THE financial sector has led the world into the current global recession and into the current rally. Too much credit risk, both personal and now sovereign, threatens banks and financial systems combined with too little improvement in employment and growth to allow them to earn their way back to health.
If anything, the arguably justified but failed massive deficit spending in much of the world has left governments even less able than ever to fund further bailouts and stimulus.
Emerging Europe
Countries such as Hungary, Latvia and Romania will struggle to implement fiscal austerity measures while trying to placate increasingly-restive voters as their economies are expected to contract. Poland and the Czech Republic will likely suffer the backwash whenever one of the more troubled markets comes under pressure, even as their economies gain some traction. And at the other end of the spectrum, Ukraine will be lucky to make it through the year without an outright sovereign default.
China
This year began with China pressing extreme fiscal stimulus to counter the rising headwind of a global slowdown that was crushing exports and stirring rumors of recession. Since then, growth has rebounded while fears have subsided, and focus is now turning toward normalizing the policy environment, adjusting the stimulus-induced imbalances in the economy, and assessing the condition of the banking sector.
According to official Chinese statistics, the economy reached its low point during Q1, 2009 when growth slowed to 6.1 percent on the year. After that point, the effects of Beijing’s 4 trillion yuan ($586 billion, or about 16 percent of GDP) fiscal stimulus package began to take hold, bringing growth to 8.9 percent by Q3 and raising expectations that the economy would reach or exceed the government’s goal of 8 percent growth for all of 2009. The trade surplus has stabilized, although at a lower level than pre-crisis, leaving some concerns about how much of a contribution net exports will make to GDP and the overall recovery.
Asia
With the exception of Japan, Asia’s public debt situation is far more manageable than other regions. Debt reduction is a key policy measure for most of the exporting economies, and as external demand rose during the 2006-2008 period and revenues grew beyond expectations, governments placed a priority on reducing their debt obligations. Even Japan’s immense public debt stock fell beneath $8 trillion (just over 160 percent of GDP) just before global credit markets locked up and brought on the global financial crisis. However, most countries in the region had debt ratios closer to 35 percent of GDP in late 2008, providing ample room for fiscal stimulus.
With Japan’s public spending binge likely to place government debt at over $10 trillion in early 2010 and on a steep upward trajectory, markets are beginning to ponder the possibility of Tokyo falling into a spiraling debt trap. Japan has been able to issue the bulk of its debt during an extended period of ultra-low interest rates that have held down servicing costs and kept compounding low when rolling over these obligations. However, such low yields make yen-backed securities less desirable, so without a better return the market is likely to get saturated at some point, forcing treasury rates higher and placing the government in a pinch to service its debt. Nobody is talking of a Japanese debt default in 2010, but unless the new government takes some measures to address the escalating debt situation, it is possible that it could receive agency downgrades, which would also force up rates and push matters ever-closer to the edge.
Excess liquidity supplied by major central banks will continue to be a driving force in 2010, and other central banks have little choice but to be highly cognizant of the changing dynamics. As the major central banks start to tighten in 2H10, the rest of the world will likely inherit rising bond yields and likely softer equity markets. This is nothing short of a de facto tightening for other central banks, most of whose economies and financial markets are linked to the major ones.
Inflation risks
As growth shows signs of being sustainable, goods prices should find some support and markets will likely start worrying about the inflation-output trade-off. On three occasions in 2009 (the dovish response of central bankers to the pricing in of rate hikes in August-September, the dovish statement after the previous FOMC meeting and Fed Chairman Ben Bernanke’s speech on Nov. 16), the rally in front-end rates was accompanied by a widening of long-term break even inflation rates. The year 2010 is likely to see more of the same since central banks are unlikely to be aggressive in their exit strategies.
In the G10, the decline in potential output growth complicates monetary policy in two ways. The accompanying decline in the natural rate implies that policy rates have less room to go upward before they reach neutral territory. This is likely to make central banks more cautious as the level of rates goes meaningfully above their current values of near-zero. Second, a fall in potential output growth directly implies that the output gap could close at a brisk pace as the recovery becomes entrenched, taking away some of the headwinds that inflation currently faces.
Emerging markets also face inflation risks, particularly those with fixed exchange rate regimes. These economies import the expansionary stance of the major central banks via the fixed exchange rate. In the absence of nominal exchange rate flexibility and aggressive interest rate hikes, macroeconomic adjustment is likely to happen via the real exchange rate, i.e., by pushing up prices in the emerging market faster than in the G10. In a nutshell, until the ultra-expansionary monetary stance — through traditional policy rate tools as well as unconventional measures — is successfully reversed, inflation risks will likely remain in the system. Not because central banks cannot act aggressively, but because they may not.
IMF reports
In two reports prepared for a meeting of G20 nations, the International Monetary Fund (IMF) said it was still forecasting a gradual economic recovery in 2010. But it zeroed in on the problem of “toxic assets,” saying the sooner they were dealt with, the better. “Even in countries where banking sectors still appear resilient, the deepening global financial crisis is likely to imply greater stresses,” the IMF said. It said G20 countries should also develop plans for coping with stricken financial institutions so they don’t infect the broader economy. A senior IMF official told a conference call with reporters there would be no enduring recovery until financial sector stability was restored and the world’s leading economies increased their policy coordination.
The reports will flavor discussions on April 2, 2010, in London, when political chiefs, including US President Barack Obama, join finance ministers from the G20 for another round of talks that will aim to bolster hopes that the recession’s impact can be cushioned to some degree. The IMF official said there were “considerable” downside risks to the forecast and the fund may need to further cut its projections if the risks intensified.
For now, the IMF said advanced economies were in a severe recession that will shrink their GDP growth by a range of 3 percent to 3.5 percent in 2009, improving to around zero growth in 2010.
Bank of America, Merrill Lynch
The Bank of America, Merrill Lynch global economics research team forecasts global gross domestic product (GDP) growth to be 4.4 percent in 2010, well above the 3.1 percent predicted by the IMF. The team projects growth will be led by China at 10.1 percent, while projecting US GDP growth to be 3.2 percent.
The team members expect a further fall in core inflation and projects that US Consumer Price Index will be 2.5 percent. They feel that the transmission process whereby monetary easing leads to rising prices is currently “stuck in neutral” as banks are rebuilding their balance sheets. They also believe that central banks will have plenty of time to sop up liquidity before inflation becomes a real issue.
Michael Hartnett, chief global equity strategist and chairman of the Bank of America, Merrill Lynch Research Investment Committee, is targeting the MSCI All-Country World Index at 350, roughly a 20 percent upside and is bullish on European equities, Asia and emerging markets.
David Bianco, head of US equity strategy, expects the S&P 500 to appreciate about 15 percent by 2010 year end to 1275. Bianco expects this appreciation to be driven by S&P 500 sales growth in four “global cyclical” sectors of technology, energy, industrials and materials.
“These four sectors have high direct foreign sales and benefit from high commodity prices and US exports,” said Bianco. “We also expect financials to outperform as a result of steepening yield curves and underestimated normalized earnings power.”
Francisco Blanch, head of commodities strategy, expects commodities will be driven by strong demand in emerging markets. “Crude oil could break $100 per barrel by late 2010 and we’re forecasting gold to top $1,500 per ounce in the next 18 months, particularly if the dollar weakens further against certain undervalued emerging market currencies,” said Blanch.
The Bank of America, Merrill Lynch US Interest Rate Committee expects returns on long-term Treasuries and municipals to be modestly negative and forecasts 10-year treasury yield to be 4.25 percent, while the 30-year treasury yield is predicted to be 4.95 percent.
Jeff Rosenberg, chief global credit strategist, expects to see normalized returns as corporate credit outperforms both government bonds and cash. “We expect high-yield returns to reach 10 percent, outperforming the high-grade sector, which we forecast as providing returns in the 2 to 3 percent range,” said Rosenberg. “The returns delivered by the credit markets over the past year are impressive, but unsustainable. Going forward, investors will need to adjust their expectations for price appreciation to more normalized levels for the entire asset class.”
(Salah Saleh Sultan is a
Bahrain-based economist.)
