Three of the big themes for 2012 are already blatantly obvious: the ongoing sovereign debt saga in Europe, the path of economic growth in America and whether China manages a soft landing.
Europe and the various political attempts to resolve the sovereign debt crisis was the major theme of 2011. It will remain a key theme into 2012. We are not as negative as some commentators on recent developments, especially on the two most recent summits. Certainly politicians have failed the deliver the “bazooka” solution that many have wanted and expected, but incremental progress has been made.
Fiscal co-ordination has been the missing link in the set-up of the European monetary union. While it’s obviously too late to prevent the current crisis, its important in establishing a framework for the way forward. The ECB has also taken important steps to provide “unlimited liquidity” to the European banking sector.
The missing part has been the same provision of liquidity to the sovereigns. By our calculations there is around €900 billion (ESM when it is established in mid-2012, IMF, and currently uncommitted EFSF funds) available next year to assist governments (those that are either insolvent or illiquid) who need support. This will most likely not be enough. The question is how leverage can be used to boost the lending capacity of the €500b available to the ESM and/or at what point the ECB steps up its purchases of sovereign bonds.
In the meantime the European economy has slipped back into recession. At this point we think the recession will be relatively mild with contractions in activity in the fourth quarter of 2011 and the first two quarters of 2012. The reasons are well known: weak business confidence, fiscal austerity, higher funding costs and the availability of credit as banks strive to meet the new 9% capital adequacy ratio by mid-year. The weakness is centred in the periphery but even Germany is unlikely to avoid a contraction in activity – Germany’s export ratio is around 40% of GDP with most of that going to its European neighbours.
We expect a 2012 calendar year GDP outcome of around -0.5%. The risk is clearly skewed to the downside, but at this point, the weak exchange rate, bank deleveraging being done and dusted by mid-year and further interest rate easing from the ECB (another 50bps of easing to 0.5%) will help prevent a deeper and more protracted recession. The important qualifier to that view is that politicians and the ECB will do all they need to do to prevent an escalation in the situation. If the situation deteriorates from here it becomes more likely the ECB goes down the quantitative easing path but uses a monetary policy (price stability) rationale rather than lender of last resort.
Economic growth in America has this far been surprisingly resilient to developments in Europe, in fact GDP growth for the fourth quarter of 2011 will most likely be the strongest for the year: market expectations are for a seasonally adjusted annual rate of around 3% for the quarter.
But it’s important not to get too bullish about next year. Using the line of “fragile debt constrained growth” for America over the last 3 years has seen us accused, at various times, of being either too pessimist or too optimistic about the outlook for America. We think this line will continue to serve us well next year – we expect GDP growth of 2% in 2012.
Activity will be constrained by the same factors – soft consumption and jobs growth, weak housing (although there are positive signs emerging here as 2011 draws to a close) and tightening fiscal policy. We have assumed the payroll tax cuts are extended into 2012 although the politics are, once again, looking somewhat fraught. We will look for exports and business investment to be the strongest areas of growth. That assumes we are right about Europe.
The inflation story will be interesting. The Fed has done a great job of avoiding deflation. Annual core inflation is now over 2%. We think core inflation heads lower in 2012, but not dramatically so. In fact we think that inflation will remain too high a hurdle for the Fed to go down the path of QE3, at least for monetary policy reasons.
Another area of interest for us will be the labour market and the inflation implications of a structural unemployment rate that is now likely higher than it was pre-GFC. We don’t know where that is, but some recent research has suggested it may be as high as 7%. More on that topic next year!
Growth momentum is continuing to slow in China, reflecting weaker external demand and the continued transmission through the economy of tighter monetary conditions. Export and residential housing are soft while retail sales and investment are continuing to hold up well.
The good news is the now rapidly cooling inflation picture. After peaking at 6.5% in July this year headline inflation has now fallen to 4.2% in November. This reflects the dropping out of some of the supply-constraint induced food price increases at the end of 2010. We expect inflation to fall further and eventually settle around 3.5% during 2012.
The authorities have started the process of easing monetary conditions with a 50bp reduction in the reserve ratio requirement. We expect that will be followed by interest rate cuts in the next few months.
We continue to see GDP growth of around 9% this calendar year which we expect will be followed by growth of around 8.5% in 2012. The lower growth reflects the weaker external environment and weakness in domestic housing.
As with America, one of the key risks to China growth is a sharper-than-expected slowdown in Europe. If that eventuates we would also expect to see further fiscal as well as monetary stimulus, most likely in the form of subsidies to support consumption, particularly in rural areas. Indeed we are keen to see China policy move towards greater support for households. The recent increase in the poverty line will expose an estimated further 100m Chinese to initiatives to support poor households.
We will also be watching inflation development with interest in China. As demand for better wages continues to build, the wage/productivity/inflation dynamic will be fascinating to watch.
But that’s all next year. In the meantime have a great Christmas. No more posts till mid-January!!