It's a clear case of more 'muddle-through' in 2013

Serious Money:The world did not end in 2012; the date that marked the end of the Mayan calendar – and supposedly foretold doom – came and went without incident. In a similar vein, none of the seismic risks that weighed on investor sentiment at the start of 2012 came to pass, enabling markets to move higher despite lacklustre growth.

First, the euro was not undermined by a Greek exit as many had predicted, while bold action by the European Central Bank (ECB) kept systemic risk in check. The increased stability contributed to a big drop in yields across the sovereign bond markets of several eurozone countries, alongside a sharp bounce in the equity markets of the troubled periphery.

Second, although growth slowed for seven consecutive quarters, China did not suffer a hard landing. Further, signs of stabilisation began to emerge during the final three months of the year, allowing commentators to become more constructive on the outlook for the current year.

Finally, the US didn’t fall off the fiscal cliff – the fiscal contraction of circa $600 billion/4 per cent of GDP – that threatened to plunge the economy into recession, at least through the first half of this year. A compromise was reached in time, undermining those flagging a downturn in 2013.

The removal of potentially destructive tail risks in the past 12 months allowed investors to push risk premiums lower and ignore the uninspiring growth backdrop. The global economy muddled through, as growth slowed to little over 3 per cent – a rate that is 0.75 per cent below the long-run trend, but sufficiently strong to avoid the world going into deflation and depression.

The US is enduring its weakest postwar recovery on record, as the rehabilitation of private sector balance sheets continues to weigh on growth. The annualised pace of GDP increase has averaged just 2.3 per cent over the 13 quarters since activity bottomed during the summer of 2009 – or roughly half the pace typical more than three years into an expansion.

Economic growth is likely to decelerate to just 1 per cent or lower during the first half of 2013 as a fiscal drag of circa 1.5 per cent restrains activity. Further, elevated unemployment rates and lacklustre wage gains will temper consumer demand, while a peak in corporate profitability could hold back private sector investment. The rate of GDP increase could come in well below 2 per cent in the coming year.

Despite ECB heroics, the euro zone crisis is far from over; continued economic contraction in 2013 could reignite investor concern. The euro is not feasible in its current format, and resolution is unlikely without a fiscal and banking union, alongside a central bank that can act as a lender of last resort to governments. Progress is likely to be painfully slow, and a deepening of the growth crisis on the back of pro-cyclical fiscal policies could see break-up fears resurface.

The economic backdrop in the developed world is likely to be no more encouraging in 2013 than in 2012. As a result, all hopes are pinned on emerging countries such as China and India to pull the global economy forward. But both are transitioning from growth models that are broken, and the adjustment may not be as smooth as many believe. China urgently needs to rebalance its economy away from investment and towards household consumption.

However, a successful transition is not feasible without a slowdown in investment growth to several percentage points below the economy’s overall growth for a protracted period, and a jump in the rate of increase in household spending to unprecedented levels. In the short term, policy easing measures are likely to underpin growth, so long as rising credit losses do not restrain bank lending.

In India, unsustainable aggregate demand policies during the financial crisis and beyond have undermined growth. Large fiscal deficits and high rural wage growth have contributed to a decline in private sector investment. Though some efforts have been made to improve sentiment, progress is likely to be slow ahead of the national elections in 2014.

More “muddle-through” seems to be in store for 2013, but the outlook could become bleak if disappointing growth across the major blocs of the developed world is not offset by a material improvement in the performance of key emerging countries. Further gains in risk assets are likely to hinge on investors’ continued faith in central banks’ unconventional monetary policies.

[ charliefell.com ]