After suffering a contraction in global GDP in 2009, the global economy came roaring back in 2010, expanding nearly 5 percent last year. Yes, some of the expansion in 2010 reflects one-time inventory swings in many economies. In addition, accommodative monetary and fiscal policies in most major economies helped to support global economic activity as well. Now that macroeconomic policies have been tightened in some countries, global economic activity has less policy support than it did last year. Consequently, we project that the global economy will expand at a slightly less rapid pace in 2011 and 2012 than it did last year.
The expansions that are under way in most developing economies are generally well established at present. Although recoveries in most advanced economies are not as strong, the expansions are becoming more self-sustaining as domestic demand in these countries has strengthened. Although macroeconomic policies are generally less accommodative today than a year ago, policies generally are not overly “tight’ either. Therefore, our base case scenario envisions further expansion in the global economy over the next two years. Specifically, we look for global GDP to rise roughly 4 percent per annum in both 2011 and 2012. However, there are a number of significant downside risks that, if realized, could lead to another downturn in global economic activity.
The sovereign debt crisis in Europe poses the most immediate downside risk. Greece, Ireland and Portugal have already received financial rescue packages from the European Union and the IMF, and Greece desperately needs more funds. However, bailouts are unpopular in some European countries, and governments are arguing over the extent to which private sector creditors need to realize losses on Greek government bonds. Recently, contagion has spread to Spain and Italy. If the governments of these two large economies ultimately need to restructure their debt, the losses borne by the European banking system would total hundreds of billions of euros. In a worst case scenario, the global financial system could grind to a halt like it did in the autumn of 2008.
Speaking of debt, the fiscal situation in the United States represents another large downside risk. The U.S. government is projected to run out of spending authority in early August. Although we believe there is a high probability that Congress eventually raises the debt ceiling, failure to do so could be catastrophic. A default by the U.S. government would cause U.S. interest rates to spike, which would lead to another deep recession. Default could be avoided as long as the Treasury Department chooses to service the debt. However, Treasury would need to freeze some other government payments, which would exert significant headwinds on the economy. Financial markets could become volatile as the deadline for the increase in spending authority draws closer.
There are some other risks that need to be kept in mind. First, energy prices continue to cloud the economic outlook. Although oil prices have retreated from their April highs, the political situation in the Middle East is far from settled. A spike in energy prices would have serious consequences for the global economy because it would reduce consumer purchasing power, thereby weighing on growth in consumer spending. In short, a spike in energy prices could lead to another global downturn.
A significant increase in energy prices could have implications for monetary policy as well. The Federal Reserve and many other major central banks would probably refrain from hiking rates if higher energy prices did not lead to generalized price pressures. However, inflation has become the most pressing economic problem that many developing countries face at present. Higher energy prices would compound inflationary pressures in those economies, thereby raising the risk that developing economies tighten macroeconomic policies excessively. With developing economies accounting for roughly 40 percent of the global GDP today, aggressive policy tightening in those countries could lead to significantly slower global economic growth than we currently project.
Outlook for Dollar Mixed in 2011
The U.S. dollar has depreciated against many currencies so far this year. The sluggish nature of the U.S. economic recovery has led to the widespread expectation that the Federal Reserve will be on hold for the foreseeable future. Low U.S. interest rates in conjunction with the current account deficit have caused the greenback to depreciate versus most major currencies. In the near term, Wells Fargo’s currency strategy team acknowledges that the U.S. dollar could remain on the defensive vis-à-vis many major currencies. However, growth prospects are better in the United States than they are in most other advanced economies, and the Eurozone remains plagued by sovereign debt concerns. Therefore, the team forecasts that the U.S. dollar should eventually strengthen modestly versus most other major currencies.
The greenback has also lost ground against most emerging market currencies so far this year. The willingness of investors to take on risk and attractive rates of return have led to strong capital flows to the developing world, which have caused those currencies to appreciate against the dollar. Developing countries in which the production of commodities is important have generally experienced currency appreciation as well due to rising commodity prices. The currency strategy team generally looks for further near-term appreciation of emerging market currencies due, at least in part, to rates of return that should remain attractive.
Summary:
- Global Recovery Should Continue in 2011, but Risks Exist
- Outlook for Dollar Mixed in 2011
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