Research Global: European Union, US and China

In this document we provide an update of our global growth forecasts. The world economy is increasingly decoupling, with the US recovering, China expected to recover and the euro area heading for recession in Q4 11 and Q1 12.

While much focus is on the weakness in the euro area, we believe the increasing strength in the US and China will underpin risk appetite in coming quarters.The main unknown is the development in the euro crisis.

China is expected to be an increasing driving force in the global economy in coming quarters. A sharp decline in inflation would boost real income growth and put a stop to monetary tightening.    

The global economy is increasingly decoupling. It seems more and more evident that the euro area cannot escape recession, as leading indicators point to a fall in GDP in Q4 followed by a small decline in Q1. This is in sharp contrast to the US and China where growth is expected to improve. The US has already seen its growth rate rise to 2.5% in Q3 and indicators support a further increase to 2.8% in Q4. In China, we are starting to see the first indications of a growth bottom following the weak first three quarters and we do indeed expect a decent growth increase in Q4 and Q1 as we expect inflation to fall sharply.

The diverging pattern is likely to stem from a different pace in inventory adjustment as well as stronger drags in the euro area now due to the euro crisis. The euro area performed much better in H1 than the US (relative to their different trend growth rates).The average growth rate in the euro area was 1.9% in H1, whereas the US grew by 0.8% on average (q/q annualised). The US has adapted more quickly to the changing environment being dragged down fast by the headwinds from higher oil prices and the earthquake in Japan. The euro area has lagged in response though, partly because the euro area is much more driven by exports and companies are responding later to the decline in global growth. This means inventory building has supported euro area activity. However, on the other hand, this is now working as a drag pulling activity down in coming quarters.

Although there is a lot of focus on the weak situation in the euro area, the global growth picture is actually improving for coming quarters. This is because the stronger performance in the US and China is more than compensating for the decline in euro area GDP. We expect the improvement in the US and China to further underpin risk appetite in coming quarters. A sharp fall in Chinese inflation would also be likely to contribute to more positive sentiment.

The risks to the global economy are still significant, with the main risk coming from a sharp worsening of the euro crisis. We do expect the euro area to continue to feel sharp pressure from markets and we expect fire fighting to continue for a long time as the euro area stays close to the brink of large-scale turmoil. However, our main scenario is that the euro area is not allowed to fall over the cliff but that the EU – and ultimately the ECB if necessary – will do what is necessary to keep the euro together.    

Recently, we have seen a strong deterioration in euro area leading indicators. This has prompted us to revise our growth forecast for 2012 to 0.3%, from 1.1% previously. We keep our growth outlook for 2011 unchanged at 1.6%.

It is the PMIs in particular that have fallen sharply but also hard data such as euro area retail sales and German industrial production have started to give in. These indicators point clearly towards negative growth in Q4. We expect a negative reading of 0.3% q/q in Q4 and another slight decrease of 0.1% in Q1 2012 before returning to positive growth rates for the remainder of 2012. Hence, the euro area is heading for a mild (technical) recession.

On a positive note, growth in Q3 was better than we expected. We estimate a growth rate of 0.2% in Q3 based on industrial production data and other hard data. The growth rotation from Q4 to Q3 is part of the explanation for the very low growth estimate for 2012, despite our expectation that the euro area will return to moderate growth already from Q2 12.

We believe the main headwinds that will weigh down on growth are as follows.

    Continued fiscal consolidation.
    Inventory adjustment following Q3 inventory build-up.
    Increased uncertainty regarding the political situation.
    Increase of credit tightening.
    Higher funding cost in the peripheral.
    Large drop in stock indices – wealth effect.

In particular, we believe the increased uncertainty will weigh on private consumption and investment, at a time when there is no room for fiscal stimuli. Indeed, there is a potential risk that the negative growth outlook rate will require additional fiscal tightening. The low growth rate implies that unemployment will continue to increase slightly throughout 2012.

There are a number of factors that we expect to support growth.

    Growth in the US and Asia is picking up.
    The inventory cycle will turn into a tailwind.
    The ECB has cut rates and we expect another cut in December.

Decent demand from outside Europe will ensure that the fall in production is only limited and temporary. We see very little risk that we will have a repeat of 2009.

In the US growth recovered to 2.5% in Q3 driven by a strong rise in final demand of 3.6%, whereas inventories gave a negative contribution of 1.1 percentage points. The improvement came on the back of higher consumption and investment growth following a weak H1. The improvement was much better than feared a couple of months ago, when markets were scared by a potential US recession. The main drivers behind the better activity have been: (a) lower inflation on the back of lower oil prices, which is giving a lift to real income, (b) a reversal of the temporary drag from the car industry following the Japanese earthquake and (c) a decline in the savings ratio, which is partly related to higher car sales.

It is interesting that actual consumption growth has improved despite very low consumer confidence. Hence, again US consumer confidence has proven a poor guide of actual consumption.

Looking ahead, current indicators for consumption and investment suggest that we co uld see close to 3% growth in Q4. We look for the composition to be less strong with lower growth in final demand – as, for example, the positive effect of the Japanese earthquake fades – but expect the inventory adjustment to be less of a drag in Q4.

For 2011 as a whole, we look for 1.8% growth (was revised up from 1.6% two weeks ago following the Q3 GDP report.

In 2012, growth in the US is still expected to be 2.5%. An unknown factor is still how much fiscal policy will affect GDP, as we are still lagging agreement on proposed initiatives to support growth. However, overall we expect fiscal policy to withdraw 0.5-1.0 percentage points from GDP growth in 2012. The economy will see some support from: (a) better emerging markets growth supporting exports, (b) decent earnings growth and very low financing costs supporting investments and (c) moderate jobs growth and lower inflation underpinning continued private consumption growth of 2.0-2.0%.

The Chinese economy slowed considerably over the first three quarters of 2011 to below 8% growth – the weakest pace since the financial crisis in 2008. Inflation has shot up sharply to above 6% this year due to the rapid increase in food prices. As food is about one-third of Chinese consumption, this crowds out spending on core consumption and as a consequence domestic demand weakened.

However, in recent months, global food prices have declined and we are now starting to see the effect of this in inflation with a drop to 5.5% in October. Going into 2012, we believe inflation will fall to below 3% in the middle of the year. Hence, the marked headwind from inflation will now turn into a tailwind. First, real income growth is now seeing a boost from this factor. Second, monetary tightening has come to a halt and there is even a chance of a small easing in the reserve requirement ratio to support the economy in 2012.

This effect will actually be a factor in pretty much all emerging markets and developing countries, as food is a large share of the consumer basket in all these countries. In India, for example, food accounts for close to 60% of personal spending and, hence, Indian consumers will also now see decent relief from lower food prices. Emerging markets will thus again be an important growth driver in the global economy following the slump seen in most of 2011 stemming from the rise in food prices.

The rebound in the Chinese economy is also likely to be an important stabilising factor for financial markets. Asian stock markets have priced a very high risk of a hard landing and, hence, we should see some relief from the improving economy. This is also likely to spill over to Western financial markets and be a stabilising force.