After little more than a year of recovery, markets have begun to fear that the world economy may go back into recession. A recent decline in world trade has coincided with some easing in manufacturing output and signs of a slowdown in China. An economic slowdown in the second half of this year has always looked likely though, as the policy boost of the last year wears off. In addition, there is a realisation that the policy focus is changing in some parts of the world. In the wake of the Greek crisis and amid concerns about sovereign debt, more countries, led by the UK, have started to tighten fiscal policy, leaving the onus on monetary policy to ensure a sustained recovery.

As a result, even though the world economy is moving into the second half of 2010 in a recovery phase, there is a substantial difference relative to how recoveries normally feel. Whereas momentum might normally be expected to kick in now, with rising confidence, the challenge is that momentum is fading, not building. Despite this, back in July, the International Monetary Fund (IMF) revised its forecast of world growth for 2010 to 4.6 per cent from April’s forecast of 4.2 per cent, reflecting upward revisions in the US, Japan and many emerging market economies.

United States

Some weaker economic indicators in recent weeks have re-ignited the discussion about a potential double-dip in the US. The boost from inventory rebuilding (as companies brought inventories back in line with sales) and the fiscal stimulus has started to fade, the housing market is suffering a major relapse, the growth in exports is slowing, consumer and business confidence have both weakened slightly and the pace of private sector employment growth has also slowed. In its July meeting, the Federal Reserve (Fed) corrected its assessment of the economic situation slightly to the downside, pointing to the deterioration in funding conditions. Moreover, in his semi-annual monetary policy testimony before Congress, Chairman Ben Bernanke referred to the economic outlook as “unusually uncertain” with risks “weighted to the downside.”

Nonetheless, a renewed slide into recession is still not the most likely scenario, as a self-sustaining virtuous circle appears to have started by now. Corporate profits are surging, boosting business investment which should ultimately see companies expand their workforce. As employment rises, more money will be available for private consumption. Some parts of the economy are still struggling with the excesses of the past, though. This is particularly true of the construction sector, consumer spending and the financial industry. Against the backdrop of massive spare capacity, the core inflation has now fallen to a 44-year low at 0.9 per cent. No quick turn to the upside can be expected given low wage pressures and as such rate hikes should still be a long way off.

Eurozone

There has been significant divergence within the euro area so far this year. Countries such as Germany, France and the Benelux have been experiencing buoyant activity and a sharp improvement in confidence, while peripheral high-debtor countries have struggled with rising unemployment and sluggish activity as a result of deepening concerns about public finances. Monetary conditions have generally been easy, with the euro’s depreciation boosting competitiveness. At the same time, dynamic growth in emerging markets, especially in Asia, has underpinned demand for European goods. In addition, interest rates remain at historic lows, mitigating the impact as households and businesses rebuild their balance sheets. On the other hand, two important drivers of growth are expected to fade in the coming months.

The inventory cycle will become less supportive as inventory rebuilding slows later this year. In addition, the stimulus from government spending is petering out, and in some case has already started to reverse. The countries with the highest deficits and worst debt dynamics are embarking on accelerated fiscal tightening, cutting public-sector wages and employment and raising taxes. Even countries with a less pressing imperative to cut their deficits quickly have announced fiscal consolidation measures, which will mostly kick in from 2011. As a result, the eurozone economy is expected to lose momentum in the second half of 2010, though many of the positive factors mentioned above are likely to prevent a double-dip recession. Underlying inflation pressures should remain muted, allowing interest rates to stay on hold for a prolonged period.

United Kingdom

The UK economy is currently in a sweet spot as evidenced by a very strong second quarter reading of Gross Domestic Product (GDP). But this is likely to be as strong as the recovery gets for a long while. The emergency budget delivered in June contained a significant degree of fiscal tightening, with projections suggesting that the state sector will subtract around 0.6 percentage points per annum from growth over the next five years. Households are unlikely to be able to drive the recovery forward. Consumers will be hit by a series of tax rises while unemployment is set to rise sharply. In addition, private sector firms are unlikely to hire much, as the recent collapse in productivity growth suggests they can squeeze more output from existing employees.

Finally, high levels of indebtedness, tight credit conditions, and the prospect of further falls in house prices, all probably mean that consumer spending will stay weak. Admittedly, sterling weakness should help exports to boost growth but exports have struggled too, most likely due to the slowing of the euro-zone’s recovery. As a result of the fiscal stance, the Bank of England (BoE) is likely to remain cautious with regard to tightening monetary policy even though headline inflation could run above the BoE’s target for a second consecutive year.

China

Concerns about overheating in China turned rapidly into worry about a hard landing during the second quarter as a string of data releases correctly predicted a slowdown in GDP growth which fell from 11.9 per cent in the first quarter to 10.3 per cent. A campaign against property speculation has caused sales to dry up, and this will presumably lead to weaker construction activity later this year and in 2011. Nonetheless, fears of a hard landing are likely to be overdone. With central government debt at around 30 per cent of GDP, China has room for another stimulus package to offset weakness in either the property sector or on the external front. Signs that the inflation threat is fading should also convince officials to do so. Interest rates remain too low to be an effective tool of monetary management. For this reason, rates are expected to rise over the medium term. But with attention focused on the economic slowdown, the opportunity to raise rates may have passed.

India

In India, GDP growth will probably accelerate further from the 8.5 per cent registered in the first quarter as fading momentum from public spending and exports is offset by more rapid expansion of private sector investment. While private consumption remained weak in the first quarter, the recent improvement in the labour-market outlook, the stabilisation of asset prices, and increased availability of consumer credit should boost household demand in the months ahead. Moreover, if this year’s monsoon rains are as promising as forecast, support from rural consumers should provide a further boost as agriculture is a key driver of purchasing power in the region.

One potential policy challenge for India is to manage excess liquidity should capital inflows continue to increase and put further upward pressure on inflation. Higher domestic food prices on disappointing rains, elevated commodity prices, and a pick-up in domestic demand have pushed annual inflation above 10 per cent since early 2010. The Reserve Bank of India has started to lift policy interest rates recently but still has a long way to go to reach “neutral” levels.

Asian tigers

Across the rest of the Asia-Pacific region, the best of the rebound in industrial production and exports has now come through. Singapore and Taiwan should be the best performers in 2010-11, even though these countries are among the most heavily-dependent on foreign trade. This is mainly because GDP growth and intra-regional trade have been so high in the first half of this year. However, Taiwan in particular, is at risk of a deep and long slowdown given its high private sector debt, low income gains, and limited policy flexibility. Nonetheless, a pick up in domestic spending, including public expenditure should support growth in the second half. Growth in Hong Kong is expected to moderate but continuing low interest rates, an improving job market and persistent tourist inflows will all continue to support growth. In South Korea, the robust job-market recovery, record-high corporate profits, and strong sentiment should support domestic demand, mitigating the expected moderation in export growth and other negative factors, such as still-weak credit growth, low household savings and fading fiscal stimulus.

Latin America

First quarter figures across the Latin American region were better than expected in many cases, but growth is expected to slow next year as the global recovery loses momentum, commodity prices may drop further, and as capital inflows move lower. Brazil and Peru should remain the regional outperformers this year, having emerged from the global financial crisis quickly with strong, domestic-led growth. Mexico is at the opposite end of the spectrum, with more anaemic growth expected in the near term. Domestic demand remains weak, and the only real source of growth at this time is driven by external demand from the US.

To the extent that US growth remains modest, with high unemployment constraining consumer spending and the housing market, we are unlikely to see a strong upturn in Mexico’s growth. In Chile, the impact of the earthquake on the economy has been small. But Chile is Latin America’s most trade and commodity-dependent economy, therefore growth in 2011-12 should struggle to match the expansion that is likely this year.

This article has been prepared by the Research & Analysis Unit of BoV Wealth Management. The document has been issued by Bank of Valletta p.l.c. for information purposes only. This document is not and should not be construed as an offer or recommendation to sell or solicitation of an offer or recommendation to purchase or subscribe for any investment. This information may not necessarily be appropriate to your particular investments requirements and risk profile. It is therefore recommended that if you require investment advice or wish to discuss the suitability of any investment decision, you should seek financial, legal or tax advice from your professional advisers as appropriate.

Opinions, estimates and projections in this report constitute the current judgment of the author as of the date of this report. The Bank has obtained the information contained in this document from sources it believes to be reliable but it has not independently verified this information contained herein and therefore its accuracy cannot be guaranteed. The Bank makes no guarantees, representations or warranties and accepts no responsibility or liability as to the accuracy or completeness of the information contained in this document.

The Bank has no obligation to update, modify or amend this report or to otherwise notify a reader thereof in the event that any matter stated therein, or any opinion, projection, forecast or estimate set for the herein changes or subsequently becomes inaccurate. Income from an investment may fluctuate and the price or value of the financial instrument described in this report, either directly or indirectly, may rise or fall. Furthermore, past performance is not necessarily indicative of future results. Bank of Valletta p.l.c. is licensed to conduct investment services by the Malta Financial Services Authority.

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