Monday, 5 March 2012

2012 - A Summary

In 2012, the major economies of the world will find their business cycles are less synchronized than any time over the last ten years. 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.

The reason for this is that domestic imbalances of savings and investment (recorded in current account surpluses and deficits) are less pronounced globally than at any time since 2001.

As a result, these economies will also be less hostage to international capital flows and their volatilities. Investors 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.

US – Accelerating Recovery
Chief beneficiary of this is the US, where we expect the recovery to continue to accelerate throughout 2012, and we expect both the current consensus forecast of 2.2% in 2012 (up from 1.7% in 2011), and the US Federal Reserve's band of 2.2% to 2.7% will prove to be excessively conservative.

By my estimate returns on capital are around their highest since 2000 and are still rising, which will continue to foster investment spending; labour productivity continues to grow (adjusted for changes in capital stock), which will underpin the slowly- accelerating addition of jobs; and, most importantly, I believe that the net develeraging of the economy which started in 2008 is now complete. I do not expect significant re-leveraging to take place this year, but the mere fact that deleveraging is no longer the key dynamic will shift the economy out of its modest 2.4% annualized growth trend which it has sustained since the end of the recession in 2009 and towards a 3%+ rate.

As this faster growth path becomes acknowledged I expect to see bond yields rise from their current excessively-low level (roughly 180bps below 'fair value' in our models). For now, it is faster growth, not higher inflation, that will do the damage to the bond markets.

This scenario faces threats from both the upside and the downside. On the upside, if monetary velocity (GDP/M2) even stabilizes at its current precedent low levels, then somehow we have to expect double digit nominal GDP growth. On the downside, the cycle could be choked off by a sustained rise in commodity prices sufficiently strong to erode the US terms of trade sharply. What would it take? Oil at US$140 a barrel would be threatening but not conclusive; oil at US$165 a barrel would trigger a 'soft patch' to disrupt the recovery.

Eurozone – Not Eurogeddon, but Recession
The ECB's willingness to supply Eurozone banks with cheap long-term funding, coupled with the US Federal Reserve's willingness to supply ECB with enough dollars to plug the hole left by financial institutions' capital flight from Europe (Eu135bn in December alone!) makes it likely the Eurozone can avoid financial implosion this year.

But it is unlikely to avoid recession. All three main ratios underpinning the business cycle point towards recession: nominal GDP growth is now so slow that asset turns and return on capital are falling – which usually triggers a downturn in the investment cycle. Europe's terms of trade have deteriorated back to their 2008 lows. And the pace of bank deleveraging, which has been the most gentle of headwinds during the last five years, is picking up dramatically. Falling returns on capital, rock-bottom terms of trade, and accelerated deleveraging dictate a private sector recession. And that's before the impact of tighter public sector budget discipline is taken into account.

Nor is it easy to expect an early exit from this recession, since the underlying problems of competitiveness within the Eurozone are ignored entirely by the current attempts to 'save the Euro'. Yet these issues will eventually be addressed in one way or another. The bullish view is that eventually Germany will reconcile itself to very rapid nominal GDP growth, including a bout of inflation and a current account deficit rather than watch deflationary forces consume southern Europe. This may, in the end, be correct. But it won't be in 2012.

China – No Hard Landing, but Hard Choices
The expectation that a hard landing will be forced on China by combination of disappearing export growth plus mounting bad debts in the banking system, linked both to local government and property projects, is wrong. The Chinese government has spent two years taking stock of the problem and trying to work out precisely who should pick up the bills coming due. It's a fraught political problem, but at least the money is there to pay them.

But this is not the main worry. Rather, the wildly-successful growth strategy pursued by China pursued in earnest since the mid-1990s is reaching exhaustion point. Policymakers have been extremely clear in their repeated assertions they wish to move China from an investment-led conomy to a consumption-led economy. But to make that transition is extremely difficult since it involves a complicated and sensitive re-modelling of China's financial system. China has had the best economic and financial advice on the topic that exists, but no-one really knows what will happens when the re-modelling gets underway in earnest this year.

Because of this radical uncertainty, our expectation of Chinese growth slowing to around 8% is best interpreted as an assertion that a hard-landing will be avoided, but that the environment for all involved in China's economy is likely to be unusually difficult and unpredictable.  

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