Shanghai's World Financial Center - - China's tallest building

Global Economy 2010: US investment bank Morgan Stanley says next year will be a tale of two worlds - - global growth of 4% but  barely 2% average GDP  (gross domestic product) growth in the advanced G10 economies while  emerging economies, led by China and India, should grow by an average of 6.5%. Meanwhile, according to the Bank of America Merrill Lynch Global Research Macro Year Ahead for 2010, issued in London on Monday, the global economy will grow at a slow but steady pace in 2010, ahead of consensus estimates and China's economy will expand by 10.1%.

This year was all about the exit from the Great Recession and it worked courtesy of massive global policy stimulus. Economists at Morgan Stanley, say next year will be all about the exit from super-expansionary monetary policy.

MS economists Joachim Fels, Manoj Pradhan and Spyros Andreopoulos, who are based in London, say they expect the major central banks to start exiting from their massive liquidity promoting programs, around mid-2010. The approach is likely to be cautious, gradual and transparent. However, the prospect and process of withdrawal may have unintended consequences: the economists say government bond markets will be the first victim. While the exit will be the dominant macro theme next year, they identify five important economic themes in the MS global economic outlook that, in their view, will be highly relevant for investors in 2010. 

A tale of two worlds: MS forecasts 4% global GDP growth in 2010, up only marginally from three months ago.  The economists say if this turns out to be about right, it would be a fairly decent outcome, especially compared to the widespread doom and gloom earlier this year. However, it falls short of the close to 5% growth rate in the five years prior to the Great Recession, and it will be the product of unprecedented monetary and fiscal stimulus, which poses substantial longer-term risks on various fronts. Moreover, the 4% global GDP growth forecast masks two very different stories. One is a still fairly tepid recovery for the advanced economies - - -the ‘triple B' recovery discussed below. The other is a much more positive outlook for emerging markets, where they forecast output to grow by 6.5% in 2010 (China 10%, India 8%, Russia 5.3%, Brazil 4.8%), up from 1.6% this year. A rebalancing towards domestic demand-led growth in EM is well underway. Moreover, the official statistics are likely to vastly underestimate the level and growth rate of consumer spending in China. In short, MS says that the theme of EM growth outperformance has staying power and has even been bolstered by the crisis.

A ‘triple-B' recovery in G10: In contrast to the upbeat EM story, the economists forecast barely 2% average GDP growth in the advanced G10 economies in 2010 - - a triple B recovery where the three Bs stand for bumpy, below-par and boring. On MS estimates, GDP growth has averaged around 2% in the G10 in the second half of this year and won't accelerate much from that pace next year - - hence the ‘up' without ‘swing' characterisation from three months ago remains valid. The two reasons why the economists think the recovery in advanced economies will be of the ‘triple B' type are that it is likely to be creditless and jobless. Creditless recoveries - - defined as a situation where banks are reluctant to lend and the non-bank private sector is unwilling to borrow - - are the norm following a combination of a credit boom in the preceding cycle and a banking crisis; and creditless recoveries typically display sub-par economic growth as credit intermediation is hampered. Moreover, the economists expect a jobless G10 recovery, with unemployment in the US declining only marginally next year and rising further in Europe and Japan. Unemployment may well stay structurally higher over the next several years in the advanced economies as many of the unemployed either have the wrong skills or are in the wrong place in an environment where the sectoral and regional drivers of growth are shifting.

More growth differentiation within the G3: Beneath the surface of what the economists call a lacklustre ‘triple B' recovery in the advanced economies lies a differentiated story for the three largest economies within this block - - the US, the Eurozone and Japan.  They expect significant growth differentials between these countries in 2010, which may well become a topic for currency, interest rate and equity markets again. They see the US as the growth leader among this group next year, with output expanding by 2.8% in the annual average of 2010. The Eurozone economy looks set to grow by less than half that rate (1.2%), while Japan should hardly grow at all (0.4%) next year and is forecast to actually fall back into a technical recession in H1 2010. One reason for relative US outperformance is that the creditless nature of the recovery affects the US private sector by less because banks (as opposed to capital markets) play a smaller role in financing the economy than in Europe or Japan. Another reason is that US companies have been much more aggressive in shedding labour this year than their European or Japanese counterparts, so the US labour markets looks set to recover (albeit slowly) next year, while MS expects unemployment to rise further in both Europe and Japan.  Further, European and Japanese exporters should feel the pain from this year's currency appreciation, whereas US exporters should benefit from this year's dollar weakness.

Crawling towards the exit, but triple A liquidity cycle remains intact: The economists expect the beginning of the exit from super-expansionary monetary policies and its implications to be the dominant global macro theme in 2010. The Fed, the ECB and the PBoC (Peoples' Bank of China) will move roughly in tandem and raise interest rates from Q3 2010, with the Bank of England following in Q4. Some, like the central banks of India, Korea and Canada, are likely to move earlier, while others, such as Japan, will lag behind. Generally, given the remaining fragility in the financial sector, central banks are likely to approach the exit in a cautious, gradual and transparent manner, so any hikes will likely be telegraphed well in advance, partly through appropriate twists in the crafted language, and partly through some cautious draining of excess bank reserves. Importantly, while the end of easing and the beginning of the exit can be expected to cause wobbles in financial markets, and this is one reason why the economists see bonds selling off sharply next year, they point out that official rates are likely to stay well below their neutral levels (even factoring in that these themselves are likely to be lower now than they have been in the past) throughout 2010 and, probably, also in 2011. Hence, monetary policy is only expected to transition from super-expansionary to still-pretty-expansionary. This would leave what we have dubbed the ‘triple A' liquidity cycle (ample, abundant and augmenting), which has been identified as the main driver behind this year's asset price bonanza and economic recovery, fairly intact next year. The economists say the metrics they follow to validate or refute this view is the MS global excess liquidity measure, which is defined as transaction money (cash and overnight deposits) held by non-banks per unit of nominal GDP. This measure exploded this year and we would expect it to rise further, though at a much lower pace, through 2010.

Sovereign and inflation risks on the rise: Fifth, but not least, the economists think that sovereign risk and inflation risk will be a major theme for markets in 2010. The current issues surrounding Greece's fiscal problems are only a taste of things to come in many other advanced (note: not emerging) economies, in their view. They say that fiscal policy looks set to remain expansionary in all major economies next year, as it arguably should be, given the ‘triple B' recovery which still requires support. However, markets are likely to increasingly worry about longer-term fiscal sustainability. The economists say the issue is not really about potential sovereign defaults in advanced economies. These are extremely unlikely, for a simple reason: most of the government debt outstanding in advanced economies is in domestic currency, and in the (unlikely) case that governments cannot fund debt service payments through new debt issuance, tax increases or asset sales,  they can instruct their central bank to print whatever is needed (call it quantitative easing). Thus, in the last analysis, sovereign risk translates into inflation risk rather than outright default risk. the economists expect markets to increasingly focus on these risks in the year ahead, pushing inflation premia and thus bond yields significantly higher. Put differently, the next crisis is likely to be a crisis of confidence in governments' and central banks' ability to shoulder the rising public sector debt burden without creating inflation.

Thomas Friedman, foreign affairs columnist for The New York Times, gives an "armchair" view on reviving the US economy and says it is all about going green:

BofAMerrill Lynch Global Research Macro Year Ahead for 2010

BofA Merrill Lynch Global Research is forecasting global GDP growth of 4.4% in 2010. Emerging Market (EM) economies are expected to take the lead, growing at an anticipated average rate of 6.3% while advanced economies are expected recover from recession and grow at an average 2.7%.

The report highlights several reasons for this optimistic, above consensus outlook.

First, after Lehman’s collapse global policy makers adopted a “do whatever it takes” attitude to the economic and financial crises. This has meant not only consistently aggressive monetary and fiscal stimulus, but policies that are repeatedly recalibrated to match the scale of the crisis.

Second, the BofA Merrill Lynch Global Economics team points out that forecasters and investors tend to underestimate the power of the business cycle. During recessions, many sectors of the economy overshoot to the downside and any improvement in confidence results in a bounce in activity.

“We expect the economic recovery to remain stronger than consensus expectations, but still significantly weaker than a normal recovery from a major recession,”said Ethan Harris, head of North America economics and coordinator of global economics.

“With few domestic imbalances, the eurozone can ride the upturn in global manufacturing and enjoy robust growth,” said Holger Schmieding, head of European economics research.

The muted recovery will likely lead to low core inflation, continued soft monetary policy and further quantitative easing, the report says. This outlook favours equities and commodities and signals a year of lower returns for government and corporate bonds.

Equities to benefit from growth: The prediction from BofA Merrill Lynch Global Research of 4.4% GDP growth in 2010 spells good news for equities. Global stock markets will be in a strong position to continue the recovery started in 2009 so long as a second recession is avoided. Despite the 30% return so far in 2009, valuations remain below the 10-year average of a 16.0x price-earnings ratio. Furthermore global economic policy favours risk-taking.

“We remain long risk assets, including global equities, until we see a policy mistake or a double-dip in economic activity,”said Michael Hartnett, chief global equities strategist.

Gary Baker, head of European equity strategy, said, “Our positive global economic view for 2010 suggests that consensus top line sales estimates are too cautious. Attractive valuations and strong earnings revisions point to another good year for European equities, led initially by cyclicals.”

David Bianco, head of US equity strategy expects S&P 500 sales growth to be led by the four ‘global cyclical’ sectors of Technology, Energy, Industrials and Materials. “We also expect Financials and Energy to appreciate the most in 2010 and expect strong appreciation with lesser risk from Industrials, Tech and Materials. Our S&P 500 12-month price target is 1275.” said Bianco.

Treasury yield curve to be steeper than market expects: Bin Gao, head of Asia Pacific rates strategy research, expects a moderate increase in global rates in 2010 given the ongoing economic recovery, the pressure of very heavy bond supply and fiscal sustainability concerns. These factors will keep many curves steeper than the forwards as central banks wait until the recovery is evident before embarking on rate hikes.

Credit - - extra risk for extra returns: Jeff Rosenberg, chief global credit strategist, expects to see normalized returns as corporate credit outperforms both government bonds and cash. He also expects high yield returns to reach 10%, outperforming the high-grade sector, which he forecasts as providing returns in the 2% to 3% range. Rosenberg believes that the returns delivered by the credit markets over the past year are impressive, but unsustainable.  Going forward, he feels investors will need to adjust their expectations for price appreciation to more normalized levels for the entire asset class.

US dollar to make gains against G10 currencies: Bullish growth predictions support the view that markets will become more positive about the dollar in 2010. This will help the US dollar continue its recent recovery against most G10 currencies in 2010. However, it is likely to weaken further against Emerging Market currencies, according to Steven Pearson, head of G10 currency strategy. While many investors took refuge in US dollar assets as a safe haven in 2009, risk appetite is set to exert a lesser influence on appetite for the dollar in 2010.

Shift of focus within Emerging Markets: Daniel Tenengauzer, head of global emerging markets economics & fixed income strategy expects emerging markets to play a central role in global growth again, however, he believes the key theme of 2010 will be emerging Asia passing the baton to Mexico and emerging European countries. Tenengauzer also believes that thanks to the global recovery, export-led economies such as Korea, Mexico and Russia, should catch up with domestic demand-driven growth in China and India.

Commodities - - Further demand for energy and industrial metals: An improving US and global economic outlook will likely boost demand for commodities, especially in the second half of the year. Francisco Blanch, head of global commodities research believes that two years of extremely lax monetary policy will lead to higher consumption of energy and industrial metals, especially in emerging markets. Oil, copper, platinum, and to a lesser extent, gold prices should move higher in 2010.

Recovery unfolding region-by-region; UK lags: While the global economic recovery is synchronised, exact timing depends on local conditions. Most economies started recovering in the third quarter of 2009. Countries that avoided a banking crisis, or which adopted a super-aggressive policy response, were the first to exit. The best example is China, which BofA Merrill Lynch Global Research predicts to grow by 10.1% in 2010.

Tighter fiscal policy and further rebalancing in the household and banking sectors are expected to weigh on the UK economy. The forecast for UK GDP growth is 1.5% in 2010. "The UK will share in the global upturn, but we expect it to lag many other major economies," said Nick Bate, UK economist. Most central banks are expected to scale back their monetary stimulus in the next two years. The pace will be determined largely by domestic conditions. Among the major central banks, the ECB will likely be ahead of the Bank of England, whereas the Fed will be last.