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The global economic recovery remains strong in 2010 but the risks are mounting for 2011, according to economists at US investment bank Morgan Stanley.

The economists, Joachim Fels, Manoj Pradhan  and Spyros Andreopoulos, all based in London, say there is no need to worry about 2010 growth:They continue to forecast solid, above - -consensus global GDP growth of 4.4% this year  - - despite growth downgrades in Europe, a weaker Q1 in the US (largely weather - -related) and the recent softening in the China Manufacturing PMI (reflecting Chinese New Year seasonality, in their view).  Monetary and fiscal policies remain very expansionary around the globe, asset markets  - - though wobbly in January and February  - - continue to be supportive, and the rebalancing towards domestic demand - -led growth in EM (emerging market) economies is in full swing.  The economists say that the risks of a global double - - dip this year are low.  Rather, they think that economic growth could surprise on the upside over the next couple of quarters  - - the MS team in the US has a preliminary forecast for March payrolls for a whopping 300,000 gain!  The economists say they don't think that bond markets are prepared for positive growth surprises and they continue to look for rising yields.

But downside risks for 2011:At the same time, the MS economists believe that downside risks for the global economy in 2011 are mounting, for three reasons.

First, many central banks in EM are about to start tightening monetary policy, and they expect the Fed to nudge official rates higher from Q3 2010 and thus earlier than markets currently expect.  Monetary policy works with a lag, so most of this will only impact 2011 growth. Second, the MS macro team is looking for significantly higher bond yields this year and for a sell-off in developed equity markets. If so, it would dampen growth prospects for next year further. Third, the economists expect sovereign debt concerns to spread throughout the advanced economies as fiscal policy in most developed countries is on an unsustainable path. If (a big if, as discussed below) governments tighten fiscal policy significantly starting next year (this year, most countries are still easing fiscal policy), this would hurt growth.  But if they don't tighten, bond yields would likely rise even more and consumers would likely become even more cautious, again hurting growth. Taken together, the economists currently look for a moderate slowing of global GDP growth to 4% next year.  However, they say that the risks to next year's growth outlook are skewed heavily to the downside.

Upgrades/downgrades support MS global themes:The upgrades and downgrades to the regional GDP forecasts over the last three months serve to underline the first three of the five global economic themes which MS laid out in more detail three months ago.

1.  A tale of two worlds: EM over DM (developed markets):Upgrades to Asian GDP forecasts in February and a recent revision to Mexico have pushed up the global EM GDP growth estimate to 7%, from 6.5% last December.  Meanwhile, MS looks for relatively meagre 2.2% GDP growth in the G10 (Group of Ten advanced countries) this year, up a quarter point since December.

2.  BBB recovery in G10:The data flow over the past three months underscores the bumpy, below - - par and brittle nature of the recovery in the advanced economies. For bumpy, see the swing in US quarterly GDP growth from annualised 2.2% in Q3 2009 to 5.9% in Q4 2009, back down to an estimated 2% in Q1 2010 and back up to a forecasted 4% in Q2 2010. For below - -par and brittle, see the disappointing Q4 2009 outcome and the weak start into 2010 in the  Eurozone and the UK. 

3.  G3 growth differentiation:Moreover, the gap between the MS US growth forecast for 2010 (3.2%, up from 2.8% in December) and the Eurozone forecast (0.9%, down from 1.2%) has widened over the past three months. With the MS Japan team having bumped up its 2010 forecast by 1.4 points to 1.8% last month, Europe now looks likely to be the weakest link within the G3.

What fiscal tightening?Another of the five themes for 2010  - - an emerging sovereign debt crisis in the advanced economies  - - has come to the fore with a vengeance over the past three months due to the fiscal issues surrounding Greece and other peripheral European countries.  Many investors have concluded that high budget deficits in many countries will force governments to implement big spending cuts and/or tax increases over the next year or so.  However, the MS economists disagree. They expect 2011 budget deficits in the major advanced economies to decline only marginally from their (in many cases multi - -decade) highs in 2009/10:

• In the US, despite relatively solid economic growth, the MS team anticipates only a measly decline in the budget deficit from 11% of GDP in 2009 to 8.6% by 2011.
• In the  Eurozone, this year's budget deficit should rise to 7.1% (from 5.6% in 2009) despite tightening efforts in peripheral countries, mainly due to fiscal expansion in Germany, and decline only marginally to 6.3% next year.
• In the UK, a deficit reduction from 12.4% last year to 10% in 2011 is expected, though much depends on the outcome of the upcoming general election.
• In Japan, a further rise in the budget gap from 7.4% of GDP last year to 9.4% by 2011 is forecast.

The current MS judgement is that fiscal deficits will remain high as far as the eye can see in the major advanced economies.  In part, this is due to political complications.  In the US, gridlock looms after the mid-term elections in November; in Germany, Chancellor Merkel's junior coalition partner is pressing for further tax cuts; in France, presidential elections will be held in 2012; and in Japan, the government is weak. But economics also plays a role: the ‘BBB Recovery' will make governments reluctant to implement major fiscal tightening,. Hence, public sector debt levels are slated to rise further over the next couple of years. By 2011, general government gross debt as a percentage of GDP exceeding 90% in both the US and the Eurozone, approaching 90% in the UK, and exceeding 200% in Japan (before offsetting Japanese pension funds bringing the level abve 110%).

Implications of rising debt:The ongoing fiscal malaise has three main implications. First, while fiscal, combined with monetary, stimulus has been instrumental in avoiding another Great Depression and stabilising the financial sector, high structural deficits and rising public debt will weigh down on the growth potential in coming years.  Consumers are likely to become more ‘Ricardian', trying to offset public dis-saving by saving more in anticipation of higher future taxes and lower future transfers.

Second, fiscal concerns and the flood of government bond issuance are likely to induce investors to demand a risk premium in government bond yields across the developed world, thus contributing to a significant increase in bond yields this year. This, in turn, will contribute to slower growth in 2011.

Third, rising public debt levels increase the incentive for governments and central banks to inflate away some of the debt, especially as only some of the debt rolls over every year and as investors have usually been slow to take on board shifts in the inflation regime.  Thus, rising debt raises the spectre of inflation  - - another reason to look for higher bond yields this year.