Cutting Forecasts; Downside Risks Remain

We are sharply cutting our outlook for global growth and inflation in 2009 for the sixth time in seven months, this time to 0.9% and 2.6%, respectively, from 1.7% and 3.9% in November.  And the 2010 recovery is likely to be moderate, despite unprecedented global policy stimulus.  Our baseline view takes growth back up to 3.3% in 2010, with inflation at 3.7%.  If that outlook is realized, global growth in 2009-10 would be the second weakest in the post-war period, barely stronger than in the deep 1982-83 downturn. 

Global Forecast at a Glance

E = Morgan Stanley Research estimates     Source: Morgan Stanley Research

More importantly, downside risks persist as a global credit crunch and falling asset prices ripple through the economy.  Indeed, incoming data around the globe indicate plunging economic activity and prices in October and November, pointing to a severe global recession and a real deflation scare.  Courtesy of globalization, this recession has spread quickly, undermining any cushion of support from abroad for the US economy or vice-versa and intensifying the adverse feedback loops.  Given the strength of economic headwinds, even ultra-aggressive policies seem unlikely to promote a vigorous rebound soon. 

If the risks still point to the downside, why not simply cut our estimates to the point where those threats are balanced?  There must be a better way to assess the balance of risks than by extrapolating the evolution of our forecasts from month to month.  

A Framework for Assessing Risks to the Outlook

We think there is a better way: Assess and quantify the risks to the outlook systematically in advance.  In this note, we provide a framework to meet that goal, thus providing investors and our colleagues with a sense of forward-looking plausible risk scenarios around a baseline (see The Method to Our Madness below for details on the methods, on specific risks, and on regional differences). 

Globally, we believe that there are five key drivers of risk: First, the extent of deleveraging by leveraged lenders remains uncertain, and further write-downs and provisioning will intensify the credit crunch in several developed economies.  The extent of further declines in asset values, especially in real estate, will deepen those risks, especially for US consumers (see “Perfect Consumer Storm to Last at Least Until Mid-2009”, Investment Perspectives, November 20, 2008).  Second, many central banks have eased monetary policy aggressively and quantitatively, but it is unclear whether and when such policies will get traction.  To be sure, there are recent signs of a revival in liquidity and money growth (see “More Action, Some Traction”, The Global Monetary Analyst, December 3, 2008).  However, monetary policy in many EM economies remains restrictive. 

Third, officials, notably the incoming Obama Administration, are considering a massive step up in fiscal stimulus, with an undetermined amount in infrastructure outlays and tax cuts.  The timing, size, and economic effectiveness of such policy actions are likely to remain unclear for a while.  Next, swings in currencies, commodity prices and risk premiums matter for the outlook in many EM economies (see Latin America: Shocking the Consensus, September 22, 2008).  Finally, the extent of the real estate downturn in China is a critical risk factor for that pivotal economy (see Outlook for 2009: Getting Worse Before Getting Better, December 9, 2008). 

The upside and downside results from those scenarios provide a very different perspective compared with the baseline.  In our ‘ugly’ scenario, global activity contracts by 0.8% in 2009 and recovers by only 1.3% in 2010 as economic headwinds dominate policy stimulus.  Given that we think of global recession as growth below 2.5%, the ugly scenario would border on something even worse than the most severe recession in the postwar period.  In contrast, the ‘good’ scenario involves 2.3% growth next year and 4.4% in 2010, as a massive range of policy actions overwhelm the downturn. 

Unfortunately, the good-ugly comparison reveals that the downside risks outweigh the upside odds.  The margin is not large in 2009, where growth in the bear case falls short by 1.7 percentage points of the baseline, compared with a 1.4 percentage point gap between the good outcome and the baseline.  But the downside margin of risk widens in 2010 to 2 to 1 (the ugly outcome is 2 percentage points below the baseline, while the good outcome is only 1 percentage point above the baseline). 

Policy Paradox: Near-Term Downside Risks Promote Recovery in All Scenarios

Two factors skew the distribution of risks to the downside.  First, while ‘tail’ risks (low-probability, high-impact events) lie outside the range of plausible outcomes, they shape the continuum of risks within that range.  In our view, depression and deflation – defined as periods of two years (or more) of declining output and prices – are today bigger tail risks than the return of a global boom and inflation.  Second, the credit crunch is powerful, and policies have been reactive rather than preemptive.  As a result, deleveraging, risk aversion, and the near-term cyclical dynamics of recession are likely to offset policy stimulus for now. 

Depression and deflation are important tail risks because, if left unchecked, the credit crunch could trigger severe consumer and business retrenchment.  But they are highly unlikely for two reasons.  For one, we see some economic excesses outside of real estate as more limited than in past periods, as a result of more limited global connectivity and supply-chain management.  Most important, we believe that misguided policies deepened the Great Depression and Japan’s crisis, and we have learned three lessons from those events.  First, aggressively use macro policies to buy time for other steps to take effect.  Second, implement policies to stabilize the financial system and attack the root of the credit crunch.  Finally, adopt measures to reduce the imbalances that triggered the downturn (see “Neither the Great Depression Nor Japan”, The Global Monetary Analyst, November 19, 2008). 

Indeed, we believe under all our scenarios that aggressive policy will eventually gain the upper hand.  That holds even in the ugly scenario for 2010. A premise of our risk analysis framework is that the policy responses and policy traction are critical determinants of the outlook in 2010: Put simply, the weaker 2009 proves to be, the more aggressive will be the policy response, including that from officials who have thus far been laggards.

Inflation Risks: Counterintuitive Skew

Finally, the risks to inflation are – somewhat counter-intuitively – tilted in the other direction from those to growth.  Normally, massive economic slack would be associated with higher deflation risks.  Make no mistake, our baseline and near-term scenarios encompass sharp declines in inflation outcomes globally.  However, four factors make deflation unlikely: First, the current inflation decline largely represents a reversal of the inflation spike of early 2008, rather than the beginning of a new era.  Second, we think that companies will quickly cut excess capacity to balance supply with demand.  Third, some of the emerging global declines in goods prices are clearly declines in relative prices, not prices generally.  This shift in the ‘terms of trade’ benefits consumers and most businesses, even in commodity-producing countries.  The vital element to keep in mind is that the Fed and other central banks are easing aggressively and in some cases now quantitatively to influence inflation expectations. 

Indeed, now there are three important factors that lead to upside asymmetry for inflation risks around the baseline.  First, we believe that low oil prices will sow the seeds for higher prices down the road.  Supply cutbacks should put a floor under prices at $30 or so, and when demand rebounds, supply will be slow to come back on line.  Moreover, in developed economies, there is a risk, albeit a small one, that policy stimulus will overstay its welcome, eventually (beyond 2010 in our view) leading to renewed inflation concerns.  Finally, in developing economies, poor growth outcomes in the short term are leading to further currency weakness, pushing up inflation at least over our two-year time horizon. 

Regional Risks: Developing Economies Are Higher Beta

These risk drivers can differentiate economic (and earnings) risks across regions.  While the US economy is at the center of the deleveraging dynamic, and thus likely will experience the deepest recession, the dispersion of risks for emerging market economies is wider than for the developed world.  That’s appropriate because EM economies are more highly leveraged to global growth through trade, capital flows and commodity prices.  In addition, many EM policymakers are still concerned about inflation risks following sizable currency declines.  Delayed policy responses will increase downside risks to growth in both EM and developed economies like Europe and Japan.

As noted earlier, the risks for inflation in the developing economies are skewed to the upside around a near-term declining baseline.  In contrast with GDP, where the risks are slightly tilted to the downside, for inflation the upside in the bull case is higher than the downside in the bear case. That reflects two factors: First, supply constraints in oil and other commodities limit the downside in the ugly scenario and push commodity prices even higher in the bull scenario.  Second, in the bear scenario, falling exchange rates offset declines in EM inflation from other sources.  In turn, such dynamics support our LatAm and Asia EM teams’ case that EM central banks have less latitude than the G7 to ease monetary policy.  Over the long term, that issue will fade in importance as these countries develop further, become less dependent on commodities and external sources of growth, and their markets become more flexible.  But for now, it perversely will boost inflation risks around the baseline.

The Method to Our Madness

A Framework for Assessing Risks to the Outlook

To assess risks, we analyze the impact on growth and inflation of a handful of critical, plausible alternative scenarios.  Until now, our assessment of the width, skew, and fatness of the tails of the distribution around our baseline forecast has been subjective.  Here, we adopt a more systematic approach by looking to key drivers in each region and to the most important common global factors that could cause change.  Plausibility is defined to cover outcomes roughly one standard deviation from the mean in either direction.  Our methodology involves shocking key drivers of risk for each economy or region and aggregating the resulting upside and downside scenarios into consistent global outcomes.  For the US, those drivers involve different paths for home prices, different rates of loss among lenders, and more or less aggressive policy actions and their effectiveness.  For Europe and Japan, policy actions are critical; for China, it is the performance of real estate.  For Latin America, the shocks come through currencies (and the response through interest rates), commodity prices, and risk premiums. 

Considering variation in commodity prices as a risk driver complicates risk analysis for two reasons.  First, the weakness in demand that has promoted the recent collapse in commodity quotes is clearly bad news for emerging-market commodity producers.  However, it is a welcome cushion for the perfect storm now battering the American consumer and by extension other consuming countries.  As a result, these massive changes in the “terms of trade” are bane to some but boon to others, and their consequences for global risks must be netted from that interplay.  Second, it is critical to assess the source of the change in commodity prices: Today’s plunge is primarily the result of weak demand, so it would be misleading to look at the drop as a new source of global stimulus.  Conversely, if it results from increased supply, the effects on global growth likely will be positive.  Indeed, we estimate that if an increase in supply allowed crude quotes to decline to $30/bbl, global growth would be roughly 0.5 percentage points stronger than in the ugly scenario (or -0.3% rather than -0.8%), and global inflation would decline by 0.3 percentage points (to 1.5% rather than 1.8%). 

In what follows, we outline region-by-region risks and risk drivers:

United States – Our baseline outlook assumes that home prices (FHFA purchase-only home price index) decline by another 10% for a peak-to-trough total of 18%, and uses MS large-cap bank analyst Betsy Graseck’s estimate of $1.4 trillion in cumulative losses for the US financial system.  We assume a $500 billion fiscal stimulus package spread over three years.  The bear case assumes that home prices will decline by an additional 7%, that cumulative losses total $1.7 trillion, and that monetary and fiscal policy efforts take four months longer to be effective.  Moreover, we assume that consumers save 10% more of the tax cut than otherwise.  The bull case assumes home prices decline by only an additional 5%, cum losses amount to $1.3 trillion, the fiscal stimulus is $700 billion, and monetary and fiscal policies begin to get traction in the spring of 2009. 

Euro Area – Our bear case (30% subjective probability) incorporates a domestic demand crunch caused by several factors. First, a noticeable reduction in the availability of credit to the non-financial private sector, rather than our baseline assumption of a gradual tightening in credit conditions and credit availability in line with a typical recession. Second, instead of easing slightly as in our baseline, the household saving rate could start to rise noticeably. Third, faced with a sharp deterioration in budget dynamics, governments might find it more expensive to fund themselves and private investment projects could be crowded out. Fourth, effective funding costs might go up considerably compared to our baseline of an ECB refi rate cut to 1.5% and a gradual easing in the Euribor/OIS spreads. In our bull scenario (10% probability), financial conditions become noticeably more favorable, fiscal policy achieves major multiplier effects, global growth surprises on the upside, and commodity prices on the downside. The sharp fall in many activity indicators in recent months would be seen as a sign of a proactive corporate sector that was fast to slash production, managed its supply-chain efficiently and made full use of the flexibility of temporary staffing.

United Kingdom – Our bear scenario assumes that the low household saving rate follows a trajectory similar to the recession of the early 1990s, rising sharply at a time when global growth is well below trend, so that reductions in domestic consumption are not offset by stronger growth in exports.  A sharp and protracted fall in output would be inevitable. This risk is not our main forecast because we are not seeing the sharp rise in interest rates that helped drive the household saving rate up dramatically in the early 1990s. A more benign path than our base case is one where the "lost" output from 2008 and 2009 is not permanent because the supply side is not damaged by the credit crunch and activity bounces back strongly in 2010 to trend. It seems optimistic to assume that the severe damage to the financial system does no lasting damage to productive capacity.

Japan – The main downside risks to our base case are a political crisis and protracted policy gridlock after the snap elections, and a policy-induced slump of construction investment (again) just like the housing shock in 2007.  Our bull scenario envisages a sharp improvement of terms of trade, which could reduce the outflow of real purchasing power and unleash pent-up consumer demand.  

New Zealand – The key drivers for the bear scenario are (i) even weaker growth in trading partner economies, damaging export prospects further, and (ii) a sustained decline in house prices, which would prolong the recession.

China – Despite much attention paid to the G3 recession, we think the biggest swing factor for 2009 growth is real estate investment.  Our base case (65% subjective probability) envisages a 6% decline in real estate investment by the private sector in 2009. If real estate investment were to contract by 30%, the impact would be so large that even the current fiscal stimulus package would not make up for the growth shortfall. We estimate that GDP growth would drop to 5%, tantamount to an outright hard landing. Under this bear case scenario (25% probability), consumption growth would likely be significantly lower as both employment and income growth would suffer.  Our bull case (10% probability) envisages a larger contribution of net exports to growth because of less-deep-than-expected recessions in G3, as well as flat instead of reduced real estate investment.  We estimate that GDP growth could reach 9.0% under this bull case, provided that the fiscal stimulus package would not be scaled back.

Korea – While many are focusing more on export and construction, we see consumption as the biggest downside risk due to household de-leveraging, wealth destruction and currency depreciation. Our bear case assumes domestic liquidity problems as foreigners continue to sell Korean bonds, squeezing wholesale funding further. The dollar shortage could re-emerge if a majority of ship orders are cancelled and shipbuilders cannot meet their external debt payment with trade credits. The upside risk depends on the effectiveness of China's stimulus measures as Korea's growth is heavily related to China's fixed asset investment.

Taiwan – The biggest downside risks stem from any delay in monetary and fiscal policy execution next year and further loss of competitiveness to Korea due to currency appreciation vis-à-vis the Korean won. The main upside risk depends on global demand for Taiwan’s technology exports.

Russia, Kazakhstan, Ukraine – For the former Soviet Union commodity prices remain the key external driver of risk scenarios.  Russia and to a lesser extent Kazakhstan have temporary scope to cushion the downturn with fiscal expansion, but through much of the region monetary policy will have to be further tightened into the slowdown given the risks of deposit flight from fragile banking systems.  IMF programs are likely to defend currency pegs in the Baltics, at the expense of a deep contraction, but to drive further depreciation in Ukraine.  The sharp recovery in steel and oil prices seen in our central case scenario would bring rapid relief in the CIS in 2010. 

Central Europe – Downside risks to growth and inflation dominate even after our recent downgrades. Open economies exposed to the auto sector (Hungary, Czech) are particularly at risk from a growth standpoint. Rates are being lowered everywhere, but the strength of the monetary transmission channel has weakened in the last few years due to increased loans in foreign currency, especially in Poland, Hungary and Romania. Fiscal policy does not have much scope to cushion the blow, and fiscal positions are set to deteriorate in 2009 on the back of lower growth. In Hungary in particular, the fiscal squeeze associated with the recently approved IMF package will provide an extra blow to consumers, in addition to slower credit and export growth.

Israel – The Bank of Israel’s pre-emptive policy easing and the government’s planned fiscal stimulus package should limit downside risks to some extent. However, an even sharper than expected decline in exports and easing domestic demand present downside risks. The absence of a housing bubble and sound fiscal policies are mitigating risks to a large extent, but upcoming elections might result in some policy slippage.

Turkey – The main risk rests with external financing, particularly the ability of the private sector to roll over debt. The expected decline in current account deficit and the funding from a possible IMF stand-by arrangement are likely to help close the potential financing gap.  Protracted weakness in global markets may cause local depositors to switch back to foreign currency deposits, resulting in a noticeable depreciation in the currency. But the central bank has started to ease monetary policy and there will be limited support for small to medium sized enterprises that could prevent a recession.  

South Africa – Risks are asymmetrically skewed towards the bear case of weak GDP growth and sticky inflation. Continued weak global growth prospects and a commensurate dearth in capital flows would keep the currency on the back foot, given the huge current account deficit.  A recovery in global growth through 2010 would likely see oil prices rise sharply enough to prevent the SARB from cutting rates aggressively, thereby capping domestic growth prospects.

United Arab Emirates – The risks to near-term outlook are driven by: (i) the oil markets; (ii) the domestic real estate sector; and (iii) the availability of foreign financing. Although both fiscal and external accounts are expected to remain balanced at oil prices of about $40 per barrel, continued weakness in oil markets may lead to further output cuts, an adverse effect on oil sector growth, more moderate growth in public investments, and lower exports of services to neighboring oil-producing countries.

Latin America – Although we now expect Latin America to contract by 0.4% in 2009, we are concerned that the downside risks still dominate.  The good news is that the starting point for Latin America has improved from the past: the region does not suffer from the same kind of current account imbalances or fiscal shortfalls as in the past. However, we are concerned that policy makers have less room to engage in counter-cyclical fiscal and monetary policy to temper the blow of the downturn.  For the bear case, we assumed the nominal exchange rate depreciates by two times the 10-year standard deviation of the real effective exchange rate.  We used a standard set of “bear case” commodity prices from our colleagues on the commodity research team as additional inputs. For the risk premium (spread over US Treasuries), we used the 10-year average.  We then estimated implied interest rates and GDP growth (for more details see “Latin America: Shocking the Consensus”, This Week in Latin America, September 22, 2008).  For the bull case, we have largely used the previous “base case” before our first revisions downward in October 2008 (see “Latin America: The End of Abundance”, This Week in Latin America, October 6, 2008). 

In 2009, assuming that the global economy finds a trough by summer, we see the dollar rallying further into the trough, but underperforming most other currencies as the world recovers in 2H.  The swings in the global business cycle will likely be the dominant driver for the dollar.  Other factors such as US government debt sustainability and the US inflation outlook associated with the Fed’s QE (quantitative easing) operations will likely be secondary considerations, mainly because we believe that US Treasuries will remain well-supported and a flare-up in inflation is not a probable risk. 

There is no official change to our forecast and we continue to look for EUR/USD to dip to 1.10 by 2Q, before recovering to 1.20 by end-2009.  USD/JPY will likely exhibit a similar U-shaped trajectory, dropping to 85 by 2Q before rising to 100 by end-2009.  Most EM currencies will likely experience intense depreciation pressures vis-à-vis the USD in 1H.  Differentiation at the EM country level will likely be unproductive in the sell-off phase.  But in the recovery phase, country-specific factors will likely drive a wedge between the currencies of the ‘good’ from the ‘bad’ economies. 

Resurrecting our ‘four seasons’ framework.  In thinking about how currencies might be affected by large swings in the global business cycle, it is important to consider both the real economy and the financial side (the buoyancy of global equity markets).  In other words, exchange rates are not only functions of relative economic growth, but are also sensitive to general levels of risk appetite, which are correlated with the buoyancy of world equity markets.  Since financial markets tend to be ‘forward-looking’ and anticipatory, when the world plunges into a recession, earnings forecasts are cut, risk-taking curtailed, and equity prices decline ahead of the actual contraction in economic activities. 

To help us think about the implications for currencies, we first calculated the historical correlations between various currencies (vis-à-vis the dollar) relative to economic growth and the equity markets.  Different currencies tend to perform best in different ‘seasons’, or ‘comfort zones.’  We suggest that high-beta currencies such as many of the AXJ currencies belong to summer or the spring quadrants, while the currencies of large capital-surplus countries, such as JPY and CHF, should be in ‘winter’ or ‘fall’.  By and large, simple correlations of exchange rate performance relative to global growth and global financial market buoyancy are consistent with these broad prejudices.  The distance of these currency cells from the origin denotes the size of the elasticities. 

We believe that EUR and CHF should underperform the dollar as we enter the ‘winter’ quadrant, due to European and Swiss banks’ exposure to Eastern Europe.  JPY, on the other hand, could be supported by acute repatriation flows as we head into ‘winter’. 

Call 1 — The dollar to strengthen first, and weaken later.  At the turn of each year, there is a temptation for analysts like ourselves to make one call on the dollar for the entire calendar year (i.e., a strong or weak dollar ‘year’).  However, more often than not, currencies don’t change trends on January 1.  2008 is a good example: The dollar did not begin to show strength until May against AXJ currencies and until July against the EUR.  In the first few months of 2008, the dollar was extraordinarily weak.  For 2009, we see the opposite trends: dollar strength in the first months, followed by possible dollar weakness in 2H.  We see the world toggling through ‘winter’ and ‘spring’ in 2009, with a risk that ‘winter’ may last longer than 1H, and ‘summer’ may come in 2010 or later.  Thus, we will be buying dollars and JPY into 1H, but with a view to flip our positions some time in 2Q in anticipation of a global economic recovery. 

Call 2 — EM currencies will be stressed in 1H.  The global EM currency ‘moment’ is not over, in our view.  In fact, the process is roughly halfway complete.  We see weaker Latam currencies in 1H09.  Pressures on AXJ currencies will likely persist, as these countries’ exports collapse and their central banks cut interest rates.  We believe that even the CNY will be allowed to weaken against the dollar in coming months.  Eastern European currencies may come under intense balance of payments pressures.  While Russia especially deserves investors’ full attention, the familiar structural fragilities of EE will expose the broad region to possible discrete changes in the RUB, in our view.  When the global economy bottoms, we would be keen to buy back KRW, BRL and MXN.  Our view on the commodity currencies (AUD, NZD, CAD) is broadly similar to that on the EM currencies. 

Call 3 — We remain bearish on the EUR in 1H.  Though the EUR is no longer overvalued, it is still over-rated and over-owned, in our view.  The sell-off from 1.60 to the high 1.20s merely puts EUR/USD closer to its fair value: EUR/USD was massively overvalued at 1.60.  The EUR is no longer expensive, but it is not cheap.  Further, the only reason why the dollar could have rallied so sharply since July was its hegemonic reserve currency status.  The fragmentation of the European sovereign bond markets helps preserve the superior reserve status of the dollar.  Finally, the negative feedback from possible fractures in EE could cause material damage to the EMU, and weigh on EUR. 

Two main risks to our dollar view.  The two key risks to the dollar are inflation and an unsustainable federal debt profile. The Fed’s QE operations need an exit strategy.  The latest talk of the Fed issuing its own debt may be one way the Fed could unwind its balance sheet in time to stabilise inflation expectations.  The dollar’s performance will be driven by inflation expectations, in our view.  Similarly, the super-sized US fiscal deficits will be a risk for the dollar, though our central case view is that US Treasuries are more likely to be a preferred safe haven asset in a global recession relative to other sovereign debt.^. 

Incoming data point to a deeper US recession than we thought a month ago, one rivaling the 1981-82 slump for depth and duration.  Measured by the decline in real GDP from its peak in the spring of 2008, we now expect a 2.6% decline in output through spring 2009, compared with the 2% decline we thought likely last month.  Thus, we are cutting our 2009 and 2010 forecasts again; we see real GDP contracting by 1.9% in 2009 versus 1.3% a month ago, and growing 2% in 2010 versus 2.1% last month.  The downturn would be deeper still, in our view, were it not for an ultra-aggressive combination of monetary and fiscal stimulus that will soon move into high gear.  Authorities are pulling out all the stops: Quantitative easing by the Fed and the largest-ever fiscal stimulus package likely will promote stability in the economy late in 2009 and a moderate recovery in 2010.

US Forecast at a Glance

(Year-over-year percent change)

Source: Morgan Stanley Research   E = Morgan Stanley Research Estimates

The economy fell off a cliff in October and November, as the full force of an intensifying credit crunch hit domestic demand and the global downturn began to depress exports.  While a plunge in energy quotes cushioned the blow, consumers still face a perfect storm: Wealth is plunging, with falling home prices and the worst single-year equity market decline since 1931.  The credit crunch has denied consumers access to credit; banks in November reported that they are less willing to lend to consumers than any time since credit controls were imposed briefly in 1980.  And capped by a horrendous loss of 553,000 nonfarm payroll jobs in November, and a revised average monthly loss of 419,000 in the past three months, consumers are losing support for labor income at the fastest rate since 1982 (see “Perfect Consumer Storm to Last at Least Until Mid-2009”, Investment Perspectives, November 20, 2008).  It’s hardly surprising that vehicle and retail sales have continued to slide, despite more than a $2/gallon plunge in gasoline prices. 

Worse, the economy is losing ground on all fronts.  Capital spending is turning down sharply, evidenced by the 35.5% annualized slide in nondefense capital goods orders in the three months ended in October.  Real merchandise exports collapsed by 7.8% in September (including the impact of the Boeing strike on deliveries), with more bad news expected in coming months as the global recession spreads.  The deepening credit crunch has tightened lending standards and credit availability further, so the three-year-old housing crash has yet to find a bottom.  In all, we estimate that output plunged at a 4.5% annual rate in the two quarters ending in 1Q09, which would be the third sharpest six-month decline since 1947.

Against that backdrop, deflation fears have risen, courtesy of plunging commodity prices, crumbling inflation expectations, a soaring dollar, and the onset of a potentially severe global recession.  Indeed, a yawning US “output gap” and emerging slack abroad will quickly reverse the global inflation surge that appeared earlier this year.  But deflation remains a ‘tail’ risk, primarily because the Fed is engaged in massive, targeted quantitative easing that will put a floor under inflation expectations and ultimately inflation itself.

Quantitative easing began a few months ago when the Fed ceased sterilizing the effect on its balance sheet and bank reserves of the numerous market support programs and liquidity facilities that continue to be implemented. As a result, the size of the Fed’s balance sheet has ballooned from about $900 billion as of mid-September to more than $2 trillion at present.  Measures that have already been announced imply that the balance sheet will approach $3 trillion over the course of the next several of months.  This balance sheet expansion has led to a corresponding elevation in excess bank reserves. 

However, as noted in our recent analysis, the sharp spike in reserves and the monetary base has triggered only a very modest pickup in money supply growth to this point (see Revenge of the Ms, November 18, 2008).  The lesson from the Japan experience is that it will probably take some time for banks to stop hoarding the excess cash.  We suggest monitoring the weekly money supply figures to determine if QE is getting some traction via an expansion of bank credit.  In the end, we suspect that QE – and particularly the targeted QE that the Fed has adopted by focusing its actions on mortgage rates and consumer credit availability – will act to reinforce the support coming from government capital injections and other types of fiscal stimulus. But a significant improvement in the intermediation of credit will not occur overnight.

The Fed has other tools at its disposal, including a commitment to keep rates low and monetizing the coming fiscal stimulus by buying Treasuries. However, we detect considerable reluctance among Fed policymakers to precommit to an extremely accommodative stance for a specified length of time. After all, isn’t that what helped to get us into this mess in the first place? Any such commitment would likely be conditional on inflation and economic performance.  Moreover, we believe that the market misread Chairman Bernanke’s recent reference to the possibility of buying long-term Treasury debt.  Treasury yields are already so low that the impact of a Fed purchase program would be minimal.  Instead, policymakers can get a lot more bang for the buck by buying up the mortgage market – where spreads to Treasuries have been historically wide.  As he did back in 2002 when he made the helicopter reference that earned him a famous nickname, Mr. Bernanke was merely offering an example of the types of actions that the central bank can deploy when they run out of room on the fed funds rate.  The most important message is that the Fed has plenty of ammunition left and there is no limit to any future expansion of the central bank's balance sheet.

Moreover, massive fiscal stimulus is coming.  We anticipate that the incoming Obama Administration will quickly sign a multi-year plan that could total $750 billion.  It likely will include short-term help for the unemployed and state and local governments, medium-term tax cuts, and significantly stepped up longer-term infrastructure outlays.  Indeed, President-elect Obama vowed on Saturday to create and implement the largest public works construction program since the initiation of the interstate highway system a half century ago as part of his stimulus plan.  From the perspective of adding stimulus, the important point about infrastructure outlays is that the ‘spendout’ rates are slow.  For example, a $500 billion infrastructure plan might involve $100 billion in first-year outlays, and could take up to a decade to implement; the highways system took nearly forty years.  Thus, although the President-elect and state governors have identified $136 billion in ‘shovel-ready’ projects, many of which are needed and long-overdue, as sources of immediate stimulus they may fall short of the mark.

Our point is that the structure of stimulus matters as much as size; the issue is bang for the buck.  For example, we believe that a reduction in the payroll tax would be more potent than many other stimulus options.  It would help to both stimulate demand and reduce the cost of labor.  Officials could implement a six-month suspension of the payroll tax quickly and inject $425 billion into the economy.  We estimate that a temporary suspension of the payroll tax – together with other measures currently being discussed in Washington – would provide a powerful dose of stimulus far beyond the magnitude associated with the Reagan tax cuts of the early 1980s and the Bush tax cuts of 2001 and 2003.  Politics are an obstacle, however; many view a reduction in the payroll tax as a “raid on the social security trust fund.”  While we think this is sheer nonsense, we recognize that the hurdles are high, and lawmakers may have to look elsewhere (see Fiscal Stimulus: Make it Bigger – and Better, December 8, 2009). 

Investors looking at our monthly updates may be tired of hearing that the risks to our outlook still point to the downside.  If so, why not simply cut our estimates to the point where those threats are balanced?  There is a better way to assess the balance of risks than by extrapolating the evolution of our forecasts from month to month.  We are now attempting to assess and quantify the risks to the outlook systematically in advance.  We provide a framework to meet that goal, thus providing investors and our colleagues with plausible risk scenarios around a baseline (see Risks to the Global Outlook: The Good, the Bad and the Ugly, December 9, 2008).  The risks around the baseline do still point to the downside; in the ugly scenario we see the US economy contracting by 2.9%, or a full percentage point below the baseline, while in the good scenario it declines by “only” 1.2%.

We think markets have digested a lot of bad economic news, but they have not completely moved beyond it.  Ten-year US yields plunged to record lows over the past week, courtesy of hopes for targeted QE and fears of deflation.  Yet crosscurrents affecting Treasury yields may surface: For now, the combination of a deeper recession, lingering deflation fears, and hopes for Fed purchases of Treasury debt may cap yields, even at today’s low levels.  However, the Treasury will issue a huge volume of supply even with no additional stimulus plan, and that volume will only grow, putting upward pressure on yields.  On net, we think Treasury yields now seem likely to consolidate, but will rise over the course of 2009. 

Likewise, equities have rallied sharply on the hope that aggressive stimulus will shorten the recession, but near-term earnings and economic disappointments will be hurdles to further gains.  In addition, sequencing matters: Until credit markets consistently improve, rallies in equities seem likely to be short lived.    

Showing the euro’s macro mettle:  The current downturn marks the first full-blown recession since the start of monetary union.  And it’s in these testing times that the euro area’s mettle is likely to be shown.  For the full year 2009 we see GDP down 1.0%:  Our base case calls for contracting activity to eventually give way to a muted recovery around midyear.

Clearly, there are some unique pressure points in the euro area, as the currency union is not matched by a political union and most economic policy decisions, other than monetary policy, are still taken at the national level. Note that this heterogeneous policy approach could also be beneficial in an environment of a high level of uncertainty about the outlook and of divergent opinions about what policy options are best to follow. In addition, the pros and cons of E(M)U membership will likely be debated both inside and outside the euro area.

The current consensus seems to be that the chances of EMU break-up have increased on the back of the current turmoil. We disagree. In fact, we think that the opposite might be the case and some countries could be fast-tracked towards EMU membership.  Here we discuss the challenges facing Europe in 2009 and conclude that EMU will likely pass this first real test of its macroeconomic policy framework. As a result, we expect the economy to recover from mid-year onwards.

Dramatic cut in production lies ahead
The first challenge lies in the nature of the recession itself, notably the sharp fall in profits and the rise in unemployment and insolvencies it will bring. One of the standout features of the current downturn is the forceful reaction of the corporate sector, notably the reduction in production schedules which is the sharpest ever recorded. Manufacturers are already prepared for a full-blown recession, even though order books still remain in mid-cycle dip territory. Many companies have already cut back investment spending, started to scale back hiring intentions or announced lay-offs. Contrary to the US, the euro area unemployment rate has barely budged yet. Since the start of the year, about 222,000 job cuts have been announced across the region, most of them in recent weeks. The increased role of temporary agencies and fixed-term contracts suggests that these layoffs could happen quickly. The share of temporary employment ranges from 9% in Belgium to 32% in Spain, compared to an EU-15 average of 14.8%. Yet, temp jobs accounted for 47% of the new jobs since 2000 in Germany, compared to about 30% in the EU-15. France saw a 9.4% shift from temporary into permanent jobs, potentially limiting its ability to scale back payrolls.

Getting the policy response right
The second challenge for the next 12 months is to calibrate the policy stimulus correctly for the euro area as whole. This will involve the use of monetary, fiscal and regulatory policy.  While the ECB’s monetary policy – including its liquidity provision to the banking system – is by definition one-size-fits-all, fiscal policies and bank rescue operations are still decided at the national level. This ‘patchwork’ approach for economic policy clearly sets continental Europe apart from the US. In general, we believe that competition between EU governments in the policy arena is desirable, even more so at the current juncture where uncertainty is high. With governments opting for different approaches, the relative merits of these become evident quickly. This holds for the bank rescue packages as well as the fiscal stimulus packages. Thus far, we find very little evidence of beggar-thy-neighbour policies being adopted.

Possibility of reduced policy effectiveness
In addition to multi-faceted policy approaches, there is a possibility that the policy measures taken could be less effective than usual. For starters, the transmission of monetary policy could be limited, possibly severely, by the ongoing turmoil in the financial industry. Clearly, ECB easing should be (and is) front-loaded. In addition, it is not limited to interest rate cuts. It also extends to generous liquidity provision and, more recently, to quantitative easing. Still, getting the total amount of easing right is a tall order at the best of times due to long and varying time-lags. It is even harder with a highly uncertain outlook, the presence of negative supply shocks and persistent structural impediments to higher trend growth.

We expect a trough in the refi rate of 1.5% to be reached in early 2009, slightly below the 2% we had pencilled in before. But the uncertainty around our main scenario is considerably higher than usual. We would therefore not rule out that the ECB will need to push policy rates to a new low. In any case, the ECB will likely aim to maintain a medium-term perspective and thus keep a firm eye on its exit strategy, given that the current trouble partly has its roots in the ECB allowing a major bubble to develop by leaving interest rates too low for too long during the last easing cycle. Hence, if the ECB deems that additional interest rate cuts are needed, it could well be keen to reverse them again as soon as possible.

Similarly, the effectiveness of any expansionary fiscal policy stance depends on the reaction of the private sector, notably the saving behaviour of private households and, to a lesser extent, non-financial corporates. Next year, fiscal policy should turn expansionary for the first time since 2001, we estimate. Currently, we count around €65 billion of discretionary measures, equivalent to 0.7% of GDP. More is on the way as we write. Thus, we would not be surprised if the deficit eventually reached, or even exceeded, the 3% mark in 2009. Bigger budget deficits, however, do not automatically guarantee stronger domestic demand. Higher spending by the government could be offset by lower private sector spending and higher savings. For a region historically plagued by big government budgets, it is thus essential to ensure that the fiscal measures remain temporary in order to avoid that the private sector becomes concerned about the long-term sustainability of government debt levels. Ideally, the measures would therefore come with a sell-by date. Alternatively, they could involve a front-loading of long-term spending plans on items such as infrastructure, research and development. 

Mind the coming country rotation within the euro area
As such, the recession should not cause a rising divergence in economic performances across the area. But it will likely cause a rotation between which countries out- and underperform the region. Countries such as Spain and Ireland, for instance, where domestic demand powered ahead on the back of booming house prices and rising household debt over the last ten years, will need to regain the price and cost-competitiveness they lost when consumer price, wage and unit labour cost inflation outpaced the rest of the euro area by a considerable margin. This adjustment process will probably require painful structural reforms, corporate restructuring and wage moderation. In our view, investors should get ready for turnaround and restructuring plays in these countries, which will eventually follow the current downturn. Additional risks stem from chunky current account deficits, which helped to fund domestic demand growth through capital imports. A fall-off in these capital inflows could imply additional headwinds for domestic demand growth. 

Postcards from the edge of EMU
Recent events have underscored that euro membership can provide some shelter against financial market (notably currency) turbulence. Countries like Denmark, which maintain an exchange-rate peg against the euro, have found themselves in an uncomfortable position where the central bank was forced to hike interest rates to fend off currency weakness. Hence, the spread over the ECB policy rate reached a new historical high of 175bp, adding to the pressure on a highly leveraged economy already in recession.

Similar pressures were also felt further afield in Central and Eastern Europe. In many respects, it is reminiscent of the tensions felt in the European Exchange Rate Mechanism (ERM), in particular in the early 1990s. Dislocations at the fringe of the euro area also have important repercussions on the euro area itself. Not only is the euro area much more open than the US – with exports of goods and services accounting for 22% of GDP, compared to 12% – but more than a third of these exports are destined for other European countries, of which Central and Eastern Europe account for a further third.  In addition to direct exports being dented by the global recession, foreign affiliate sales of euro area multi-national companies will likely also feel the pinch. Unfortunately, there aren’t any data available at the euro area level. But as a rough guide, foreign affiliate sales can total as much as 210% of exports in the case of Germany, 98% in the case of France and as little as 38% in the case of Italy.

Investment spending will likely take the hardest hit
Being weighed down by tighter financing conditions, falling corporate profits, faltering global demand and declining house prices, we expect investment spending to contract by close to 5% next year, the sharpest contraction in 15 years. On our estimates, export demand will also experience a very sharp slowdown and ease by about 1%, the first outright contraction in exports since the start of our database in the early 1990s. Meanwhile, consumer spending should prove somewhat more robust, we think. Assuming a slight fall in the saving rate, which at 13.7% is high by international standards, we expect consumer spending to expand by a modest 0.75% next year as protracted payroll reductions will likely cap the dynamism.

Some support should come from falling consumer price inflation, which will likely fall markedly and should trough around the 1% mark in July, before starting to rise rapidly again in the second half on the back of flip-flopping base effects. This sharp fall in headline inflation should not be mistaken for the start of a deflationary demise à la Japonaise though. Instead, the falls in energy and food prices, which are the main drivers behind this development, should be seen as a factor supporting real demand growth. The ECB will look through these massive swings in headline inflation caused by base effects, we believe. In our view, investors should do so too.  

Bottom line
Our base case is that EMU will withstand the pressure and contracting activity will eventually give way to a muted recovery in mid-2009. For the full year, we now expect an outright contraction in GDP by 1.0%, after we had to tweak our numbers again in the light of the sharp fall in activity indicators. After contracting sharply in 4Q08, we expect the rate of decline in overall economic activity to start slowing in 1H09. In 2H, sequential GDP growth rates will likely turn positive again though, but even then growth will remain timid, we think. Our 2010 GDP growth estimate stands at a sub-par 1.1%. The muted recovery is partly the result of the less aggressive policy stimuli compared to some Anglo-Saxon countries. It is partly due to the remaining structural rigidities, which not only limit the scope for demand-side stimulus, but also suggest that it might take longer to work through the downturn. In this sense, the pressure for further structural reforms exerted by the downturn combined with a shift in country performance could turn out to be an important long-term positive.

Our surprise: EM-Umbrella
A number of market indicators, including the sharp widening in country-specific bond yield and CDS spreads, would suggest that the current consensus is that the present turmoil increases the chances of an EMU break-up. In our view, the opposite is probably the case: a number of countries in fact could find themselves being fast-tracked towards EMU membership. In cases such as Denmark, this could be due to a shift in public opinion about EMU membership potentially paving the way for a ‘yes’ vote in a referendum. In other cases such as Hungary, it could turn out that the involvement of the IMF strengthens the commitment to near-term fiscal consolidation, thus bringing forward the likely timeframe over which the convergence criteria for EMU entry will likely be fulfilled. As a result, a number of countries might find themselves under the EM-Umbrella somewhat earlier than the current market consensus would suggest.

For the past year or so, growth in the UK has been weakening, and quarterly output growth turned negative in 3Q for the first time in more than 15 years. Credit conditions have tightened markedly and global growth has slowed sharply.

Our central forecast for calendar year 2009 GDP growth is for an outright contraction (the first since 1991) of 1.0%, and we continue to see the balance of risks to that central forecast as skewed to the downside. The prolonged tightening in credit conditions seems unlikely to suddenly dissipate in 2009.  Employment levels are likely to contract. The risk of ‘negative feedback loops’ developing in the UK economy remains present.  Asset price falls (including housing), the slowing economy and rising unemployment make banks less willing to lend, and households and corporates less willing to spend, all worsening the outlook for the real economy.

However, we remain cautiously optimistic that we can avoid a deep and prolonged recession in the UK. This is largely due to three factors: 1) Massive monetary (and substantial near-term fiscal) policy stimulus, which is likely to prevent household demand falling precipitously and which encourages a lengthy period of balance sheet and savings adjustment rather than a short, sharp one. 2) A determination by the UK authorities to get credit markets functioning and revive the flow of lending. 3) The recent large depreciation in sterling, which is likely to boost net exports and offset some of the effect of slower growth in the UK export markets.

The pessimistic case: Sharply higher household savings.  The household saving rate could follow a profile similar to that of the early 1990s. Then, the household saving rate increased from around 4% at the end of the 1980s to about 12% by 1992. If a rise in the saving rate on that scale were to happen now, consumer spending would fall very sharply for a couple of years.

We have constructed a scenario along these lines where, alongside a very sharp decline in consumption, we mix in three years of contraction in fixed investment (both residential and business investment contract in 2008, 2009 and 2010). On such a scenario, the unemployment rate reaches a 15-year high, with unemployment rising 1.2 million peak to trough (compared to around 1 million in the early 1990s). In this scenario, UK GDP contracts by almost 3% in 2009. The key to whether this scenario materialises is consumer spending and saving behaviour. If the household savings rate, which is exceptionally low, follows a trajectory similar to the recession of the early 1990s, it will be rising sharply at a time when global growth is well below trend, so that reductions in domestic consumption are not offset by much stronger growth in exports. In that scenario, a very sharp and protracted fall in output will be inevitable.

There are many good reasons for households to want to build up their savings over the next couple of years. These include: offsetting the hit to wealth created over the past year by falling house and equity prices; greater uncertainty about job prospects; and a reduced ability to smooth consumption by borrowing. While our central case is that households will prefer to raise their savings rate gradually, there are some reasons to expect this to happen rapidly, despite the weak economic backdrop:

1. The baby boom generation is nearing retirement and many households’ pension plans will have been hit by the decline in property and equities. If unwilling to significantly defer their retirement plans, households may ramp up sharply their rate of voluntary contributions to pension schemes. 2. A large number of households are likely to be in negative equity (or very close to it) by the middle of 2009. Many of those households may wish to increase their savings and need to do so rapidly to lower their mortgage relative to the value of their property, making it easier to obtain a new mortgage or to retain a mortgage on relatively favourable terms. Some households will have been holding off selling a property despite a desire to move, given conditions in the housing and mortgage market. A rise in the number of forced sellers might see such capital injections increase.  3. Households may expect deposit rates to fall sharply, given cuts in the policy interest rate, so that it makes sense to ‘lock-in’ higher fixed savings deposit rates now.

The optimistic case: Positive supply-side effects.  In this scenario, households significantly increase their supply of labour, boosting potential output. The ‘lost’ output from the period of sub-trend growth is not permanent. That is because the supply side of the economy might not have been damaged significantly by the credit crunch (an optimistic view, since it assumes that the severe damage to the financial system we are seeing does no lasting damage to productive capacity).

This could imply that the recovery is significantly more vigorous than many expect (and is ultimately sustainable). So, if growth in 2008 and 2009 is substantially sub-trend (as we expect) – creating 3-4% of spare capacity if trend growth is unchanged – then a bounce-back to trend over the following two years means cumulatively growth would need to be 3-4% above trend in those years. The point here is that a couple of years of growth approaching 5% in 2010 and 2011 – which now looks wildly optimistic – is actually what is implied by a return to an unchanging underlying trend four years or so down the road.  Of course, this assumes that the trend level of output has not been damaged by the credit crunch. Whether that is so depends on how supply potential evolves.

Supply-side responses to some of the huge shocks we have seen may be both pro-growth and supportive of corporate profits. Those huge shocks include: 1) A big fall in equity values; 2) A big fall in house values; 3) A perception by many households that their debt is too big relative to their income; and 4) A potential overhang of some types of residential properties, meaning that construction investment will be very low for some years.

Factors 1) and 2) lower household wealth. With household wealth a lot lower, we should expect two things: higher household saving and higher labour supply. (Factor 3 generates a similar response.) Higher saving is a negative for growth in the near term (because we can’t expect other components of spending to adjust up to offset it). But the impact of more labour supply – as people need to work more to replace nasty shocks to wealth – is ultimately a clear positive for economic activity and for corporate profits. It means the capital-labour ratio is lower (boosting the return to capital, reducing real wages, and encouraging more investment).  Factor 4) implies that residential construction will be much reduced, maybe for many years. The resources used there will be available elsewhere, and land prices are likely to be lower than they otherwise would have been. Those are not negative factors for the (ex-construction) corporate sector.

Our main scenario for 2009 foresees the worst recession of the post-WW2 era.  Even in the bull case, we estimate negative growth in 2009 and tepid recovery in 2010.

Acute negative feedback from the financial markets is worse than we foresaw. Given the breadth and depth of manufacturing production cutbacks, we foresee maximum recession momentum in Oct-Dec 2008 and Jan-Mar 2009. With extra damage from technical factors such as the lower base effect, out of necessity we sharply lower our outlook for 2009. We also think recovery in 2010 will be slow. Given the overwhelming uncertainty, we also look at what might happen if conditions proved better or worse than in our base case scenario.