Cyclical recovery in the making

- compiled from information supplied by UBS

United States

Monthly growth indicators already point to positive growth in 3Q09, to be reported on 29 October. This fits our view of a cyclical recovery ensuing in 2H09 as we laid out in the last edition of this publication. A few developments since then have prompted us to revise our 2010 real GDP growth forecast higher from +2.2% to +2.6%. First, the pace of inventory liquidation likely moderated in 3Q09, as we projected, but not by as much as we thought. Thus, following quarters will likely see a stronger growth boost from further moderation. We also now expect inventories to be rebuilt sooner, in 2Q10, rather than 3Q10. Second, we bumped up our consumer growth outlook a bit as consumer sentiment indicators have risen to levels that are consistent with real consumption growth of around 2%, which is above our current forecast. As we think that labor market conditions will continue to improve, we believe that consumer sentiment could stay at current levels to say the least. Note, however, that the consumer outlook is still a very cautious one compared with the historical recoveries after deep recessions. Third, we now expect government spending to stay expansive for longer, as opposed to contracting already in late 2010. Consequently, the growth boost should simply fade as opposed to turn into a drag.

A revised forecast assumes a steadier growth profile in 2010, with real GDP growth staying around 3% q/q annualized in the four quarters of the year. Before the revision, we were expecting growth to moderate throughout 2010, ending the year at clearly below 3%. A more robust, but still moderate, consumer outlook coupled with further fiscal support in the second half of 2010 were the main drivers for this growth profile change. Implicitly, this entails a lower likelihood of a double-dip recession. However, we still want to point out that a more robust growth path in 2010 is not akin to a full-blown structural recovery. Such a recovery would necessitate a higher growth rate, as historically has been the case after deep recessions. Furthermore, fiscal payback in the form of higher taxes and at least a moderation in government spending could weigh on growth in the out years. Thus, we think that 2011 will see real GDP growth of 3%, which again does not fit the profile of a strong recovery.

Massive resource slack coupled with a moderate growth recovery suggests that inflation will remain tame for quite some time. We expect core CPI inflation to continue to trend lower in 2010. Headline CPI inflation will probably rise out of negative territory in late 2009, but also remain well-behaved in late 2010. Resource slack affects inflation, as any pick up in aggregate demand can be met with an increase in production.

Any firm that tries to raise its selling price will be challenged by competitors ready to offer more of the same product at the existing price. Once resource slack vanishes and the economy operates at full potential inflationary pressures can build. However, given the depth of the past recession and our estimate for a moderate recovery, it will likely take some time for that to happen. We thus expect headline and core inflation to remain tame even in 2011.

Historically the Fed has always waited until the unemployment rate stabilizes before reversing course from an expansive to a restrictive monetary policy. We do not expect this cycle to be an exception. As we raised our growth forecasts a bit, we now expect the unemployment rate to peak in 1Q10 instead of 2Q10. Therefore, we expect the Fed to raise rates in June already, instead of September, but given that we now expect inflation to remain tamer, even in 2011, the Fed will not have to raise rates as quickly as we thought before. Thus, we expect the Fed to raise its fed funds rate target to 1% instead of 1.5% by year-end 2010, and to 3% by year-end 2011.

Eurozone

The Eurozone economy is likely to return to growth in the second half of this year, after contracting for five quarters in a row. However, economic data have come in somewhat below expectations recently, which is a reminder that the current stabilization may not transition to a strong and self-sustained recovery, but that it may instead remain a rather lacklustre and volatile affair.

Monthly data suggest that the Eurozone economy may have grown by around 0.5% in the third quarter after contracting by 0.2% in the second three-month period of the year. Behind the pickup in economic activity are various factors; most of them are temporary in nature. Thus, we think that the inventory drawdown, which subtracted strongly from GDP growth in the past few quarters has come to an end and a rebuilding of inventories may even add strongly to GDP numbers ahead. Most importantly, the combination of ultra expansive monetary and fiscal policy, which had already prevented a more pronounced contraction in the second quarter will likely continue to provide a strong artificial lift to the economy in the near term. The economic outlook for the months to come remains positive.

Domestic demand is likely to post further strong growth. As a result, businesses will resume some of the investments that had been stopped abruptly following the bankruptcy of Lehman Brothers. Exports too should continue to grow. Global demand should rise further, particularly in the Asian region. Yet, since the lows in late 2008, the trade-weighted EUR exchange rate has gained more than 10%, which erodes the price competitiveness of Eurozone exporters and potentially limits the extent to which the Eurozone may benefit from a global economic recovery. We expect the Eurozone economy in the final quarter to grow by a similar rate as in the third quarter. Still, this would mean that over the year as a whole gross domestic product will have shrunk by 3.8%.

For next year, the cyclical rebound is expected to be more pronounced than most observers expect at this point and we expect GDP growth of more than 2%. Much of the impetus will likely come from trade, the inventory rebuilding, and fiscal and monetary policy. However, we expect the underlying conditions to remain weak. House prices in some Eurozone countries will likely continue to fall and require additional asset value adjustments. This in turn may further restrict bank lending. At the same time, the housing surplus on the market will likely put a damper on new building projects for some time to come. And last but not least, both the corporate sector and the private sector will be working on further scaling down their debts. This will depress the recovery of domestic demand. Investment, in particular, is likely to grow much less initially compared with what is usual in a classical upswing.

Consumer price inflation dipped briefly below zero in recent months, but will likely return to just below 1% by the end of 2009. We expect the inflation rate to average 1.2% in 2010 and 1.5% in 2011. Thus, for the European Central Bank (ECB) inflation is of no concern. We think the bank will keep rates on hold until the third quarter 2010 and then raise the main policy rate only gradually from 1% to 1.75% by the end of 2010 and 3.5% by the end of 2011. After all, the ECB will find it difficult to effectively implement a rate hike until June 2010 as banks have already satisfied a major part of their liquidity needs by then. The move will probably be preceded in the first half of 2010 by gradual reversal of the unconventional policy measures.

United Kingdom

The latest provisional GDP data suggest that the UK economy contracted 0.4% in the third quarter. This was the sixth consecutive quarter of contraction, making this the longest recession since quarterly GDP data began in 1955. The third quarter numbers were somewhat at odds with more upbeat survey evidence and we think that some upward revision is likely to come with a later release. Nevertheless, the report confirms that the UK economy is lagging behind in the global recovery. We think this is attributable to two things: first, given its strong financial sector and past housing boom, the UK economy was particularly vulnerable to a downturn that was led by a housing crash and a financial crisis; second, discretionary fiscal support has been smaller in the UK compared with most other major economies.

Fourth quarter GDP will probably be positive, helped not least by the January 2010 VAT hike, which should cause many households to bring forward expenditure from 2010. Yet, with this spending missing next year, the start into 2010 could be quite weak though. However, helped by the very weak exchange rate and ultra-low interest rates, we think that the stabilization continues next year with a full-year growth rate of about 1.8%.

Consumer price inflation has likely troughed at 1.1% in September. In early 2010 inflation should jump back up above 2% or even higher owing to tax hikes and the energy-related basis effects. The Bank of England (BoE) remains concerned about the state of the economy and we think that it will expand its program of government bond purchases further in coming months. Interest rates will likely remain exceptionally low in 2010. We envisage two small increases in the second half of the year, taking the Bank rate up from 0.5% to 1.0% by the end of 2010. By the end of 2011, we think that the Bank Rate will stand at about 3%.

Japan

After four consecutive quarters of negative growth, GDP expanded 0.6% quarter-on-quarter in the third quarter. Although we expect growth to remain positive in the quarters ahead, a full recovery may take a long time to achieve. The labor market is extremely weak and wages are falling sharply as businesses try to cut costs in the face of lower revenues.

Deflationary pressure remains intense as consumers try to stretch their shrinking paychecks. Fiscal stimulus has been an important factor helping to support the economy. While the impact from stimulus spending may already have peaked, we do not expect to see a serious attempt at narrowing the budget deficit in the near future. not to be expanded. Also, we expect the PBoC to introduce some monetary tightening in the first half of next year as inflation is expected to turn positive in November and should pick up to 3.0% in 2010. Loans are likely to grow at a significantly slower pace than the 35% bank lending growth recorded currently. Net exports, which so far have been a significant drag on overall GDP growth should contribute positively again or the negative contribution should narrow substantially, particularly in the first half of 2010, when we expect the biggest boost from improving global demand. However, with our expectations for muted economic growth in the Western world into 2011, we believe that China’s growth will moderate as well and forecast an economic expansion by 8.7%.

Asia ex-Japan

Strong economic growth rates are expected across Asia over the next couple of quarters as a consequence of a strong export rebound, a recovery in domestic demand as well as favorable base effects. We continue to be more optimistic than consensus regarding the extent of the rebound, forecasting growth in Asia ex-Japan/China to accelerate from 1.1% in 2009 to 6.2% in 2010 versus the consensus expectations of 0.9% and 5.2%. We are particularly bullish on the outlook for exports in the near term, which explains most of the discrepancy for 2010. While this expectation is not entirely new, we have nevertheless lifted our forecasts for export-oriented economies partly also because of surprisingly strong third quarter GDP figures. Thus, for small open economies such as Singapore, Hong Kong, Thailand or Malaysia, our forecasts are significantly above consensus expectations.

However, the above-mentioned base effects, in particular from exports, will likely lead to a significant moderation in GDP growth from the second half of 2010 onwards, in line with the expected moderation in the US and Europe. Also, during the first half of next year, the fiscal policy support in a number of Asian economies is waning and is unlikely to be extended given the robustness of growth. Monetary policy is expected to become tighter as inflation moves back into positive territory and economic activity has rebounded. However, by then, domestic demand should have recovered to fairly robust levels and thus should compensate for lower government spending and a smaller growth contribution from exports. Going into 2011, we growth should moderate. However, fairly robust growth at 5.4% is expected for Asia ex-Japan/China. Growth in countries with large domestic economies, such as India or Indonesia, should hold up better.