The global economy in H1'2012

A recession in Southern Europe, sluggish growth in the U.K. and much of Northern Europe, near-trend growth in the U.S. and sustained but slower growth in China and other emerging market countries characterized the global economy in H1’2012. During the period, the lagged impact of last year’s monetary tightening in the E.U. -- and in many emerging countries -- and the direct (and indirect) effects of the continuing financial crisis in Southern Europe remained the key constraints to economic growth. In spite of these constraints, economic activity in 2012 started off stronger than I expected with global GDP expanding 2.9% Y-o-Y in Q1’2012[1] -- 10bps higher than Q4’2011 -- as economic data in the U.S. and Asia remained above trend in early Q1’2012, and the European debt crisis appeared reasonably well contained.

With the strength in global economic data, particularly in the U.S. labor market in Q1’2012, global equity markets enjoyed their best rally in several years. In Q1’2012 the Dow Jones Industrial Average gained 8.8%, the S&P 500 Index rose 12.6% and the Nasdaq Composite jumped an impressive 19.0%. The results outside of the U.S. told a similar story, although the magnitude of gains trailed slightly. The MSCI World ex-US Index rose 10.4%, with the DAX up 17.8%, the FTSE up 4.8%, the Nikkei 225 Index up 20.3% and Shanghai Composite advancing 4.7%. Emerging markets as a whole were a bright spot, with the MSCI Emerging Markets Index up 14.1%.

Despite a strong start to 2012, U.S. economic activity took a turn for the worse; with inventories -- which had contributed an outsized 1.8% to Q4’2011 GDP – dropping to a far more sustainable pace of 0.6% compared to 2.2% of GDP growth in the same period in Q1’2012. Also, the strength in consumer spending, which increased by 2.9% in Q1’2012, was offset by tepid core business expenditures which advanced 1.7% and government spending which contracted by 3% -- led by a drop in defense spending. The U.S. manufacturing sector remained a bright spot for economic activity in H1’2012 as the Institute of Supply Management (ISM) Manufacturing Index remained stable and firmly above the expansion/contraction demarcation level of 50%. Additionally, consumption – which represents ~70% of U.S. GDP -- continued to rebound during the period, led by improving automotive sales. Interestingly, U.S. personal consumption expenditures exceeded the growth in personal income during H1’2012, resulting in a drop in the savings rate by 50 bps Y-o-Y to 3.7%. On the other hand, U.S unemployment remained stubbornly high, with the decline to the current level of 8.2%, resulting from a drop in labor participation rate -- as discouraged workers exited the work force.

In Europe, the sovereign debt crisis remained at the forefront of the economic deceleration. In H1’2012, E.U. policymakers came under significant pressure to allay global doubts about the solvency of several Southern European states and their banking systems. This pressure was couponed by the incessant sovereign ratings downgrades across the E.U. which limited member state’s ability to put in place sufficient financial firewalls to moderate the impact of a possible crisis – given the E.U.’s weakening fundamental outlook and a possible Greek exit from the E.U.  In the midst of the deteriorating economic spiral, the European Central Bank (ECB) intervened with a EUR1.01 trillion lending program to European banks in late Q1’2012. The primary goal of this program was to spur on-lending to increasingly constrained Southern European governments. While the ECB’s quantitative easing bode well for financial markets, it did little to stem the fiscal avalanche and even less to promote economic growth in the region. In H1’2012, most European countries remained mired in recession and yet still faced significant fiscal austerity programs.

In Asia, Chinese and Japanese growth held up; with fiscal stimulus and reconstruction efforts combining to support growth in China and Japan respectively, while export demand from Europe waned.  In China, policy makers crafted definitive policy measures to ensure a soft landing – and they succeeded. In H1’2012, the Chinese GDP growth remained at a brisk pace, in spite of a pull back in the manufacturing and exports, and the continued correction in its domestic residential property sector. Overall, China’s real GDP surged 8.1% Y-o-Y in Q1’2012 while inflation remained persistently high around 6.31% in H1’2012 -- compared to 5.6% in the same period last year. In spite of the inflationary pressures, the People’s Bank of China (PBoC) cut its minimum reserve ratio for the first time since 2010.

In Japan, the economy rebounded strongly in Q1’2012, growing 2.7% Y-o-Y, albeit from a low base of -0.2% in Q1’2011 -- when the March 2011 earthquake and tsunami occurred. In H1’2012, private consumption -- which makes up about 60% of economic activity -- rose 1.1%, helped by government subsidies on sales of fuel-efficient cars, even as public investment to cover the post-tsunami rebuilding effort added 0.3% to the expansion. A fall in the yen in H1’2012 compared with Q4’2011 and a mild pick-up in overseas demand late in the period saw exports rise 0.1% to end the period.

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[1] IMF

Outlook for H2’2012 (Developed Markets)

U.S.: Remains likely to outperform

The U.S. economic recovery lost momentum in H1’2012, however with moderate employment gains in recent months and a pick-up in the pace of consumer spending; I expect real GDP growth to increase to trend thorough H2’2012, in spite of the events in the E.U. -- I remain of the view that the transmission mechanism of the European crisis to the U.S. economy are relatively limited. My view on the U.S. economy is further anchored on improving confidence in both businesses and households across the U.S., as well as slower deleveraging, which should allow the saving rates to ease. Housing demand has increased noticeably in 2012, but the overhang of unsold homes and the tide of foreclosures have scuttled a speedy revival in residential investment.

I expect the medley of the aforementioned factors to spur growth in H2’2012, driven by private-sector demand rather than by policy. In fact, I see fiscal consolidation in the U.S. as a possible drag on growth with the risk of excessive fiscal tightening in 2013 still to be addressed. Moreover, long-term fiscal sustainability in the U.S. remains to be achieved, and a credible fiscal plan is needed to ensure it.  Given the still fragile recovery, monetary policy should remain accommodative, but conditional upon other developments. Given the foregoing, I do not expect a moderation in fiscal policy to significantly offset the gains in private sector activity in H2’2012. Furthermore, I have adopted a cautiously optimistic, view of the U.S. equity markets in H2’2012, while being mindful of the risks.

Europe: Outlook remains negative

Activity in the E.U. stagnated in Q2’2012 after contracting at the end of 2011 and Q1’2012. Unemployment has risen consistently through H1’2012 and is set to rise further in H2’2012, owing to weak confidence and difficult financial conditions related to the sovereign debt crisis. Provided that policy actions are sufficient to improve confidence, activity should begin to recover gradually in the H2’2012, notwithstanding fiscal consolidation and private sector deleveraging across the region. However, I am not optimistic that this view will materialize. Rather, I anticipate that E.U. policymakers will muddle through H2’2012 with a series of half measures (the result of a sustained failure to reach consensus) that will prove inadequate to thoroughly resolve the region’s problem. Accordingly, I expect a divergence between moderate growth in creditor countries (particularly Germany and France) and, weaker/delayed recovery in countries with large debt overhang, even as the large margins of spare capacity across the region moderate inflationary pressures. The main risks to this outlook for the region in H2’2012 centre’s on a possible intensification of the debt crisis and the economic effects of high public and private indebtedness. Though recent decisions have significantly increased the capacity of Europe’s firewall to address government funding problems, I remain of the view that it remains insufficient and fraught with regulatory handicaps. With these constraint in view, I expect monetary conditions to ease further in H2’2012 – possibly in the form of a 25 bps cut to the ECB’s prime rate. With the scope for monetary and fiscal stimulus limited, reforms to labor market institutions, product market regulations and the tax system needed to sustain growth and boost jobs, I retain the view that European financial markets are likely to underperform their developed market pairs.