to rise by 200 basis points to restrain inflation. "The same challenges are already evident across much of South and East Asia, particularly India and Indonesia—the two economies, alongside China, that are not so open and are driven more by domestic demand," notes Gerard Lyons, chief economist at Standard Chartered, in a recent research report.
Given the increased importance of emerging markets to global growth—during 2010 the emerging economies, which represent one-third of global GDP, accounted for more than two-thirds of its growth, says Lyons—it is perhaps as important that these countries are successful in controlling inflation as that the developed world is in sorting out its structural problems. Fortunately, the track record of China's technocrats is sound: Authorities played a cool hand throughout the financial crisis and more recently took focused action to limit, for example, credit in the housing sector in order to prevent real estate bubbles. If one is to sleep soundly in 2011, one will need to have confidence in the abilities of the Peoples Bank of China and the Chinese government—while, of course, remaining prepared for every eventuality.