The global economy will inevitably be hit by Europe’s faltering economy in 2012 but Europe’s direct impact has waned. US growth is proving very resilient. Emerging countries, meanwhile, are slowing but falling inflation is giving them more room to manoeuvre. Other dynamics are on a positive trend: in both the developed and emerging zones, most companies are still looking to expand and invest. The unprecedented nature of the government debt crisis in developed countries has thrown investors off course. Markets will probably remain turbulent at the beginning of 2012; investors should be cautious and focus on defensives given the current slowdown in global growth. Nevertheless, widespread pessimism is already creating opportunities in certain heavily oversold assets.
The likely exit to the European sovereign debt crisis
Apart from the central bank, Europe’s institutions were not designed to deal with emergencies. The agreements reached in July, October and December are a significant advance but they will need to be convincingly rolled out. The European treaties set debt and deficit targets but they are not binding. A complicated web of clauses, and unanimous decision-making in particular, has prevented strong action being taken. Basel II regulators meant well but encouraging banks to buy sovereign debt has turned out to be a costly mistake which has pushed rates higher in peripheral Eurozone countries.
True, there are rescue plans like the European Financial Stability fund and ECB intervention on bond markets -and at some stage Eurobonds or some similar asset class might come into existence- but they are not sufficient. Germany’s position in a nutshell is that financial solidarity must necessarily be accompanied by budgetary responsibility and closer surveillance of budgetary policy. The various European summits have made slow progress towards improved coordination of budgetary policy and created better-adapted financial aid tools like the European Stability Mechanism. In the meantime, ECB action will be decisive and the operational link between it and the EFSF is highly significant.
Is Europe in poor shape ?
We can rule out an exact repetition of 2008 because today’s financial situation is different. The link between a sovereign debt crisis and banking woes has become systemic but today’s proactive stance from the ECB means the current banking crisis is not as serious. The extent of economic and budgetary difficulties varies between each country. Intra-European trade means that the entire zone has been hit by falling demand from austerity drives but to differing degrees. GDP in the Eurozone’s weakest countries only represents 17% of the total compared to 45% for the most financially robust members.
As far as solvency is concerned, regulatory constraints are weighing on capital ratios for Europe’s banks. This has made borrowing more difficult and dearer but reinforcing these ratios can be done in several ways so there is not an automatic impact on credit distribution. As for liquidity, the ECB has shown its determination to deal with stress on the interbank market by resorting to all the instruments at its disposal. This has reduced bond yields and made it easier for the weakest Eurozone countries to issue new debt. Lastly, the ECB has reduced its benchmark rate from 1.25% to 1%.
More resilience in the US
US consumers are determined to maintain spending levels even if they are keen to pay down debt. Although the unemployment rate is still high, more jobs are being created, the cost of debt servicing has fallen and household net worth has risen. At the same time, the worst effects of the property correction are now a thing of the past.
Short term rates will stay low until 2013 and the Federal Reserve has not ruled out further monetary easing. Budgetary policy is, however, a trickier area. In a presidential election year, it is impossible to repair imbalances in public finances. The automatic cuts stipulated in August’s agreement will start in 2013 and stretch over the next 10 years. The biggest concern is that taxes which are currently suspended will come into force on January 1st 2012 unless Congress manages to find a solution. The stand-off will also mean that aid to the long-term unemployed will cease from the end of 2011.
Emerging economies: China's contribution in 2012
China’s inflation seems to have reached an inflection point. Even so, the government’s determination to rein in lending and property prices will probably remain unchanged. The transition in political leadership scheduled for the autumn of 2012 should ensure moderate policies. In a new development, accelerating trade with other emerging countries is reducing the direct influence of the developed zone.
The US economy weighs as much as Europe but investment flows between emerging countries are now an integral part of their relationship and this is curbing the impact of European flows. Inflation is falling due to base effects in commodity prices and governments now have more room to manoeuvre. For example, central banks in Indonesia, Brazil, Israel, Turkey and China have started to ease monetary policy. [...]