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Five themes for the global economy in 2010: Joachim Fels, a Managing Director and US investment bank Morgan Stanley's Chief Global Fixed Income Economist and Strategist, based in London, says last year was all about the exit from the Great Recession - - and it worked courtesy of massive global policy stimulus, as expected. This year will be all about the exit from super- - expansionary monetary policy. MS expects the major central banks to start exiting around the middle of this year. He says the recovery in advanced economies will be creditless and jobless.

He says central banks will likely be cautious, gradual and transparent, but the prospect and process of withdrawal may have unintended consequences and government bond markets will be the first victim. While the exit will be the dominant macro theme, he identifies five important economic themes in its global economic outlook that should be highly relevant for investors in 2010. 

2.         ‘BBB recovery' in the G10: MS expects the recovery in the advanced economies to be creditless and jobless, making it bumpy, below- -par and boring.

3.         G3 growth differentiation: MS sees the US as the growth leader among the G3, the Eurozone to lag behind, and Japan to double- -dip.

4.         ‘AAA liquidity cycle' remains intact: Central banks will crawl rather than rush towards the exit, so global liquidity continues to be ample, abundant and augmenting. 

5.         Sovereign and inflation risks on the rise: 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.

1. A Tale of Two Worlds

MS forecasts 4% global GDP growth this year, which would be a fairly decent outcome, especially compared to the doom and gloom that prevailed for much of last year. However, it falls short of the close to 5% average annual GDP 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.

"Importantly, our 4% global GDP growth forecast masks two very different stories. One is a still fairly tepid recovery for the advanced economies, the other a much more positive outlook for emerging markets, where MS forecasts output to grow by 6.5% this year (China 10%, India 8%, Russia 5.3%, Brazil 4.8%), up from 1.6% in 2009," Joachim Fels says. "A rebalancing towards domestic demand- -led growth in EM is well underway. Moreover, as our China economist Qing Wang has pointed out, the official statistics are likely to vastly underestimate the level and growth rate of consumer spending in China. In short, we think that the theme of EM growth outperformance has staying power and has even been bolstered by the crisis."

2. ‘BBB Recovery' in the G10

In contrast to the upbeat EM story, MS forecasts barely 2% average GDP growth in the advanced G10 economies this year - - a ‘BBB recovery' where the three Bs stand for bumpy, below-par and boring. On MS estimates, GDP growth averaged around 2% in the G10 in H2 2009 and won't accelerate much from that pace this year. The two key reasons why the recovery in the G10 will be ‘BBB' are that it is likely to be creditless and jobless. Creditless recoveries - - 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.  Creditless recoveries typically display sub-par economic growth as credit intermediation is hampered. Moreover, MS expects a jobless G10 recovery, with unemployment in the US declining only marginally this 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. 

3. G3 Growth Differentiation

Beneath the surface of a lacklustre ‘BBB recovery' in the advanced economies lies a differentiated story for the three largest economies - - the US, Europe and Japan. Significant growth differentials between these economies in 2010 may well become a topic for currency, interest rate and equity markets again. MS sees the US as the growth leader among this group, with output expanding by 2.8% (annual average) in 2010. The Eurozone looks set to grow by less than half that rate (1.2%), while Japan should hardly grow at all (0.4%) and is forecast to actually fall back into a technical recession in the first half of this year. One reason for US outperformance is that the creditless nature of the recovery affects the US 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 last year, so US labour markets look set to recover (albeit slowly) this year, while MS expects unemployment to rise further in both Europe and Japan.  Further, European and Japanese exporters should feel the pain from last year's currency appreciation, whereas US exporters should benefit from last year's dollar weakness.

4. ‘AAA Liquidity Cycle' Remains Intact

The beginning of the exit from super-expansionary monetary policies will likely be the dominant global macro theme in 2010.  MS expects the Fed, the European Central Bank and the People's Bank of China to move roughly in tandem and raise interest rates beginning in Q3 2010, with the Bank of England following in Q4. Some, like India, Korea and Canada, are likely to move earlier, while others, such as Japan, will lag behind. 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 twists in the crafted language and partly through cautious draining of excess bank reserves.

Joachim Fels says the end of easing and beginning of exit can be expected to cause wobbles in financial markets - - one reason why MS see bonds selling off sharply this year.  However, official rates are likely to stay well below their neutral levels 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 the ‘AAA liquidity cycle' (ample, abundant and augmenting) - - the main driver behind last year's asset price bonanza and economic recovery - - fairly intact this year. The metric MS follow to validate or refute this view is its 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 last year, and is expected to rise further, though at a much lower pace, through 2010.

5. Sovereign and Inflation Risks on the Rise

Fels says sovereign risk and inflation risk will be major themes for markets this year.  Greece's fiscal problems are only a taste of things to come in other advanced (not emerging) economies. Fiscal policy looks set to remain expansionary in all major economies this year, as the ‘BBB recovery' still requires support. However, markets are likely to increasingly worry about longer - - term fiscal sustainability. The issue is not really about potential sovereign defaults in advanced economies. These are extremely unlikely, for a simple reason: Most 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, their central banks can print whatever is needed (call it quantitative easing). Thus, sovereign risk translates into inflation risk rather than outright default risk. MS expects markets to increasingly focus on these risks, 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.

SEE also today's Finfacts report: Multi-billion bond fund manager Bill Gross warns US economy not strong enough for government to “gracefully exit” stimulus spending programs