US & Eurozone

Figure 3 – Unemployment has not fallen as fast as after previous recessions

Figure 3 – Unemployment has not fallen as fast as after previous recessions

Slowing economic growth in the second half of 2012

  • After a promising start to the year, the US economic growth has slowed. Strong output and employment growth over the winter months, combined with a steady fall in the unemployment rate, had appeared to suggest that the US was on the road to recovery. However, data from the last 6 months has replaced optimism with renewed concern, with business and consumer confidence low for much of the summer. This has been reflected by both the Fed and the IMF downgrading their expectations for US economic growth in 2012 and 2013.
  • The US labour market continues to suffer. Job growth and improvements in unemployment have been modest. Overall unemployment has recovered more slowly compared to other recent recessions (see Figure 3).

What’s gone wrong?

  • Much of the slowdown in the pace of recovery can be attributed to a declining rate of job creation, which shrank by more than 75% between January and June. Weaker global conditions, particularly in Europe and Asia, and uncertainty around the ‘fiscal cliff’ — the $600bn worth of automatic tax rises and spending cuts due to come into effect on 1st January — explain much of this decline. In addition, an increase in the rate of deleveraging amongst households has further limited consumer spending.
  • It is not all bad news, however, as, the housing market is providing a rare source of optimism, with house prices increasing for 4 consecutive months, suggesting that the market may have finally ‘bottomed out’. An increase in residential investment should begin to provide increased revenue to manufacturers and retailers of durable goods, as well as those within the real estate and construction industries.

Figure 4 – The economic agenda is dominated by talk of unemployment and jobs

Figure 4 – The economic agenda is dominated by talk of unemployment and jobs

Policy responses and implications for business

  • The Fed has responded to this period of slow growth by announcing a third round of quantitative easing (QE3). Specifically, the Fed has said that it will purchase $4obn of mortgage-backed securities every month until the labour market improves “substantially”. This should provide further support to the recovering housing market and keep the cost of borrowing for firms low.
  • Unemployment is on top of the presidential candidates’ agenda (see Figure 4), but failure to deal with the approaching ‘fiscal cliff’ is probably the single greatest risk. The CBO estimates that it could increase unemployment to 9.1% and push the economy into negative territory if no action is taken. Figure 5 below sets out the candidates’ policy solutions.

Figure 5 – Key policy issues facing the presidential candidates

Area Policy issue and their impact on business Obama Romney
Taxes & Spending The impending ‘fiscal cliff’, $600bn worth of automatic tax rises and spending cuts, would slash consumer spending and business investment, potentially sending the US back into a recession. This would result in a further slump in business activity for firms in the US market.
  • Increase top-end taxes
  • Reform taxes to cut corporation rate to 28%
  • Taxes and spending cuts for deficit reduction
  • Tax reform to cut individual rates by 20%
  • Territorial corporate tax with 25% rate
  • Spending cuts only for deficit reduction
Jobs & Growth Persistently high unemployment rates and low growth limit production and consumer spending. This further leads to loss of skills, increasing firms’ costs when finding and recruiting new staff in the future.
  • Retrain workers to prevent outsourcing
  • Provide incentives for firms hiring domestically
  • Simplify and modernize business regulation
  • Invest in domestic sources of energy
Trade Increased international competition, particularly from China, threatens American businesses. Strengthening export markets and improving competitiveness are key to protecting and expanding US firms’ market share and revenue.
  • Pressure the WTO to maintain trade agreements
  • Provide tax credits to firms who promote American production
  • Open new markets
  • Confront perceived anti-competitive behaviour by Chinese firms

Figure 6 – Heatmap of economic fundamentals

Figure 6 – Heatmap of economic fundamentals

Figure 7 – Eurozone scenarios (real GDP growth, % change)

Figure 7 – Eurozone scenarios

The Eurozone is set to re-enter recession in Q3

  • Many economic fundamentals across the Eurozone are still at dangerously adverse levels (see Figure 6). In particular, persistently high levels of government debt and deficits continue to threaten the stability of the region. At the same time, planned fiscal consolidation measures are becoming increasingly difficult to implement, as shown by the intensifying social unrest, most notably in Spain, Greece and Portugal.
  • Our main scenario is for the Eurozone economy to contract by 0.7% this year and to be flat in 2013 (see Figure 7). The sustained manufacturing slowdown reflected by Purchase Managers' Index (PMI) activity indicators across the region, particularly in Germany, is contributing to the poor short-term growth outlook.

We may see progress towards a resolution in early 2013

  • Spain looks likely to apply to the European Stability Mechanism (ESM) for a credit line over this period. This move could also trigger bond purchases by the European Central Bank (ECB) in the secondary market to bring down Spain’s long-term cost of borrowing. Meanwhile, there are signs that the Eurozone periphery countries are starting to regain their competitiveness as unit labour costs fall (see Figure 6). Painful as this is, the adjustment will provide a foundation for a future recovery.

Our refreshed scenarios for the Eurozone

  • Our main scenario continues to assume loose monetary policy, additional rounds of ECB financing and greater fiscal transfers for the Eurozone periphery. By 2014, higher inflation could ease the debt restructuring burden, but output growth may still disappoint – constrained by the necessity of running budget surpluses.
  • Our first downside scenario involves a Greek exit but also a commitment by leaders of the remaining Eurozone countries to ‘do whatever it takes’ to save the euro. In practice, this will mean building a firewall around vulnerable economies and accelerating fiscal austerity measures in the periphery to avoid ‘the Greek fate’.
  • A more severe scenario assumes a Greek exit is contagious and the European authorities fail to keep the Eurozone together. A ‘new euro bloc’ of the strong economies forms, benefiting from capital inflows but suffering a higher ‘new-euro’ exchange rate and more stringent fiscal rules. The breakaway economies would face depreciation, soaring inflation and falling output but perhaps also a boost to exports.
  • However the crisis actually plays out, the one thing that is clear is that the structure of the Eurozone economy is fundamentally changing. Businesses need to recognise and respond to this in order to thrive in the future. This will involve reviewing whether their existing business models and supply chains can deliver in the ‘new normal’ environment.
  • More immediately, business leaders should watch out for potential trigger points along the way. Figure 8 sets out political events and data releases over the next couple of months which could have an impact on market sentiment.

Figure 8 – Potential flash points

November

Release of troika report on Greece (early Nov)

12-13th Eurogroup meeting

15th - Q3 GDP flash estimates

22nd-23rd European Council Meeting

30th unemployment figures

December

13th-14th European Council Meeting