• Recovery. The global economic outlook keeps brightening, albeit in an uneven and uncertain way. Worldwide growth should have accelerated in 4Q09. Although the current pace of the recovery can't be maintained (resulting in a W-shaped recovery), we expect global GDP to grow at around 3% next year (2009: -1.2%; pages 2-4).

  • Emerging Asia, first and foremost China, will clearly remain at the top of the growth league table also in 2010. This lends a helping hand to the economies of the industrialized world, which we expect to grow by 1.4% next year (2009: -3.6%).

  • Exports. It is, therefore, primarily exports that support European economies in the coming year. Combined with an ongoing expansionary monetary policy, they will prevent a renewed relapse into recession once the effects of the huge stimuli programs and the inventory re-stocking have run their course.

  • United Kingdom. This applies not least for the UK economy, which has emerged from severe recession only recently, thus lagging behind the EMU. The recovery of global trade combined with the weak pound will help bring real growth up to 1¼% in 2010. Final domestic demand, however, should do little more than stagnate (pages 5-6).

  • Italy. Still shrinking investment activity and only stagnating private consumption will prevent a pronounced upswing in Italy next year. Net exports should lead to at least moderate GDP growth in 2010 (+0.5%; 2009: -4.8%). The strong expansion in 3Q09 will soon be last year’s news (pages 7-9).

  • Further topics:

    – Weekly Comment: A happy New Year!?

    – Germany: Holiday shopping season brings no salvation (page 10).

    – Data outlook: Consumers remain skeptical (page 13).

    – Market outlook: Euro under pressure for the time being (page 16).


A happy New Year!?

It has been a tough year for everyone. Luckily, thanks largely to the timely, decisive and creative intervention of policymakers around the world, the global economy is now back on its feet and poised for a recovery in 2010. Moreover, risk appetite has returned once it became clear that the end-ofthe- world scenario, which seemed inevitable just after Lehman collapsed, had instead been avoided. The ensuing recovery in asset prices has brought positive returns on most asset classes in the last nine months, and in some cases these returns have been extremely high. We have therefore gained some precious breathing room. The year ahead will be extremely difficult, in many ways much more difficult than the one that is about to end, but we can at least now take a deep breath, regroup, and try to plan our strategies for 2010 without feeling overwhelmed by the sense of helplessness, doom and desperation which marred the last holiday season.

As we look ahead, the first question is what kind of macroeconomic environment we are likely to face over the next couple of years. Our view remains best characterized but what we have dubbed “a double V, not a double dip”. We believe the recovery is sustainable, but we think its initial pace is not: we expect some loss of momentum early next year before growth settles on a more sustainable pace, which will be significantly lower than before the crisis.

We believe the recovery is sustainable for two main reasons: First, there is genuine strength in the robust recovery of global trade, driven by large emerging markets that have emerged relatively stronger from the crisis. Second, the support measures put in place by policymakers have been effective in stabilizing the situation, so that some sign of life is coming back into the domestic side of the largest developed economies. The arguments as to why the current momentum is unsustainable are well known, and largely uncontroversial: the contribution of the inventory cycle is by its very nature temporary, and policymakers seem unlikely to provide fresh stimulus, so that the policy impulse will wane. Moreover, we need to keep in mind that while emerging markets are becoming more and more important, it is the developed economies which still account for the largest share of the global economy. And the two largest developed economies, the US and the eurozone, are rather closed economies. Their recovery prospects therefore hinge on domestic consumption and investment, and both still face “formidable headwinds” (Bernanke) in both countries.

Let’s start with investment. The most obvious obstacle is capacity utilization, still at record low levels – companies have plenty of room to expand production to meet demand before they have to invest. And demand prospects remain uncertain. In fact, one trend we have noticed in the eurozone is that companies tend to maintain a still very lean level of inventories, suggesting they are not optimistic about the recovery. And if they are not confident enough to rebuild inventories to normal levels, they are certainly not likely to invest. (Note however the silver lining: once they become more confident, the inventory cycle should enjoy a second wind). A second potential obstacle to investment is credit. In the US, evidence of a credit squeeze has been visible for some time; in Europe, there is so far no evidence that a lack of supply has been a problem, given the collapse in demand. The ECB, however, has expressed clear concern that as demand recovers, credit supply might be unable to keep pace with it. The concern is legitimate. Our estimates suggest that, if eurozone banks will indeed be hit by the over EUR 200bn in losses predicted by the ECB, and they aim at maintaining their capital ratios at current (healthy) levels, they would be forced to curtail lending by over 10% unless they can raise additional capital. Only a risk at this stage, and several banks have been taking steps to strengthen their capital base – but a significant risk. Consumption is held back by the poor state of the labor market, with unemployment rates still on the rise on both sides of the Atlantic. In the US, this is compounded by households’ overdue need to deleverage, while in Europe the crisis has reinforced longstanding cautious attitudes.

Overall, we are therefore expecting a rather lackluster recovery: we see the world economy rebounding to a healthy 2.9% next year after a 1.2% contraction this year – but the picture for developed markets is significantly worse, with a -2.5% contraction this year followed by an 1.4% expansion in 2010 – confirming the relatively healthier state of emerging markets. We are more positive on the US, which we see growing at 1.8% in both 2010 and 2011 after a 2.5% contraction this year, than on the eurozone, where we expect a mere 0.9% next year and 1.3% in 2011 after a nearly 5% contraction this year. Japan is not faring much better. Within the eurozone we see ample disparities: Germany will benefit from its strong positioning in export markets that make it ideally suited to capitalize on the recovery in global trade – we expect 2.0% growth next year, slowing however to 1.2% in 2011. France has had a milder recession, but the payback will be a weaker recovery: we forecast growth at 1.4% and 1.6%, respectively over the next two years. Spain will still be in recession next year, while Italy will have an extremely weak recovery, posting growth of 0.5% and 1.0%.

As always, and perhaps more than usually, these forecasts are subject to a margin of uncertainty. The most interesting question, however, is whether we will get surprises that will prove the superiority of either the European or the US growth model. In Europe, various automatic stabilizers have been used to cushion the blow, and in particular to limit the rise in unemployment, with shortened work weeks, partial layoffs funded by the state, etc. Some economists argue that these policies can be extremely efficient, as by keeping people even partially employed they support consumption and put the company in a position to quickly go back to full utilization of human resources whose skills will not have deteriorated as much as if they had been laid off. On this theory, we should observe a relatively faster recovery. The less kind interpretation is that if the crisis requires a recalibration of the economy, shifting employees from one sector to another, these policies will undermine the adjustment, prevent reallocation of resources, and thereby limit growth potential. The test lies ahead of us, and the result could have profound implications. Should the US economy surprise once again on the upside, leaving Europe mired in a slump, European policymakers will need to take a hard look in the mirror and open a frank public debate on whether the current social model is serving Europe well. Should Europe outperform, the current US administration seems very likely to make a push to bring the US closer to the old continent’s model.

So far, just looking at the growth forecasts mentioned above, my preliminary conclusion is that Europe needs to accelerate structural reforms in a hurry in order to boost potential growth. This seems even more urgent now that public debt levels are rising dangerously across the common currency area. The only way to eliminate this collective debt problem is to grow our way out of it. I said “this collective debt problem”, and this is partly true, but with some caveats and explanations. Debt levels are rising across the eurozone, with the average debt to GDP level projected to soon reach 80% of GDP. The jump is greater in some countries which started from a lower level, but the increase is more problematic and dangerous for countries with a higher ratio. The recent turmoil on Greece is a case in point: the fact that investors have come to wonder whether Greece might default on its debt clearly proves that not all countries are equal in this respect. The Greece episode, however, has also proved that the vulnerability of one eurozone country cannot be ignored by other members: integration has gone far enough that trouble in one country threatens dangerous contagion on the rest of the area, so that the only possible response is to proceed towards even more integration.

Policymakers, having done an outstanding job in containing the crisis, now face the next challenge, namely to get the timing and pace of the “exit” exactly right. Too soon, and the economy might tip back into recession; too late, and the cycle of bubbles and bursts might start again. So far, they are being cautious: The Fed confirms rates will stay low for an “extended period”, commonly understood as about six months; and the ECB has committed to maintaining the system flush with liquidity at least through 1Q next year, and has indicated that it is in no hurry to hike interest rates. Concerns that central banks might be too cautious are mounting: Fed Chairman Bernanke in particular has come under heavy criticism. Is there really a risk of new bubbles arising? A risk yes, but I would say not an “imminent and present danger”. The global financial system is still deleveraging. However, central banks are taking the first steps towards the exit: the ECB is moving to gradually drain some liquidity from the system; and the FOMC this week noted some improvement in the labor market, a key precondition to a tightening of monetary policy.

We expect the Fed will be the first to hike, towards the end of 3Q next year. The ECB will follow only in 2011 with the Refi, but will start tightening monetary conditions “under the radar” in the second half of 2010, draining liquidity and pushing short-term market rates gradually back in line with the Refi (short-term rates much lower than the policy rate, such as the EONIA at around 0.35%, are an anomaly). And once central banks start hiking, they will do so with gusto, eager to avoid the “Greenspan mistake” of raising rates too slowly over too long a period.

This sets the stage for a sharp bear flattening of yield curves in 2H next year: short-term market rates will move up quickly and strongly, while rates at the long end of the curve should move up more gently, reflecting the fact that 1. inflation pressures remain muted, and 2. growth seems likely to remain weak for some time. Our implicit assumption is that the increase in public debt ratios will not lead investors to significantly reassess credit risk premia, which might induce them to demand significantly more attractive yields on longer term bonds – it is however worth keeping this in mind as a plausible risk scenario.

As far as exchange rates are concerned, we believe that we have to be prepared to live with a strong EUR in 2010 as well. This remains in large part a reflection of the weakness of the USD: a large fiscal deficit, an economy that still needs to deleverage, and some market skepticism on the sustainability of the recent improvement of US external accounts will keep the USD under pressure. As it seems unlikely that China and other Asian countries will allow a marked appreciation of their currencies, the EUR seems destined to continue shouldering most of the burden. Only at the end of the year, as the Fed embarks on its tightening cycle, will there be some relief for the euro – and for eurozone exporters. But this relief will only be moderate, as markets will expect that the ECB will not be far behind the Fed. The strong euro is likely to persist and potentially magnify the differences in performance across eurozone countries, with Germany best positioned to benefit from its specialization in high value added investment goods, while Italy and France will struggle more.

Looking ahead to 2011 and beyond, the outlook appears somewhat disappointing at the moment. As many central banks and international organizations have noted, it seems most likely that both Europe and the US are coming out of this crisis with a lower potential growth rate. In the case of Europe, we believe the “speed limit” might have dropped to about 1.5% annual growth, which is neither exciting, nor sufficient to allow for a significant reduction in debt burdens together with a steady improvement in living standards and per capita incomes. The only silver lining in this picture is that it is hard to imagine inflation picking up in any significant way: we have made careful simulations, and they suggest that the earliest we might have to worry about inflation again is sometime in 2013. This, however, is a rather meager consolation for a rather disappointing growth outlook.

Europe deserves better, and the end of the year is traditionally the best time for new, ambitious resolutions. We are hopeful that the shock of the crisis, the burden of debt, and the tensions generated by the Greece episode, will impress upon our policymakers the urgency to press ahead with reforms that can increase productivity, make Europe more competitive, and offer all of us a more exciting and rewarding future. Reforms are never easy or costless, and governments might be reluctant to suggest them to people who have already suffered a lot. But we believe that Europeans realize that they have been cushioned by the crisis primarily by the fast advances in growth of the previous decades, and that this is the time to roll up our sleeves and make a serious effort to resume a faster growth path. If policymakers have the courage to clearly explain the trade-offs and choices ahead, we are confident that European citizens can take up the challenge, and will do so successfully.

On our side, our resolution is to double our efforts to work with all of you to understand the economic and financial environment and identify the best strategies to deal with it. We thank you sincerely for your renewed attention and confidence over this long and difficult year, and we wish you a very Merry Christmas and Happy New Year!