Slowing global economy needs strong response from government leaders
Waddell & Reed Market Perspective – July 2012
As 2012 began, economic forecasters were optimistic about future global growth opportunities. But at midyear, growth rates again are disappointing forecasters both here and abroad, and recent events have added even more uncertainty for the global economy. The efforts to deal with the eurozone's debt continue as government leaders seemingly do just enough to get by at each critical juncture. But Europe's fundamental problem of a lack of economic growth remains. Growth in China is slowing, causing widespread concern for financial markets. And the political landscape in the U.S. is making it very difficult for policymakers to reach agreement about the impending "fiscal cliff." Against this backdrop, what does the second half hold?
Uncertainty affects U.S. growth
Growth in U.S. gross domestic product (GDP) was disappointing in the first quarter of 2012, rising at an annualized rate of 1.9 percent, compared with a rise of 3.0 percent in the fourth quarter of 2011. By and large, the slowdown came from a larger-than-expected decline in government spending as well as a smaller pace of inventory accumulation. However, in our view there was another important change in the first quarter: a decline in the personal savings rate in the face of rising gasoline prices. We think this will bring about slower growth in personal consumption going forward.
In fact, recent statistics have pointed to slower employment growth, which will feed into slower income growth and further weaken the inclination to maintain spending levels. While the recent decline in gasoline prices may help to offset this headwind, we think the headwind will remain.
In addition, global economic uncertainty coupled with the increasingly relevant fiscal cliff is likely to continue to weigh on overall sentiment about the economy, especially in the corporate sector. Growth in capital spending has already slowed; we think it will continue to be weak as companies are likely to spend at reduced levels. Given the weakness in the global economy, we expect exports also will continue to slow.
The fiscal cliff itself represents the impact of a number of tax cuts and social benefits that are scheduled to expire at year-end. The provisions include the Bush era tax cuts, which also affect the tax rate on dividend payments; the payroll tax cut; extended unemployment benefits; and a number of other provisions. Based on our research, economists have estimated the impact at $500 billion to $700 billion, or as much as 4.5 percent of GDP. As we have stated before, we do not think all provisions will be allowed to expire, which means that the fiscal drag on the U.S. economy should be much less than the estimate. Nevertheless, uncertainty remains about the ultimate outcome because of the proximity to November's elections and the level of political disagreement in Congress now.
In the second half of 2012, we expect GDP growth will be at or below levels posted in the first half. We believe the Federal Reserve will continue to ease until the unemployment rate falls further and the disinflationary pressure now evident in the economy subsides. In our view, neither of these criteria are likely to reverse this year.
Eurozone staggers under debt load
Aggregate first-quarter GDP data for the eurozone surprised many, as it showed a growth rate of zero compared with expectations for a decline. We continue to believe that the region is in recession and that data in subsequent quarters will confirm our view. We expect countries in the southern part of the eurozone to show worse results than those in the north. We also think GDP growth will show meaningful declines over coming quarters. Policymakers across Europe continue to push for countries with high debt levels to move toward more fiscal austerity as well as increased capital in their banking systems. Both of these demands are crimping growth. To be sure, recent discussions among Europe's leaders have centered on shifting this focus to include an element of growth, but we think more needs to be done.
Going forward, we expect policy will increasingly shift toward further integration among eurozone countries, as this must be the ultimate goal in order for the currency union to survive. In the meantime, the European Central Bank will continue to provide ample liquidity to the region's banking system. We hope that policymakers will become more proactive in dealing with the crisis; thus far, they seem to respond only when pressure increases in the sovereign debt market. The recent European Union summit of heads of state did provide a somewhat positive surprise to markets, against very low expectations, with signs that policymakers realize further integration of banking and fiscal policies is necessary. While these steps are encouraging, we do not think a quick resolution is likely.
The U.K. economy still is heavily reliant on the outcome of the eurozone debt crisis, given the economic linkages across the region. Economic growth in the U.K. continues to be disappointing as domestic activity remains weak and the shock from the eurozone flows through. We think the Bank of England is likely to maintain its loose monetary stance as long as this headwind remains.
Emerging markets feel the impact of global slowing
Japan's economy continues to benefit from reconstruction following the earthquake, tsunami and resulting nuclear disaster in early 2011. Furthermore, government policies have been put in place to try to boost domestic consumption during this time of global uncertainty. This is providing an offset to weak global demand, but we do not believe it can completely offset external influences. Thus, we expect economic growth to slow throughout the rest of the year.
Growth in emerging market countries continues to slow, a byproduct of weak developed markets and a policy-induced slowdown following tightening in 2011. Most emerging markets have switched to easing policy, both on the monetary and fiscal sides. However, the global economic uncertainty coupled with overhangs from the last economic upswing has made for a tepid response in terms of emerging market economic growth.
We continue to look for a soft economic landing in China, although growth has slowed from prior levels. China's growth in the first half of the year averaged 7.9 percent on a year-over-year basis. We now think it will average around 7.5 percent for the year as a whole, versus the 8.0 percent we forecast at the start of the year. We also think it is increasingly unlikely that the economy bottomed in the first half of the year, as we initially expected. The bottom is likely to come now in the second half, as policymakers in China have little appetite to allow the economy to slow much further. Thus, given the continued weakness in Europe and expected softening in the U.S., we expect China's government to continue to move along the path of looser policy. However, as long as external demand continues to be weak, the recovery is likely to be muted.
The story in India remains the same. Stubbornly high inflation and a paralyzed government have prevented India's central bank from easing more aggressively. These factors have caused economic growth to remain weak, and the government has little room on the fiscal side to boost growth. We think it would be most helpful at this stage for the government to put policies in place to boost confidence and investment by the corporate sector. We are still concerned that India's long-term growth potential may be damaged by continued delays in investment and structural reforms.
The situation in Brazil is similar to China, in the sense that economic growth has remained weak. Monetary easing by the central bank that started in the second half of 2011 has failed to boost growth in a meaningful way. The government has now acted with various measures to boost domestic demand. Although exports are small relative to the country's GDP, they have added to growth in recent years because of Brazil's exposure to commodities.
However, exports have been overwhelmed by imports. As the Brazilian currency, the real, has strengthened, imports have become cheaper and displaced domestically produced goods. The manufacturing sector therefore has struggled greatly over the last few years. This factor, along with a substantial increase in consumer borrowing in recent years, has made the economy less responsive to policy easing. We think the combination of government policy still focused on stimulating demand and a much weaker currency in the last few months will mean Brazil's economy will bottom sometime in the next few months.
Markets know the risks, but solutions unclear
In our view, uncertainty and a subsequent lack of confidence continue to be the key risks for the global economy. Many of these risks are well known, such as the fiscal cliff in the U.S. and the debt overhang in Europe. However, despite all of the research published on these issues, we think the risks come down to one question: Will government leaders provide a cohesive and rational policy response? These major economic problems rely on a solution from policymakers who often view the world differently from one another, and that in turn creates another level of uncertainty about how and when the problems will be resolved.
Past performance is not a guarantee of future results. The opinions expressed in this article are those of Mr. Hamilton and are not meant to predict or project the future performance of any investment product. The opinions are current through July 16, 2012. Mr. Hamilton's views are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed.
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