World economy: EIU’s global forecast ­ Upgrading the US, downgrading emerging markets

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FROM THE ECONOMIST INTELLIGENCE UNIT

(Forecast closing date: January 13th 2012)

Europe’s financial crisis will continue to weigh on the global economy in 2012, and still has the potential to cause disaster. There is little change this month to the Economist Intelligence Unit’s forecast for aggregate global GDP growth. We sharply lowered our euro zone forecast last month, and have not materially changed our view since then. In contrast, we think growth prospects in other regions—and their ability to weather the global slowdown—have changed in significant respects. Most notably, we have raised our forecast for US growth but have cut our forecasts for some emerging markets.

We expect world GDP to grow by 3.1% at purchasing-power parity in 2012. This marks a considerable slowdown from 2010 and 2011, and by some definitions would put the global economy perilously close to another recession. However, we reckon that growth would need to weaken to about 2% to qualify as a recession. While trading conditions have clearly become more challenging in many countries, the world is still quite some way from that bleak outcome. This assumes that implosion is prevented in Europe; a break-up of the euro zone remains a very real threat, and if that were to occur the global economy would suffer a recession much worse than the one recorded during the post-Lehman financial crisis of 2008-09.

Political bickering in Europe continues to hamper efforts to save the single currency. Policymakers haven’t done nearly enough to prevent further contagion, and the viability of the euro remains in question. We still attach a 40% probability to a euro break-up occurring within the next two years. The “fiscal compact” announced in early December looks unpromising, which matters not just for future economic governance in the EU but also because in the short term it may discourage the European Central Bank (ECB) from overcoming its reluctance to intervene more heavily in government bond markets. The ECB did take an important step in mid-December by boosting liquidity, but this welcome development was quickly followed by further bad news, including the decision by Standard & Poor’s to downgrade its credit ratings for nine euro members. Even if policymakers ultimately do enough to save the euro, which is still our core assumption, the process won’t be quick or painless.

The poor economic outlook for the euro zone is being offset globally by a more promising prognosis for the US. Most economic indicators have improved, and growth in the fourth quarter of 2011 is likely to have been above 3% in annualised terms. But the US economy is still weak by almost any standard. Partisan politics is making serious policy decisions all but impossible, and there is an added risk of contagion if conditions in the euro zone worsen.

Elsewhere, the negative effects of the euro crisis and slowing global growth are rippling through into emerging markets. Eastern Europe faces the twin spectres of weaker demand from its main export market and a credit squeeze as western European lenders deleverage. In Latin America and Asia, meanwhile, Europe’s problems have hit growth prospects for commodity producers and countries that rely on manufacturing exports. We have also lowered our forecasts for Africa.

Developed world

The US economy continued to gain momentum towards the end of 2011, shrugging off financial disruption from the euro crisis. Consumers proved surprisingly spendthrift during the holiday season, and the labour market is showing signs of moving past the soft patch it suffered during the summer, with non-farm payrolls rising by 200,000 in December. We have raised our GDP growth forecast for 2012 to 1.8%, from 1.3% previously, to reflect the improvement in current conditions. However, the US cannot fully escape the drag that the euro zone’s recession will create. Moreover, households still have a long way to go with deleveraging, which will make it difficult to sustain more rapid economic growth.

The euro zone probably slipped into recession in the fourth quarter of 2011, and we continue to forecast a 1.2% contraction in 2012. The ECB has provided nearly €500bn of three-year funding to commercial banks at low interest rates, which has eased their funding pressures. However, it is far from clear that banks will now become more willing to lend. Strong risk aversion and the need to increase capital-adequacy ratios will encourage lenders to hoard their new funds. Meanwhile, pressure on the region’s troubled sovereigns remains intense, even if bond yields have come down slightly. Leaders are sticking by their stance that austerity is the route out of this crisis, but in the drive to become fiscally virtuous there is a risk that policy will become damagingly pro-cyclical, exacerbating the recession. For example, Germany, which cut its fiscal deficit to only 1% of GDP in 2011, is reluctant to relax fiscal policy even though this would stimulate demand in the rest of the euro zone.

Japan has largely overcome the disruption to supply chains that crippled its economy in the wake of the natural disaster in March 2011. A surge in residential construction in the third quarter suggests that rebuilding following the disaster is well under way, and we expect reconstruction to boost the economy throughout 2012. Weak external demand and a strong yen will, however, limit the strength of Japan’s recovery. We expect GDP growth of 2% this year.

Emerging markets

Most developing economies will perform decently this year thanks to robust domestic demand, but few will remain immune to the slowdown in the West. Economic growth in globally integrated Asia and Australasia (ex Japan) is set to slow from 6.5% in 2011 to 6.1% this year, although the region will remain the world’s fastest-growing. Despite a slight downgrade to our forecast for Chinese GDP growth, we do not expect a hard landing by the region’s main economic engine. Instead, the most worrying signs are emanating from India, which is more sheltered from global headwinds but faces a year of economic weakness and political paralysis. We now expect Indian GDP to expand by just 6.3% in 2012.

In eastern Europe, the looming recession in the euro zone is casting deep shadows over economic prospects. The euro zone’s troubles will sharply curtail economic activity in neighbouring countries in 2012, with trade, investment and financing conditions set to weaken further. As external demand falters, domestic demand will not be robust enough to pick up the slack. On the policy front, large budget deficits raise worrying questions about debt sustainability and the ability of governments to roll out stimulus. We expect regional growth to slow from 3.5% in 2011 to 2.3% in 2012.

Latin American economies are losing impetus after a stellar recovery in 2010-11. As a result, policymakers are shifting their focus from dampening inflation and currency appreciation to supporting growth. We think regional growth will slow to 3.5% this year, largely as an outcome of poor performances by the EU and US. But provided that the global slowdown is not too protracted, sound macroeconomic policies and resilient domestic demand will mean that Latin American growth starts to accelerate again next year.

In the Middle East and North Africa, the economic outlook for 2012 reflects the divergent impacts of the Arab revolutions. Those countries directly affected by unrest have suffered sharp economic slowdowns. Others, particularly oil producers, have been able to boost public spending. In the year ahead, political instability and a more hostile external environment will weigh on growth across the region, but these negative factors will be balanced by massive infrastructure investment in Saudi Arabia, robust growth in Iraq and a surging recovery in Libya. Overall, we expect regional GDP to rise by a relatively robust 4% in 2012—although prospects would change drastically if the geopolitical risks emanating from Iran led to open conflict. In Sub-Saharan Africa, the economic outlook is worsening as the West stumbles and China slows. Specific risks include tighter trade credit, lower commodity prices, contracting external demand and falling remittances. We have revised down our forecast for regional GDP growth in 2012 to 4%.

Exchange rates

The US dollar has soared against the euro in recent weeks, a trend that most analysts—including the Economist Intelligence Unit—had expected to happen far earlier. In mid-January the dollar was trading at around US1.26:€1, its highest level since August 2010. We expect the euro to remain relatively weak against the dollar in 2012, averaging around US1.27:€1. Upward pressure on the yen will continue. Meanwhile, emerging-market currencies can be expected to remain under downward pressure until risk aversion subsides.

Commodities

We expect commodity prices to remain hostage to sentiment surrounding the outcome of the euro crisis and global economic prospects. A marked deterioration in the outlook for the euro zone could lead to dramatic falls in commodity prices. Even if that does not occur, most commodity prices will be lower on average in 2012, owing to slower consumption growth and—depending on the commodity—some improvement in supply. A stronger US dollar will also be negative for commodity prices. Brent crude prices will ease to an average of US$100/barrel this year, although this is higher than our previous forecast of US$95/b owing to supply uncertainties and to the upgrade in our US GDP forecast (which implies higher US oil consumption).

The Economist Intelligence Unit