In 2010, the European economy should transition towards a more sustainable, albeit still sub-par, recovery. Economists at US investment bank, Morgan Stanley, say this economic transition will be reflected by a shift in the engines of growth from a swing in the inventory cycle towards an ongoing recovery in domestic demand and net exports. This transition is unlikely to be smooth, though. They say investors should brace themselves for potential setbacks in the course of the next few quarters. The new MS quarterly forecast profile suggests a gradual slowdown in growth momentum over the course of the year. The prognosis is that until some domestic demand dynamics start to materialise, the European economy remains in what could be called the no man's land of the business cycle.
The MS economists Elga Bartsch and Daniele Antonucci, both based in London, say that monetary and fiscal policy decisions will move from triage treatment towards long-term rehabilitation. Thus, exit strategies will likely be a focus for financial markets. With a few exceptions (the UK, Spain, Ireland and Greece), they don't expect any meaningful fiscal policy tightening in 2010. Hence, the fiscal policy issue is mainly about preparing the budgets for 2011 and beyond. These are likely to bring more meaningful tightening in order to ensure a return to fiscal sustainability over the medium term. As such, they will be key in shaping medium-term growth expectations too. Monetary policy, by contrast, will likely start exiting its current ultra-expansionary stance in late 2010. The anticipation of the new tightening cycle should cause higher bond yields and wider country spreads.
From an inventory-led bounce in industrial activity to a broader demand-based recovery: The economists say, as expected, the European economy emerged from recession in mid-2009. The trigger was a turnaround in the inventory cycle, a normalisation in global trade flows and a policy-induced stabilisation of the financial system. With the global economy clearly having turned the corner courtesy of buoyant growth in emerging markets, and with the euro's unrelenting ascent having been stopped for now, a revival in external demand is already coming through in the quarterly GDP reports. The key question for 2010, however, is whether the initial spark that ignited the engine will translate into a broader domestic demand recovery. MS says that until these domestic demand dynamics materialise, the European recovery remains vulnerable. There is no mistaking the considerable headwinds still faced by both consumers and corporates. After a steep decline in 2009, MS therefore looks for what is probably best described as a stabilisation in domestic demand.
Investment spending still struggles with subdued capacity utilisation and what companies argue are tight financing conditions. Yet, rising business confidence and rebounding corporate profits should suffice to create a small rise in machinery and equipment investment - consistent with repair and replacement and possibly some rationalisation projects - in the course of the year. Construction investment is a much more diverse story, driven by local property prices, public infrastructure projects and excess capacity issues. Public construction investment aside, the economists expect construction investment to lag behind capital goods investment in 2010. For the year as a whole, investment spending will likely stagnate due to a negative statistical overhang from 2009.
Consumer spending is to be dampened by a rise in unemployment, modest gains in wages and an increase in inflation: Bartsch and Antonucci say that in terms of their debt load, balance sheets and savings rate, European consumers are in better shape than their US and UK counterparts. But the lower number of layoffs recorded in Europe since the start of the recession suggests that part of the labour market adjustment is still to come - - after all, activity shrank more sharply on this side of the Atlantic. Thus far, tighter employment legislation, voluntary labour hoarding and government-sponsored short-shift programmes have prevented an adjustment in labour costs. The economists see payrolls being trimmed further and expect the Eurozone unemployment rate to rise well into H2 2010. Against this backdrop, and factoring in the expansionary fiscal policy measures taken by several governments, they forecast broadly stable consumer spending for 2010. After what likely will be a marked contraction in 2009, a stabilisation can already be regarded as an achievement in itself.
After a marked divergence in growth between countries in 2009, they expect to see some renewed convergence in 2010. Export-oriented countries with sizeable industrial sectors, such as Germany and Sweden, will outperform in terms of headline GDP growth. However, the bigger bounce-back partially reflects that they were hit harder by the global trade slump than many of their counterparts. The economists expect other countries, such as Spain and Ireland, which were hit hard by the financial turmoil, to continue to underperform as they work their way through the aftermath of a property price bubble, a construction boom and a savings-investment imbalance. Both are making good progress though in rebalancing their economies and should be able to return to positive GDP growth in 2011.
The ECB, the BoE and Sweden's Riksbank will start raising rates gradually in H2. In total, they expect the ECB and the Riksbank to hike by 50bp (0.5%) and the BoE by 75bp by the end of 2010. In conjunction with raising rates, central banks will also begin to unwind their quantitative easing (QE) measures. This unwinding might at least partially precede the first interest rate hikes, but will unlikely be completed before the start of the new interest rate tightening cycle. The details of the unwinding of QE are largely determined by the QE strategy pursued during the market turmoil. The ECB and the Riksbank have resorted to passive QE via their various refi/repo bank liquidity funding operations. Hence, unwinding QE will affect the banking system directly and asset markets indirectly. Meanwhile, the BoE pursued a strategy of active QE, where it purchased assets directly in the open market. Unwinding these measures will thus likely affect markets more directly and banks more indirectly.
At this stage, the MS economists says there has been little indication that unwinding of QE or rate hikes are imminent. The ECB signalled that it is no longer willing to offer one-year funding at a fixed rate of 1% - - instead opting for a tracker rate reflecting the average refi rate in 2010 - - and that it will phase out its one-year and its six-month LTROs during the year. The cornerstone of the ECB's QE, the fixed-rate tenders with full allotment (which allow the banking system to draw down unlimited funds from the ECB), will remain in place for as long as it takes though - at least until spring 2010. Under this operational set-up, the overall liquidity entirely depends on the bids submitted by banks - unless, of course, the ECB takes additional action (e.g., reverse tenders). Where the EONIA overnight rate and the EURIBOR money market rates trade relative to the ECB refi rate therefore depends on these bids too. Hence, in addition to the two factors that would normally drive EONIA - - the ECB's decision on the refi rate and/or the deposit rate and the ECB's liquidity provision (notably the decision to drain liquidity from the system via conducting reverse tenders or by issuing debt certificates) - - the third risk factor is the banks' bidding behaviour. Thus far, overbidding by banks has caused excess reserves to swell and pushed market rates well below the policy/benchmark rate of 1%. But this bidding behaviour could change going forward, potentially causing the market rate to jump higher.
The unwinding of QE will likely have marked effects on money markets, bond markets and country spreads. The heavy use of the ECB's refi facilities allowed banks to become big buyers of bonds. Since the start of the turmoil, Eurozone banks have added about €330 billion to their holdings - - effectively indirect QE via the banks. These purchases have likely helped to lower benchmark bond yields. But the main beneficiary probably was the EMU periphery.
The economists say that less generous liquidity provision this year is likely to have repercussions on the Eurozone government bond markets. During the credit crunch, intra-EMU (European Monetary Union) spreads were characterised by a high degree of co-movement, reflecting systemic concerns; they think that country-specific factors are likely to play a bigger role again in 2010. The start of another ECB tightening cycle should also contribute to wider spreads across the board, as it has done historically. Eligibility for the ECB's collateral pool, which is scheduled to revert back to A risk assets - - at the end of 2010, could become another country-specific concern for investors in 2010.
Key Surprises for the European Economy
The MS base case for the Eurozone economy in 2010 is that of a lacklustre, sub-par cyclical recovery,subdued consumer price inflation and a hesitant removal of policy stimulus in H2 2010. MS and the consensus expect the European economy to expand by around 1% this year, thus recovering only some of the ground lost when the currency union plunged into the deepest recession in post-war history. With capacity utilisation still extremely low and unemployment set to rise until H2 2010, domestic demand dynamics will likely remain rather muted. Overall, MS believes that the risks to its baseline forecasts are broadly balanced.
It considers four potential macro surprises that could challenge the outlook and the market consensus. The main surprise element is the qualitative direction in which they would affect the macro outlook, not necessarily the quantitative measure in which they occur. As such, they are not part of the base case and only some are among the factors underlying the bull and bear scenarios. However, none of these surprises seems to be priced into financial markets or much talked about by macro thinkers at this stage. The potential surprises include:
1. A late-cycle credit crunch seriously curtails access to bank lending in the non-financial sector.
2. Brisk growth in emerging economies and/or renewed supply setbacks cause another surge in commodity prices.
3. Ample liquidity helps to keep government bond yields subdued, notwithstanding massive debt issuance.
4. Country-specific political risks replace systemic risk concerns in driving intra-EMU spreads, but matter less than expected in the UK.
Surprise #1
A late-cycle credit crunch seriously curtails access to bank lending, causing the recovery in investment spending to falter.
MS says a year ago, everyone, including itself, talked about the credit crunch as a serious risk to the economic outlook. But, what they were debating at the time should probably have been more accurately labelled a liquidity crunch for banks and corporates in funding markets. Since then, credit spreads have contracted sharply, corporate debt and more recently equity issuance have surged, and financial institutions have been propped up by a variety of government measures. Lately, Eurozone and UK banks have projected looser credit standards. Effective interest rates on loans have been falling for a while. The MS banks team believes that the provisioning cycle has likely peaked. While companies will initially be able to draw on internal cash flows, eventually they will likely need external funds to bump up investment spending - - even if it is largely to repair and replace - - and possibly also for re-stocking. If they cannot obtain these funds, the rebound in activity following a turnaround in the inventory cycle could quickly reverse.
At this (vulnerable) stage of the recovery in Eurozone domestic demand, the yet-to-be crystallised write-downs, timid recapitalisation and excessive reliance on ECB funding might backfire in a financial system that is still largely bank-based. Such a credit crunch could potentially be a particular problem in Germany, which ironically is the only large Eurozone country that deleveraged in recent years and which - - as its current account surplus shows - - enjoys a funding overhang from domestic savings. A credit crunch would spell bad news for growth in the near and medium term and would likely hit investment spending hard. More prolonged feedback effects between bank profitability and economic growth in bank-based financial systems could make the credit crunch a constant feature weighing on Eurozone growth in the coming years. In contrast to the earlier liquidity crunch, there would be little that the ECB could do, for it cannot boost banks' equity capital buffers. This would need to come from either governments or private investors. Without decisive government action, it could not be ruled out that Eurozone banks just shrink their loan books.
Surprise #2
Emerging economies expanding at a brisk pace and/or renewed supply setbacks fuel another surge in commodity prices.
In this scenario, a surge in commodity prices would put additional pressure on companies' profit margins, eat into consumers' purchasing power and potentially force central banks to hike interest rates earlier than expected if higher commodity price inflation spills over into higher inflation expectations. As a result, the composition of nominal growth would likely become more much stagflationary again, at least initially. The commodity price surge could be triggered by further upside surprises on growth, especially in EM, on the back of the unprecedented monetary and fiscal stimulus that has been put into place globally, or by a disruption in the supply chain, say, due to geopolitical events. For example, the price of oil might rise noticeably through the US$100/bbl mark, in line with MS commodity strategists' bull case and above the US$81/bbl implied by the forward curve. Such an overshoot would hit commodity importers particularly hard, such as virtually all the European countries with the exception of Norway and (to a much lesser degree) the UK.
Although this implies stronger European exports to commodity producers, the overall effect on economic activity would be detrimental, for three reasons. First, European companies would face significant pressure on profit margins, which are already under stress, as employment and hence labour costs have not fallen a great deal. Second, European consumers would need to tighten their belts even further, as was the case during the 2008 commodity-driven inflation shock. Third, the feed-through of higher commodity prices into inflation might push inflation expectations - which have remained relatively well-behaved for now - higher. As a result, central bankers could be forced to move earlier and more boldly than the MS base case forecasts show.
If central bankers didn't act to anchor inflation expectations, a sharp rise in bond yields could equally derail the recovery. In this scenario, money markets would probably start to price in earlier and more aggressive tightening, and risky asset markets would probably be affected too. A sharper tightening of monetary policy - especially if coupled with faster fiscal consolidation in the face of rising interest payments - might well push the European economy into another (this time policy-induced) recession. Eventually, the commodity price shock would likely add to renewed deflationary pressures.
Surprise #3
Ample liquidity keeps government bond yields subdued, notwithstanding massive debt issuance.
Consensus is forecasting benchmark ten-year Bund yields to reach 3.8% in late 2010, some 60bp above the current level of 3.16%. MS is even more bearish on bonds and forecast ten-year Bunds to break above 4% in H2 2010. Thw MS interest rate strategy team would be short the long end and long forward-curve steepeners. The reasons for rising bond yields are not difficult to find: ongoing economic recovery, abating deflation risks and tightening monetary policy (through traditional interest rate hikes and unwinding unconventional quantitative easing).
The wildcard in all of this is to what extent the unprecedented excess liquidity created by central banks globally in the past year and still sloshing around the global financial system could find its way into the government bond market. In the Eurozone, additional demand has come largely from banks, which have added €330 billion to their government bond holdings since October 2008. With monetary policy still expansionary and policy rates potentially staying low for longer than the base case forecasts show, government bonds might actually be better bid. Additional demand for bonds could come from asset reallocation away from risky assets and from looming bank regulation on liquidity buffers (the latter particularly likely to provide a natural buyer of bonds in the UK). Finally, if a credit crunch causes deflationary concerns to resurface, bond yields could potentially fall further from current levels - as they did in Japan in the 1990s.
Surprise #4
Country-specific political risks replace systemic risk concerns as a driver of spreads in the Eurozone.
In 2009, spreads in the Eurozone periphery were characterised by a very high degree of co-movement, suggesting that systemic concerns were the main driver. In 2010, the focus could swing towards country-specific issues. None of the Eurozone countries has the option of inflating their way out, something that is still possible for EMU ‘outs'. The economist argue that the ability of countries to address the fiscal policy challenges ahead crucially depends on the institutions. Of course, these challenges also differ between countries, depending on their fiscal position before the crisis, how hard they were hit by the crisis, and the size of subsequent stimulus packages. But to what extent they can be tackled successfully will very much depend on the institutional set-up. For starters, the extent to which the electoral system generates clear political mandates to rein in budget deficits is important. Where the system generates fragmented coalitions or hung parliaments, matters become more complicated. Whether a clear mandate can be executed also depends on the degree of administrative centralisation. Countries with a federalist structure - one - that grants financial independence to lower levels of the administration - - might find it harder to successfully implement their budget plans (Germany, for example).
In the MS view, rich developed countries would only experience a sovereign debt crisis if they became unable to act because of a political stalemate or unwilling to act because the costs of doing so were deemed higher than the benefits. The latter is especially relevant within the Eurozone, where the disciplining effect of a potential currency crisis is absent. In this case, often a sizeable share of securities held in other Eurozone countries and substantial spill-over effects onto the borrowing costs of other countries create incentives for looser policy. Outside the Eurozone, a sovereign debt crisis could call the independence of the local central bank into question. Within the Eurozone, the ECB's independence might be put to the test if the government debt of one country were to become in danger of not making the A- cut-off for eligible collateral when it reverted back to the pre-crisis pool at the end of 2010. In this case, the ECB would face a very difficult decision indeed.
Germany - Taking a Breather Before the Budget Savings Start
In 2010, Germany is likely to outperform most other European countries. MS expects Europe's largest economy to expand by an above-trend 1.9%, compared to only 1.2% for the Eurozone. The forecasts are a littel above the current market consensus (1.7%). But contrary to many other forecasters, MS expects the recovery to lose momentum into 2011, when it projects growth to ease to the trend rate of 1.2%. The absence of further gains in business expectations and a marked correction in orders and production in October suggest that Q 3 2009 might already have been the strongest quarter in terms of growth. Germany's outperformance is partially a mirror image of it being hit much harder by the global recession due to its greater export-orientation and its bigger industrial sector. Having contracted a total 6.7% from its Q1 2008 peak, German GDP will likely recover a cumulated 3.1% by Q4 2010. This would leave activity still 3.6% below the peak and would close most of the gap to the Eurozone, where GDP should stand 3.2% below the peak, despite a more muted recovery outside Germany.
The outperformance also reflects a larger fiscal support package, which was upped again by another €8.5 billionjust before Christmas and now totals 2.3% of GDP - - an increase of 0.8% over the stimulus already implemented in 2009. In addition to cutting income taxes and social security contributions, raising child and healthcare tax credits and investing more in public infrastructure, the new centre-right government decided to lower corporate taxes, raise child benefits further and extend short-shift subsidies. As a result, the budget deficit will likely increase from around 3% in 2009, to more than 5% in 2010 - - which would still make Germany's budget deficit one of the lowest in the Eurozone! While the stimulus will help to support domestic demand, brisk headwinds still lie ahead. These stem most notably from the labour market. Thus far, the labour market has held up surprisingly well, thanks to a massive extension in short-shift subsidies and, also, some voluntary labour-hoarding by companies that are concerned about a shortage of skilled workers. The main adjustment came via a marked reduction in the hours worked per employee. As these reductions weren't matched by wage cuts, unit labour costs surged. Looking ahead, MS expects a marked reduction in payrolls by a total of 1.4% and a perceptible moderation in wage increases.
From an inventory-led bounce in industrial activity to a broader demand-based recovery: The lack of labour cost cutting, very low capacity utilization rates and a renewed moderation of export demand suggest to us that the recovery in investment spending will likely be muted. This holds in particular for investment in machinery and equipment, where only the phasing-out of the more favourable depreciation rules at end-2010 add a temporary boost to an otherwise anaemic recovery. Similarly, consumer spending will likely be held back by ongoing job losses, a renewed rise in inflation and the prospect of a multi-year fiscal consolidation starting in 2011. Even leaving the pay-back from the car scrapping scheme aside, purse strings will likely remain tight and savings elevated. Domestic demand should expand only moderately, after a sharp contraction in 2009. The main risk to the outlook is a credit crunch as discussed in the previous section.
German policymakers will have to make tough decisions: For starters, the draft budget for 2011 due in July will have to reconcile the election promise to cut income taxes noticeably with the need to rein in the budget deficit. Substantial budget savings are needed to comply with new constitutional ‘debt brake' and the European Stability and Growth Pact (SGP). In addition, policymakers will have to fend off pressure to revive the car industry, which will likely see sales falling after the end of the car scrapping scheme. Finally, the financial sector, notably the state-owned Landesbanks and savings banks, have to be put back on a healthy financial footing.
France - Saved by Consumers
The French economy held up better than the Eurozone as a whole during the turmoil and is likely to outperform in 2010 too, although to a smaller degree relative to the previous year. This resilience is due, at least in part, to a more rigidly regulated economy. However, this will likely hamper France's long-term growth prospects. MS is more bullish than the consensus for 2010, but expect the economy to decelerate in 2011. The two main themes for this year are:
1. Domestic demand will continue to face several headwinds - - but will remain more robust than in the Eurozone as a whole:A housing market correction is now underway. The economists do not anticipate prices to fall as much as in hotspots such as Spain and Ireland, but with lending conditions still tight and unemployment rising, the risks are skewed to the downside. More broadly, France is the major Eurozone country showing the biggest discrepancy between firms' assessment of order books and inventories. This gap will likely close in the coming quarters. This can happen in two ways. The first possibility is that demand starts to improve more visibly, in line with the base case. The second is that firms start seeing their stock of inventories less optimistically. Clearly, there are grounds to remain cautious. However, relative to the other major Eurozone members, as well as the consensus, MS thinks that the stimulus put in place and some new fiscal measures augur for a better outlook, especially on the consumer front.
2. Fiscal policy will remain expansionary and aggravate the deficit - - tightening to start in 2011:Given the size of the budget deficit, fiscal leeway will be limited in 2010. At the same time, the economists don't expect a tightening either, at least while the economic outlook remains uncertain.
A national loan plan called the ‘Grand Emprunt' will be put in place in early 2010. The amount is around €35 billion. Almost €13.5 billion in state aid repaid by the banks will be used to finance the loan. This means that approximately €22 billion will be raised by tapping the market. The loan aims to fund investment in sectors that could strengthen France's competitiveness and growth potential in the long term, ranging from higher education and research to renewable energies and digital technologies. France is pursuing supply-side policies that could even help reduce the deficit, thanks to the future ‘economic dividends' of a strengthened economy.
In the short term, however, the loan will weigh on France's public finances. Of course, the investments will be spread over several years, thus affecting the 2010 budget only to a limited degree. MS thinks that the impact on government debt will amount to slightly less than 1% of GDP this year and a debt-to-GDP ratio of 82.3% in 2010 and 88.5% in 2011, is forecast. Although there is no indication of eventual tightening plans, MS say 2011 is likely to see the beginning of fiscal restraint.
Italy - The Aftermath of the Crisis
Like other advanced economies, Italy is now expanding again. However, the main issue for 2010 relates to how quickly and to what extent the country will recover, for three reasons:
1. Trend growth will be lower than before the crisis:The economic fallout of the financial turmoil damaged both labour productivity and the labour force. MS estimates that Italy's potential growth rate will be negative this year, and average 1% between 2011 and 2014 - - below the pre-crisis estimate of 1.2%. The main takeaway for investors is that extrapolating into the future the pre-crisis growth rate of potential GDP might be too optimistic. If the recession lowered the pace at which the Italian economy can sustainably expand, the rate of growth of aggregate corporate profits, over the long term, will be lower too.
2. Period of disinflation ahead, but price pressures might emerge sooner than later:Lower trend growth implies a smaller output gap relative to the pre-crisis baseline scenario. Indeed, the standard measures of the output gap, taken at face value, point to outright deflation. MS disagrees with that view. If the economy's productive capacity has been damaged by the recession, the output gap might not be as big as these calculations suggest. In turn, this implies weaker deflationary pressures. However, the country is likely to go through a prolonged period of disinflation. However, price pressures will emerge sooner rather than later and the above-consensus call on inflation is maintained.
3. Limited ability to carry a higher debt load, but Italy's fiscal prudence during the crisis augurs well:MS says Italy's likely return to a slight primary budget surplus, i.e., a surplus in the budget balance excluding interest payments, will help sustain a high and rising debt burden. However, for a swifter reduction of the debt-to-GDP ratio, the rate of nominal GDP growth should be higher than the interest rate that Italy has to pay on its debt. With potential growth even more subdued than before, bringing down the public debt to an acceptable level will be more difficult. The good news is that markets don't seem excessively concerned about Italy's fiscal situation - - owing to the fiscal prudence the country showed during the market turmoil.
Of course, none of this means that Italy will not continue to recover: MS expects an expansion of around 1.2% in 2010, some 0.4% above the consensus view. The short-term outlook, however, remains challenging. After considerable disappointment in the industrial production numbers over the past couple of months, an economic ‘double dip' at the turn of the year cannot be ruled out. Indeed, while this is not the central scenario, the MS GDP indicator - - which is based on a numbers of indicators ranging from industrial production to the yield curve - - does suggest that this is a real possibility.
Spain - More Rebalancing and Retrenching Ahead
MS has five reasons for thinking that Spain will contract outright in 2010 - - unlike other major European countries - - and expand far slower than the Eurozone in 2011:
1. Stabilisation in the construction sector still far off: The construction sector is still unlikely to stabilise any time soon. With house prices overvalued by as much as 30% on some metrics, the economists don't expect a return to positive growth rates in construction investment until end-2011.
2. Consumer spending likely to remain anaemic:Although the job shakeout will be sharper but shorter in Spain than in the rest of the Eurozone, a revival in consumer spending this year is too much to hope for. With wage growth set to slow further, private consumption will lack support.
3. Private sector deleveraging to weigh on the economy:Private sector deleveraging will continue for quite some time. The pass-through of lower official and market interest rates to mortgage and corporate loan rates might provide some relief, but it is unlikely to prevent a period of belt-tightening altogether.
4. Constraints to credit availability to remain in place:Credit will continue to remain a scarce resource over the next two years. With still considerable uncertainty over potential losses, banks may remain reluctant to lend, even if the government ensures that they are well capitalised.
5. Fiscal stimulus to be scaled back this year:With a ballooning budget deficit and long-term sustainability problems in its public finances, Spain looks set to be one of the first countries in the Eurozone to scale back its stimulus measures. Tax hikes are on the agenda as early as this year.
The good news is that Spain's adjustment is happening at a fast pace.With GDP contracting less than employment, labour productivity growth has accelerated. If sustained, these gains will lower Spain's unit labour costs and boost export competitiveness. With export demand likely to be subdued even in the MS best case, this might prompt an export-led recovery further down the line and help the rebalancing of an economy that has been driven primarily by domestic factors during the boom years.
The main takeaway for investors is that, with its economy still out of balance, Spain has to endure a structural adjustment.While most of its European neighbours have been affected by the same cyclical headwinds - - from the commodity-driven inflation shock last year to the economic fallout of the financial turmoil in 2009 - - they do not have to simultaneously address imbalances of the same scale. Spain looks set to be one of the last economies in the Eurozone to emerge from recession.
Sweden - Still the Best Show in Town
On the MS updated 2010 forecasts, the economists expect Sweden to deliver the strongest growth in Western Europe. Sweden returned to positive growth in Q2 2009. Since then the recovery has gained momentum, most notably in Q4 2009. Sweden is in better shape than most other European countries when it comes to the drivers of growth in 2010.
For starters, the policy stimulus in Sweden is very sizeableboth for monetary policy and for fiscal policy, with the Riksbank aiming to keep its repo rate at 0.25% until late 2010 and the government implementing additional discretionary fiscal stimulus of 1.2% of GDP in 2010. In addition, an undervalued currency boosts export demand along with the revival in the global economy. Given that industry accounts for nearly a quarter of the Swedish economy - - a considerably larger share than in the UK or US - - this is a key reason for the outperformance. That said, export demand is likely to be less buoyant than previous recoveries - - thanks to an appreciating SEK and relatively sluggish growth in the rest of Europe.
Hence, most of the momentum will come from domestic demand. Consumer spending is being supported by low interest rates, robust real estate markets and additional income tax cuts. In addition, government spending has been upped, notably at the local level. Balance sheets, especially in the household and the government sector, are healthy and banks weathered the storm reasonably well - - despite their Baltic exposure. One notable difference with the Eurozone is that consumer bank lending is still expanding robustly in Sweden. Sweden has experience in successfully handling a financial crisis as it eventually emerged strongly from the banking crisis of the early 1990s. This experience should have a positive impact on consumer/corporate sentiment and on policymakers' willingness to take bold actions, if needed.
Inflationary pressures will likely stay low, allowing the Riksbank to continue its extra-expansionary policy. Unemployment will likely rise further, albeit at a slower pace, and is likely to stay elevated for quite a while. With the output gap remaining wide, pricing power will likely stay low, also for trade unions representing workers in the upcoming wage talks. In addition, a stronger SEK will likely cap imported inflation pressures. Only once the Riksbank starts to hike interest rates is headline CPI likely to pick up noticeably due to the impact on the mortgage interest rate payments.
The Riksbank will only gradually remove some of its policy stimulus in autumn 2010. MS expects it to start raising rates in September 2010, slightly ahead of what its own repo rate forecast shows. As two out of six executive board members continue to expect an earlier tightening, MS see little reason at this stage to alter the call for the tightening to start in Q3 2010. Subsequently, it expects the bank to nudge rates gradually higher by another 25bp in 4Q10.
The Riksbank conducted its unconventional policy measures via its lending to the banking system. These measures will reverse quasi-automatically once the loans mature. Initially loans were offered at three- and six-month maturity and later at one-year maturity as well. The Riksbank still offers these loans at a variable rate that is tracking the repo rate, but decided to stop offering fixed-rate loans at the December meeting. For variable-rate loans, the Riksbank has presented a timetable until the end of February.
MS expects the Riksbank to gradually reduce the amount of liquidity in 2010 by allowing the existing loans to roll off. Indeed, the bank has already phased out some emergency measures. It also ended its USD auctions against Swedish collateral. Finally, it raised the spread for its variable rate auctions in early November, when the bank decided to raise the spread over the repo rate from 15bp to 25bp for maturities below one year and to 30bp for one-year loans. The outstanding loans to the banking system have created a structural liquidity overhang of around SEK 300 billion until later in 2010.
