2012: A Year When Cycles Diverge

(I have just returned from a short period in Bahrain (about which more at a later date), where, among other things I was asked to write an overview of the global economy highlighting the likely trajectories for 2012.   The result was a series of five pieces, of which the following is the introduction. I hope you find the series meets your standards.) 

This will be another year in which the best thing an investor can do is forget the lessons that have been drilled or beaten into him during the last few years. Two of the most popular lessons are that deleveraging once started is pernicious and long-lasting. The second is that we live in a risk-on, risk-off world in which the global economy and global financial markets are so inter-related and inter-dependent that trouble anywhere means trouble everywhere. In the globalized economy, there is simply no place to hide, since business cycles of separate countries cannot escape being heavily synchronised.

Yet in 2012, we can and should expect the major economies of the world to diverge in their business cycles, as cycles become less synchronized than probably any time over the last ten years. More than at any time in a decade the fate of the world's major economic power-houses will rest on the underlying fundamentals of return on capital, financial leverage, terms of trade and policy-development.

We will gradually discover that we're exiting the 'risk-on, risk-off' world, and backing blindly into a world where asset discrimination once again begins to matter, a lot.

This divergence between economic cycles is already apparent even at the beginning of 2012, with the US accelerating more than expected, China (probably) beginning to slow more painfully than seemed likely at the end of last year, even whilst avoiding a 'hard landing', and the Eurozone straightforwardly heading into recession and, on the periphery, into something far worse.

Separate economies, rather than being harnessed together, are now responding to their different underlying cyclical stimuli, as well as policy settings which are now quite different in, say, China than, say the US.

This divergence is not yet widely recognized or understood. It is possible because the imbalances between savings and investment, reflected in current account balances, have fallen in virtually all economies to unusually low levels. Think of the global economy as a giant jigsaw puzzle, in which the giant regions fit together: in that analogy, current account surpluses and deficits are the cut-outs and bulges that lock the pieces together. The bigger the current account imbalances, the tighter the fit. Looking at the four major economies of the world (US, Eurozone, Japan, China), one can see reasonably clearly that the current account surpluses in China and Japan have peaked, whilst the US current account deficit has improved somewhat.

But if one simply counts up the total imbalances (negative or positive) as a % of GDP for these countries, the radical fall in the total current account imbalance shows up much more clearly.

 In 2008, the combined current account imbalances of these countries amounted to 24% of GDP: by 2011 this had shrunk to 11.1% - which was the lowest total since 2001. On current trends, that ratio will shrink further in 2012.

There are two profound consequences for the world economy. First, this chart tracks the degree of inter-dependence of these major economies, the degree to which, for example, China's growth is potentially exposed to a slowdown in the US. The lower the total, the more the fate of these separate economies lie in their own domestic circumstances. When China's growth was predicated on running at current account surplus of 10% of GDP (2007), what happened to US demand mattered a whole load more to it than it does now, when its current account surplus has shrunk to 3.9%. Ditto all the other bilateral economic relations possible among these four leading economic blocks.

So the first consequence is a lesser degree of inter-dependence, and therefore a greater ability for cycles to diverge according to individual economic circumstances. And we expect those circumstances do diverge considerably now.

The second consequence is that economic cycles are less hostage now to capital flows than at any time since 2001. Again, this is simply a consequence of the shrinking of current account imbalances, since every current account deficit must and will, by definition, be met by a capital flow. The lower the underlying imbalances, the less important the outcome of international capital flows.

So, we propose that in 2012, we to cast aside the assumption that the world and its financial markets are inextricably entwined and that what afflicts one will necessarily infect the other. It's not that its not true exactly – it's just that that truth is less effective, less important, in 2012 than it has been at any time since the beginning of the Euro in 1999.