This article has been prepared by the Research and Analysis Unit of BoV Wealth Management. It was written on March 22.

Overview

Following its deepest downturn in recent history, the global economy has bounced back to modestly above-trend growth in 2010. Over the past few months, economic data clearly indicates that the global recovery is intact, and fears of a double-dip recession have abated. Concerns around the European debt crisis persist, but growth in the euro area as a whole has held up quite well, led by surprising strength in Germany.

Nearly all signs in the US point to a continued modest re-acceleration in growth and recently renewed tax cuts strongly suggest that activity will continue to pick up in 2011. Concerns about excessive slowing in China have been replaced by worries about how much policymakers will have to tighten to slow down the economy and control inflation, which has exhibited renewed strength.

After a strong first half, growth in most regions in 2011 is expected to moderate due to knock-on effects from the financial crisis, higher oil prices and the effects of policies aimed at quelling growing inflation pressures, notably in emerging Asia and Latin America. Furthermore, with inflation returning above target levels in Europe and in the UK, central banks are also being pressured to start tightening monetary policy earlier than anticipated. Despite this, the International Monetary Fund revised upwards global economic growth for this year to 4.4 per cent in January, from October’s projection of 4.2 per cent.

United States: Growth still reliant on policy stimulus

Growth in the US has been picking up lately. Although the inventory cycle has been the biggest contributor, domestic demand has proven resilient in the face of multi-decade-high unemployment and immense wealth destruction. Growth in the first half of this year is expected to remain strong, with both consumer and business spending boosted by the fiscal stimulus enacted in December 2010.

However, consumers are still burdened with debt, while the persistent weakness of the labour market suggests that underlying income growth will remain sluggish. As a result, it is doubtful whether the fiscal stimulus will sustain growth in the long term, especially given that firms continue to report tight credit conditions, the housing market remains weak and the government recently announced measures to tackle its debt.

Higher gasoline and food prices may boost the headline inflation rate in the near term, but, with so much spare capacity still to be absorbed core inflation is expected to remain subdued. Renewed economic weakness may well trigger further unconventional policy from the Federal Reserve, but for the time being steady but uninspiring growth, coupled with high unemployment, should allow the Fed to keep rates on hold.

Eurozone: Stable core, but still weak periphery

Although the euro area is recovering from the deep recession of 2009, the growth path has been very uneven. Germany and some of its smaller neighbours have seen a forceful rebound, while several countries at the periphery of the euro area are implementing painful economic adjustments and remain mired in deep recession. Recent news suggests that the region as a whole is still expanding at a healthy pace, driven by the industrial sector.

Going forward, investment should continue to recover as capacity utilisation rises, however, consumption is expected to only rise markedly in the further course of the year. Germany is expected to continue to drive growth in the region, supported by the Benelux countries, Austria and Finland. However, the peripherals are likely to experience weak growth at best.

Following Greece’s and Ireland’s request for financial support, the risk remains that Portugal may also need to tap the European Financial Stability Facility (1). There are also concerns that banks’ balance-sheet problems, alongside the need to rebuild capital ahead of the Basel III regulatory changes, will keep loan availability weak and limit growth prospects. The European Central Bank’s more hawkish stance expressed in the March meeting raised the risk of an early rate hike, possibly in April (2). This may simply undermine the recovery, but the peripheral banks’ heavy reliance on ECB funds means that its unconventional measures can only be wound down gradually.

United Kingdom: Fiscal squeeze and inflation threaten recovery

In the United Kingdom, the rebound in economic growth was supported by the inventory cycle. However, the recovery looks set to lose pace this year as a severe fiscal squeeze, relatively high inflation and weakening housing and labour markets all act to subdue growth. Households will bear the brunt of the fiscal squeeze which will be most intense in 2011, as retailers look set to pass on most of January’s increase in VAT. Public sector job cuts, as well as weak private sector employment growth, may swell unemployment further.

On the other hand, investment may benefit as companies spend their stockpiles of cash and from increasing exports, driven by a lower pound. Meanwhile, the recent rises in commodity prices are adding to the UK’s already high inflation rate. Concerns have therefore grown that the Bank of England’s Monetary Policy Committee may hike interest rates, which could further weaken growth just as the fiscal squeeze is hitting the economy.

Notwithstanding this, the MPC remains deeply divided and caught in a dilemma since there remains a good deal of uncertainty regarding global growth due to the tensions in the MENA region and the Japanese natural disaster. In fact, the MPC has recently shown preference to assist growth rather than taming inflation.

China: Combating inflation

A relaxation of credit policy helped economic growth to accelerate in the second half of 2010, reducing fears of a possible hard landing. By the start of 2011, the economy was expanding at a probably little higher rate than the sustainable rate.

That said, worries about inflation are rising as consumer price inflation in February rose to an annual rate of 4.9 per cent, above the central bank’s target of four per cent. This shows that the People’s Bank of China’s monetary tightening has been insufficient so far to contain prices, since concerns about speculative inflows made it reluctant to raise interest rates too far.

The PBoC has set reining in inflation as the nation’s top economic priority this year as this can undermine social stability. As a result, further interest rate hikes are expected in the coming months. Moreover, more rapid lending, which has been exceeding the quota has produced a re-acceleration in the pace of broad money growth.

However, the new investments under the 12th five year government plan are expected to drive up growth again by year-end, while exports are expected to continue to benefit from brighter prospects in most of its major markets.

Although policymakers should allow continued renminbi appreciation against the dollar, this will probably not be enough to bring down the trade imbalance with the US. As a result, tensions over trade and the currency will probably persist.

India: A year of consolidation

In India, economic growth is expected to moderate in 2011 after a strong rebound in 2010. Slower agriculture output, increased margin pressure from rising cost to manufacturers, adverse base effects and lagged effects of policy tightening should restrain growth. Industrial activity has suffered because of rising raw material costs, higher wages and sluggish investment restraining demand for capital goods’ production.

However, growth should be supported by robust consumption growth, recent signs of a resurgence of exports and a pick-up in credit growth. The overall inflation pressure is expected to remain intense due to rising business input costs, elevated inflation expectations and the rising risk of second-round effects.

As a result, the Reserve Bank of India (RBI) is expected to continue tightening monetary policy this year. On the fiscal front, with less scope of proceeds from asset sales and a higher subsidy burden, there is a risk of fiscal slippage above the government’s 4.6 per cent of Gross Domestic Product.

Asian Tigers: Challenges of policy rebalancing

Overall GDP growth in Asia’s smaller economies looks set to continue to pick up this year, driven by industry and exports. Domestic demand and intra-Asia trade are expected to offset the drag from relatively weak conditions in the US and Europe. However, the cost-push inflation shock from higher food and oil prices is feeding into more worrying demand-pull inflation as wages and domestic prices rise.

As a result, ‘negative’ real interest rates may suggest that the central banks may be behind the curve and need to tighten further. Although free trade will support growth, external weakness will affect the more trade-dependent economies such as Singapore and Hong Kong. On the domestic demand side, investment is expected to lead the way due to high corporate profitability, new reforms implemented to lift competitiveness and improvement in infrastructure.

In addition, increased household wealth, better public services and rapidly expanding credit penetration, should continue to support private consumption. However, managing capital inflows, and avoiding an asset price boom-bust will remain major challenges in the region. As a result, the policy response will be similar to 2010, more currency appreciation, more curbs on inflows and additional macro-prudential measures.

Latin America: Strong growth and capital inflows pose a policy dilemma

The outlook for Latin America remains positive, with the major downside risk being that of a drop in commodity prices. With the developed world still facing an uphill struggle, capital inflows to Latin America’s star performers have picked up. These inflows will support growth however they will also pose several challenges such as stemming further currency appreciation which may cause macro economic imbalances to start to build as exporters are squeezed and domestic demand booms.

Furthermore, the increasingly speculative nature of capital inflows may cause a growing threat of a bubble, while inflation pressures are also brewing in a number of countries such as Peru and Brazil. As a result, countries in the region are increasing interest rates and deploying other forms of monetary policy such as raising the banks reserve requirement ratio and imposing capital controls. Tighter fiscal policy and perhaps lower commodity prices will be the key to prevent overheating in the region’s star performers.

Footnotes:

(1) Post this report, Portugal officially asked for financial assistance on April 7.

(2) Post this report, the ECB also raised interest rates for the first time since 2008 to 1.25 per cent, also on April 7.

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