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How Does RGE Differ from Consensus? A Perfect or Semi-Perfect Storm for the Global Economy
- The current consensus is sanguine about the global economic and geopolitical environment. RGE’s baseline views by contrast are relatively conservative; moreover, we see significant downside risks to the global growth/recovery story.
- Specifically, we see five key tail risks for the global economy in the eurozone (EZ), the U.S., the Iran/nuclear issue, China and emerging markets (EMs). Even if the chance of all five tail risks materializing at the same time is low (a “perfect storm”), each one could materialize to some extent. Thus, the joint probability of a milder version of this perfect storm—a storm nonetheless—is significant.
Current Consensus on the Global Macro Outlook
- The EZ will muddle through: There will be no Greek exit; Spain and Italy will make it and avoid a loss of market access and bailouts; Ireland and Portugal are solvent.
- The U.S. is an “island of growth” and close to returning to strong and self-sustaining potential growth by H2 2012 and 2013.
- An Iran war will be avoided as negotiations/sanctions work, persuading Iran to credibly give up nuclear option.
- A soft landing occurs in China given policy stimulus this year and reforms in years to come.
- Strong growth in other EMs will continue and they will rebound toward potential in H2 2012 and 2013; EMs will decouple from slow growth in developed markets (DMs).
RGE’s Scenarios for 2013: The Possibility of a Perfect Storm
- Our base case is for a slow-motion train wreck in the EZ with an orderly Greek exit in early 2013, a Spanish bailout and debt restructurings in Portugal and Ireland. But there remains a high and worrying chance of a disorderly Greek exit (a messy divorce).
- We expect modest, below-potential U.S. growth as annual inflation decelerates over the year and fiscal drag sets in. But there is a non-negligible chance of stall-speed by 2013 if the fiscal drag is greater than expected due to political gridlock.
- Regarding Iran and the nuclear threat, our baseline scenario for the rest of 2012 involves extended saber-rattling by Iran, with an eventual cool-down, but the risk of a U.S./Israel-Iran military engagement is rising in 2013 as negotiations/sanctions fail and the U.S./Israel cannot accept the containment of a nuclear Iran with deterrence. This would lead to an oil price spike and a stall or global recession.
- Our marginal base case is for China to continue with a “slow grind,” but there is a material risk of a hard landing by 2013 or 2014 at the latest, as the investment bust is ongoing and reforms to boost consumption may happen too little, too late.
- If the downside scenarios in the U.S. China and EZ come to pass, we would see a massive slowdown of growth in other EMs due to their trade/financial links with the U.S./EU (no decoupling), in tandem with a lack of structural reforms hampering potential growth which reduce their resiliency.
Details of RGE’s Out-of-Consensus Views
- Slow-motion train wreck: The EZ is lurching from crisis to crisis. Eighteen EU summits have produced no real progress toward actually resolving the crisis—a recent FT headline after the latest summit, “EU leaders decide to postpone key decisions,” sums up this muddle-through approach. The EZ policy response has been reactive and will ultimately amount to staggered bailouts, sequential debt restructurings and some EZ exits, starting with that of Greece. Austerity fatigue is now colliding with bailout fatigue.
- A Greek exit will occur, most likely in 2013. Even if Syriza wins the upcoming election, it is in Greece’s and the troika’s best interest to find a compromise. For the Greek political parties, which overwhelmingly still want Greece to remain in the EZ, they are incentivized to at least wait until Greece has a primary balance to default. The troika is incentivized to buy time until the EU-IMF firewall is actually in place, as contagion will spread from Greece to Spain swiftly, no matter how orderly a Greek default and exit is handled. We expect the troika to play hardball with the new Greek government, particularly because German Finance Minister Wolfgang Schauble is in favor of an orderly Greek exit and some Bundesbank representatives want a return to the deutschmark and/or a Greek exit. Both sides will find a compromise this time around, but any coalition in Greece will be unstable and we will see new elections by the end of 2012. Eventually, the electorate will be willing to consider alternatives to the current path of bailouts and austerity, and will vote into power a government that is in favor of exiting the EZ (which is a political decision at the end of the day). The only way to avoid a Greek exit is for the core to accept a transfer union, which we think Germany would oppose.
- Spain will need a bailout from the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) as: bank recapitalization costs are large, there is a larger deficit than targeted (6% of GDP or more rather than 5.3% in 2012), provincial regions’ deficits are large and there is significant capital flight. But the government will try to prevent that from happening. It prefers the ECB’s securities markets program (SMP), but ECB would prefer the ESM route. Portugal’s and Spain’s problems are related, via their banks. The Spanish authorities are still in denial about bank recapitalization needs (they expect a maximum of additional €50 billion, including the Bankia recapitalization). We expect the bank recapitalizations to cost €100 billion-250 billion, which will be difficult for the government to finance without official support. Front-loaded fiscal austerity will be kept to assuage market fears, although Spain may be granted an extra year to reduce its budget deficit to 3% of GDP. If the troika were to give Spain several more years to hit its fiscal deficit targets, it would make a material difference to Spain's growth prospects, which in theory would change the country's public and external debt sustainability. In reality, even a relaxation of the fiscal targets probably wouldn't generate enough growth for Spain to be sustainable given the deleveraging occurring in the rest of the private sector in Spain and the challenging external environment.
- Italy is in better shape given more significant austerity/reform, but a Greek exit and Spanish distress may tip Italy over the edge. Mario Monti isn’t likely to be prime minister after the new Italian elections in 2013. Former prime minister Silvio Berlusconi and his party may pull the plug on Monti by next year, as they have suffered in regional elections. Berlusconi is pushing for an electoral law with a semi-presidential system like in France to become president. This is unlikely to occur, but he is pushing….
- Ireland has high unemployment and needs debt restructuring, but will not exit the EZ. The austerity is making the recession worse. Ireland's government is most likely bankrupt, even though wages have adjusted and it is now more competitive. Still, looking at unit labor costs, the headline figures are distorted by the implosion of the relatively unproductive construction sector. Unemployment is nearly 15%, much of it long term. The current account is flat, meaning that if growth resumed, there would likely be a deep structural deficit revealed. Household debt is over two times income, and deleveraging has not begun. The fiscal deficit is targeted for 8.6% for 2012, and all the consolidation to a 3% goal is supposed to come from expenditure cuts, which will optimistically stabilize debt at 120% of GDP. Mortgage defaults have not yet crystallized, but when they do Irish banks will require further recapitalization. This will most likely be foisted right onto the state's balance sheet.
- France has elected Francois Hollande as president: A moderate who is not ideological; a technocrat with political leanings. His agenda is not as radical. He will pursue fiscal discipline (balanced budget by 2017); he may even do structural reforms if pushed by markets and German pressure. He might be capable of a Nixon-in-China effect: Schroeder, Blair, Clinton, Amato/Prodi/Monti were center-left leaders who achieved structural reforms in their countries. The same could happen in France.
- Portugal will be rewarded with a second bailout, but it is insolvent and uncompetitive. A debt restructuring is down the road.
- Cyprus will soon need a bailout as it has a large fiscal deficit and debt and the recapitalization of one bank will cost 10% of GDP. The EZ will be wary of that bailout coming from Russia, whose influence has already been increased.
- E-bonds: While Germany for now will not accept E-bonds, there is some chance that the ERF (European Redemption Fund) will be eventually accepted, though probably not before 2013. However, the ERF is not very realistic: Giving up significant national fiscal sovereignty, and reducing debt from 120% to 60%, implies massive fiscal discipline. The ERF doesn’t lead to permanent E-bonds. Spain shares Germany’s views on E-bonds—they are both scared of bond vigilantes. If things really worsen, Germany may accept E-bonds in extremis, but if things improve E-bonds become unnecessary.
- Banks: Direct recapitalization from the EFSF/ESM is an option, but many are resisting it. This option requires a resolution regime with losses on unsecured creditors; it also requires EU-wide regulation and supervision as well as deposit insurance. The European Commission plans for this, but it is unlikely that Germany/the core and the ECB will accept this plan soon as it implies significant credit risk for the core.
- Growth compact: Germany stands tough on the growth compact; what will be accepted is cosmetic (EIB capital; more infrastructure spending; project bonds for EU-wide infrastructures; structural reforms; more flexibility in achieving fiscal targets). Germany resists/reluctant to accept demand/fiscal stimulus but is willing to listen to ideas about growth as long as proposals are translated into “German language.” Monti is pushing for more substance in the growth compact, but not E-bonds right away or changes in ECB mandate: more infrastructure spending disguised as supply rather than demand-side policies (“reduce supply bottlenecks via investments”). Also, Italy notes the need for a “golden rule” to exclude public investment from fiscal targets. Italian view: “German ‘castle of virtue’ will go down in flames without growth.” SPD may win the 2013 election. Or there is the possibility of a Grand Coalition. SPD is more flexible about fiscal austerity and E-bonds.
- ECB: It prefers ESM to SMP to help sovereigns under stress. We expect a 25-bp policy rate cut in June. In the event of a Greek exit, the ECB would likely step in with emergency liquidity to finance the resultant bank “jog” or run. While an EU-wide insurance scheme is currently on the table, we do not expect the core countries to accept the risk (the German constitutional court in particular would oppose it) and consequently national deposit insurance schemes are most likely. The ECB is concerned about its capital, so is not willing to lower collateral standards and reduce its haircuts. It is opposed to Spain recapitalization plan, which represents debt monetization.
- EZ firewalls are too small. Now, we have the ESM plus new IMF resources. But Italy and Spain would need a €1.5 trillion-2.0 trillion firewall in the event of a bailout.
- U.S. growth remains below potential. Q1 growth was revised lower to 1.9%, as we expected, and we expect growth in the remainder of the year will barely average 2%, below consensus. Expectations of the impending fiscal drag may affect sentiment and spending in H2 already.
- The overdone expectations formed around Q4 growth have already started to pare back following weak employment, real income, spending and investment data. We believe near-term growth will continue to disappoint the consensus and the Fed. In addition, there are elevated risks of a disorderly outcome in the EZ, falling inflation expectations and downward pressure in financial market and rising risk aversion. We envision the Fed announcing QE3 by July, likely in form of a sterilized program (a fig leaf against hawks). This may help the markets by summer; and a little the economy by election time.
- 2013 looks worse than 2012: under an adverse scenario, potential fiscal drag of 4% of GDP would drown the economy in recession. A more plausible outcome of continued gridlock regardless of elections, the makings of another debt ceiling showdown in late 2012/early 2013, and at least a 1% fiscal drag would still cast a significant shadow on 2013 growth, which we currently expect at 1.8%, well below consensus.
- Substantial deleveraging may have occurred following the post-recession recovery, but this process itself has been propped up by government transfers. Consumers would start to deleverage more 2013 as taxes go up and transfer payments are reduced.
- U.S. deleveraging is less ugly than in the EZ, but is not “beautiful.”
- Shale gas will help only in the long-run, as demand grows slower than supply. At $2/ MMBTU it is not profitable to drill shale gas, and only the production of natural gas liquids and tax policy has kept activity high. Power companies are only slowly abandoning coal, while transport remains oil focused.
- Revival of manufacturing will be capital intensive (automation; robotics), thus will not be labor intensive, so will not help the job market.
- Labor demand is challenged in the medium term: following the manufacturing sector, the services sector is now showing an information technology-driven productivity revolution.
3. Middle East, Iran-Israel, Oil:
- Iran-related geopolitical and supply shock risks have not evaporated and are underpriced by an oil market focused only on EZ risks and China slowdown. The chance of a war before the U.S. elections is low, even if we cannot rule out an October surprise by Israel.
- Ultimately, negotiations will fail, as Iran will be unwilling to give away its bargaining chip of a potential weapon or accept extensive monitoring. Iran now has the greatest incentive to play for time, trying to increase oil exports. Tighter sanctions may add strain to the oil market.
- Sanctions will not stop Iran from going to a zone of immunity, so the window for Israel to act is approaching. U.S. and Israeli views are converging. The red line for the former is weaponization; for the latter, it is nuclearization.
- U.S. policy now insists that containment of a nuclear Iran and deterrence are not options and that they are not bluffing. After the November presidential election, the U.S. may attack Iran, together with Israel.
- Although Israeli leaders are still building a coalition for an attack (key military leaders are wary still), the recent Kadima alliance with Likud makes an attack more likely, as there would be a broader coalition in favor. Israeli opposition parties suffering weak popularity would be reluctant to oppose this. Sunni Arabs are wary of conflict, as their export channels might see collateral damage, but they too want to avoid a nuclear Iran.
- We thus see a conflict as a meaningful risk, though it is not yet our baseline. Should an attack occur, it would cause a spike in the oil price, which would raise the risk of a global recession or stall speed. Even short of an attack, an escalation of the covert war that has been underway for some years could tighten oil markets, add distortions and undermine fragile demand.
- Once a conflict began, it may be difficult to engage in a surgical strike to knock out Iranian nuclear capacity, and a series of conventional retaliations could occur, engulfing sectors of the Middle East through proxy conflicts.
- Alternatively, if the U.S. views the attack as too risky, and Israel wants to avoid crossing its only ally (alternately, it may lack the technological heavy power and demur), that could set up a nuclear arms race in the Middle East. The U.S. will not attack as this would be too risky; Israel would not cross its main ally and therefore would not attack either. In that scenario, Iran and the rest of the Middle East would all become nuclear in due time, over the next decade.
- Beyond Iran, the post-Arab Spring transitions will be rocky (witness the continued divide between Egypt’s military and Islamist groups). The lack of resources, competitiveness and jobs to absorb a young and growing population will add pressure to global resource markets, as costly subsidies overextend demand.
4. China Hard Landing Risk:
- China’s growth model is broken, regardless of whether easing/stimulus can soften the landing.
- A hard landing is a material possibility by 2013-14:
- NPLs are rising as provincial debt is surging;
- Public debt is at 80% of GDP; provinces cannot pay interest on the debt;
- An investment bust is ongoing while private consumption’s share of GDP is not rising fast enough.
- There will be no major credit-based stimulus in 2012, as it would cause more inflation, an asset bubble in housing and more NPLs; most importantly, China’s local governments do not have the space to take on more credit.
- A change to the unsustainable growth model will occur too slowly as political transition will slow reforms.
- A new leadership may surprise with “rule of law” reforms and push to have more private-sector-driven growth rather than more state-owned enterprises.
- Urbanization is not accelerating like the consensus appears to assume; instead, it has slowed in recent years. A real estate bust and deleveraging has started at a rapid speed.
- The marginal product of capital collapsed in 2008 and remains low; as the government green-lit many unproductive projects following the global financial crisis. This means that the projects have not, and will not, be able to increase aggregate output enough for local governments to pay the bill. Government revenue stands at nearly 30% of GDP, which is relatively high for a country at China’s income level, and the government's spending commitments are only going up due to increased political pressure. Local governments have about RMB17.5 trillion in debts, meaning they need at least RMB1.1 trillion of interest payments alone this year. They won't be able to cover that though, because all of their revenues are already pledged elsewhere and land sales (their main off-balance sheet revenue source that is not committed elsewhere) are drying up fast. Basically, even though China’s capital stock per capita remains low, it's not the stock that is so out of whack, it's the flow. China can't keep increasing its rate of investment, China's local governments don't have the cash flow to cover the interest on their debts, and so China can't keep growing 8%.
- As Chinese growth slows, RMB could even possibly depreciate rather than appreciate further as EUR weakness becomes a problem. Two-sided currency movements are now allowed by China.
- Easing and currency pegging unleashes inflation and asset bubbles; rebalancing to investment spurs over-capacity and NPLs in waiting. Rebalancing towards consumption entails slower growth as consumption is a small part of activity. Even if there is a soft landing now, there will be an eventual hard landing. Contradictions in the political-economy model, of liberal economics and authoritarian politics, point to more turbulence ahead as the economy slows.
- Slowdown is now inevitable and underway, from low double digits precrisis, to high single digits postcrisis, to low-mid double digits post-rebalancing, since household income is a low share of GDP.
5. EMs—Sharp Growth Slowdown Ahead:
- Most EMs are slowing down—the BRICS, Turkey, Mexico, Argentina and East Asia—and the recovery in H2 and in 2013 will be muted. Most EMs will grow below potential and, in some cases, inflation remains elevated, limiting the space for easing.
- In part this slowdown reflects trade links with Europe and the U.S./DMs, but also can be traced to a stall in structural reforms: Most countries are supporting some form of state capitalism and a heavy role for SOEs and/or state banks in the economy, protectionism and a lack of private-sector-led development. All large EMs need some form of rebalancing.
- As a group, EMs/the BRICs are over-hyped, over-bought and misunderstood; they are still treated as high-beta assets, which leaves them exposed in periods of risk aversion—all EM assets are more correlated with global moves than in the past. Despite their fundamentals, investing across EMs exposes investors to a series of country-specific risks, as well as a high correlation with global risk sentiment.
- EMs are still too small to hold up global growth and offset the slowdown in DM consumption growth as deleveraging takes hold. In part, this reflects the low level of consumption in China’s economy, but it also reflects imbalances in other EMs, which leave them trapped in a boom-bust cycle. A lack of investment and infrastructure leaves them vulnerable to supply-driven inflation, which necessitates tightening, which in turn slows growth. Many EMs are still caught in the governance challenge that undermines policy credibility and macro/market performance, for example, India is running into the buffers of trying to catch up to Chinese growth rates without investing in infrastructure. Russia, which has coasted on oil revenues, risks a lost decade thanks to weak institutions, poor demographics and ideas. Brazil is exposed to global capital flows, Chinese demand for commodities and EZ trade, while domestically it has focused on boosting demand instead of addressing supply side constraints on growth.
- Turkey is exposed to EZ financing strains, as well as MENA risks, while having an unsustainable and poorly financed current account deficit and unconventional monetary policy. South Africa suffers from the paradox of sharply rising unit labor costs, but the highest unemployment rate in EMs, and relies extensively on Chinese and EZ demand. Mexico is highly exposed to the U.S. and has not adopted significant reforms to foster medium-term growth. Argentina’s policy mismanagement becomes more unsustainable all the time. Eastern Europe is still recovering from boom-time twin deficits and over-spending, as well as exposure to EZ deleveraging and weaker demand. Although deficits have narrowed, fiscal adjustment is restraining domestic demand, while a lack of investment has sharply reduced potential growth. The region needs to find a new growth model as the adjustment is not only cyclical. Emerging Asia is exposed to China, the U.S. and the EZ, and lacks sufficient final demand.
- Despite the slowdown in growth, elevated inflation or financial stability concerns will keep many EMs from easing monetary policy. Meanwhile fiscal balances are no longer as strong as in 2008, as many countries have eroded their cushions.