SG: Global Economic Outlook - Outlook 2012: Euro area will be knocked into recession

Global Economic Outlook - Outlook 2012: Euro area will be knocked into recession
2011.11.06 04:47 PM

■ Outlook 2012: Euro area will be knocked into recession

The bombshell of the announcement of the Greek referendum (now off the agenda) and new twists and turns in Italian politics made the decline in financial stress offered by the euro summit agreement only fleeting. The persistence of this extremely high level of financial stress is the trigger for the downgrade to our global economic outlook, and we now see recession in the euro area. Our full year 2012 forecast now stands at 0% for the euro area, 1.4% for the US and 8.1% for China, which places us below consensus for both 2012 and 2013. Against this backdrop, we expect G4 central banks to pursue an extended period of policy accommodation. The risk to the forecasts remains skewed to the downside with potential for fiscal policy errors, notably in the euro area and the US.

■ From financial stress to the real economy

Our financial conditions indices remain elevated and continue to act as a drag on the real economy via the channels of (1) wealth effects, (2) credit conditions and (3) confidence. What began as an uncertainty shock in the financial sphere has morphed into a broader confidence crisis in the real economy with businesses holding off from both hiring and investment plans. This was partly discounted in our previous forecast, but as financial stress has failed to ease, these effects are now proving deeper than expected and constitute the main reason for the downgrade to our outlook.

■ Euro area to see recession

The spill-over from the euro debt crisis has proven greater than previously expected and we now see recession as inevitable. Implicit in our forecast is a gradual easing of financial stress in the course of the first quarter of 2012. This will depend critically on two factors; (1) the ability of the euro area to quickly define the new rescue mechanisms and make them operational and (2) the ability of the fiscally weak member states to advance on structural reform and austerity. On this latter point, Italy is the key focus, and we assume that some progress will be achieved. However, this will not come without cost; we have made a substantial downgrade to our outlook for Italy.

Against this backdrop, the ECB will ease rates by an additional 25bp in December, bringing the repo rate to 1.00% and the deposit rate to 0.25%. With excess liquidity, the Eonia will trade at the lower end of the range, implying that the ECB is de facto close to a zero rate policy. In our opinion, the ECB would be reluctant to take the deposit rate below 0.25% as this poses a potential problem for money market funds that could aggravate financial stress.

■ US at stall-speed

The financial stress from the euro crisis remains a headwind for the US as well. In addition, the fiscal outlook remains highly uncertain in the countdown to November 23. To our minds, the most likely outcome is that the payroll tax cuts and extended unemployment benefits will be prolonged until the end of 2012. This is the assumption behind our 2012 forecast which clocks in at 1.4%. Looking ahead to 2013, however, we look for fiscal austerity to kick-in. The 2012 elections add uncertainty to the policy outlook, but the US cannot indefinitely delay austerity at the federal level.

Turning to the Fed, we believe that the next step will be an announcement of a conditional-trigger policy, with rates promised to be kept at zero until unemployment falls below 7.5% or inflation rises above 3% on a sustained basis. Based on our forecasts, this would put the first hike in 2016. We believe that this type of announcement is likely to come in January, when the next two-day FOMC meeting will be held. QE3 remains in our central scenario and is likely to follow changes in communication strategy. The next round of QE, expected to come at the March FOMC meeting, will likely be heavily focused on MBS purchases. We look for a run-rate of about $75bn per month, with a pre-commitment to about 8 months' worth of buying. This would increase the Fed's securities portfolio from $2.65tn currently to $3.25tn by the end of 2012.

■ China property set to correct

The trajectory of the property sector will be one of the biggest swing factors for China's economic outlook in the next four quarters. A correction seems to be set in stone, thanks to the government's unprecedented determination to improve housing affordability. Given the level of commitment, we expect the magnitude of this upcoming property downturn to match the previous cycle in 2008, and probably to be more extended. As this engine of growth and exports begin to stutter in the coming months, the first half of 2012 is likely to be quite difficult for the Chinese economy.

The government has several tools at its disposal to put a floor under growth. However, with the lesson of the 2008-09 credit bubble still fresh in their minds, policymakers are expected to be more cautious in their approach and the magnitude of policy easing. Structural tax cuts and reforms to promote economic rebalancing are likely to be at the forefront of this easing cycle. Property tightening will only be lifted after some real damage is done to developers and speculators.

With regards to monetary policy, the credit tap would be turned on once again, but the flow would be much more modest and the destination more selective. Existing infrastructure projects and labour intensive SMEs are likely to be given some priority. In order to ensure a “reasonable” pace of credit growth, we expect the PBoC to cut required reserve ratios five times (250bp in total) for large banks, and six times (300bp in total) for other smaller banks. Cuts would be frontloaded, with the first one for large banks in Q1 2012 and that for smaller banks in Q4 2011. These moves will free up CNY 3~4 trn (7% of GDP) for lending.

Nevertheless, inflation is unlikely to drop substantially below 3.5% any time soon — the level of the best 1yr deposit rate at the moment. Against this background, interest rates are unlikely to be cut. Otherwise, it would only exacerbate deposit flights and put further strain on banks' ability to extend credit.