The 4 Biggest Downside Risks To The Global Economy

While recent developments seem to suggest some positive news for the global economy, there are at least four downside risks that could materialize this year – undermining global growth and eventually negatively affecting investor confidence and market valuations of risky assets.

Say a Prayer: The Worst Could Yet Come

RIO DE JANEIRO – Since late last year, a series of positive developments has boosted investor confidence and led to a sharp rally in risky assets, starting with global equities and commodities. Macroeconomic data from the United States improved; blue-chip companies in advanced economies remained highly profitable; China and emerging markets slowed only moderately; and the risk of a disorderly default and/or exit by some members of the eurozone declined.
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Moreover, under its new president, Mario Draghi, the European Central Bank appears willing to do anything necessary to reduce stress on the eurozone’s banking system and governments, as well as to lower interest rates. Central banks in both advanced and emerging economies have provided massive injections of liquidity. Volatility is down, confidence is up, and risk aversion is much lower – for now.
But at least four downside risks are likely to materialize this year, undermining global growth and eventually negatively affecting investor confidence and market valuations of risky assets.

 

First, the eurozone is in deep recession, especially in the periphery, but now also in the core economies, as the latest data show an output contraction in Germany and France. The credit crunch in the banking system is becoming more severe as banks deleverage by selling assets and rationing credit, exacerbating the downturn.
Meanwhile, not only is fiscal austerity pushing the eurozone periphery into economic free-fall, but the loss of competitiveness there will persist as relief at the waning prospect of disorderly defaults strengthens the euro’s value. To restore competitiveness and growth in these countries, the euro needs to fall towards parity with the US dollar. And, while the risk of a disorderly Greek collapse is now receding, it will re-emerge this year as political instability, civil unrest, and more fiscal austerity turn the Greek recession into a depression.

Second, there is now evidence of weakening performance in China and the rest of Asia. In China, the economic slowdown underway is unmistakable. Export growth is down sharply, turning negative vis-à-vis the eurozone’s periphery. Import growth, a sign of future exports, has also fallen.

 

Similarly, Chinese residential investment and commercial real-estate activity are slowing sharply as home prices start to fall. Infrastructure investment is down as well, with many high-speed railway projects on hold and local governments and special-purpose vehicles struggling to obtain financing amid tightening credit conditions and lower revenues from land sales.
Elsewhere in Asia, Singapore’s economy shrank for the second time in three quarters at the end of 2011. India’s government predicts 6.9 percent annual GDP growth in 2012, which would be the lowest rate since 2009. Taiwan’s economy fell into a technical recession in the fourth quarter of 2011. South Korea’s economy grew at a mere 0.4 percent in the same period – the slowest pace in two years – while Japan’s GDP contracted at a larger-than-expected 2.3 percent, as the yen’s strength weighed down exports.
Third, while US data have been surprisingly encouraging, America’s growth momentum appears to be peaking. Fiscal tightening will escalate in 2012 and 2013, contributing to a slowdown, as will the expiration of tax benefits that boosted capital spending in 2011. Moreover, given continuing malaise in credit and housing markets, private consumption will remain subdued; indeed, two percentage points of the 2.8 percent expansion in the last quarter of 2011 reflected rising inventories rather than final sales. And, as for external demand, the generally strong dollar, together with the global and eurozone slowdown, will weaken US exports, while still-elevated oil prices will increase the energy import bill, further impeding growth.
Finally, geopolitical risks in the Middle East are rising, owing to the possibility of an Israeli military response to Iran’s nuclear ambitions. While the risk of armed conflict remains low, the current war of words is escalating, as is the covert war in which Israel and the US are engaged with Iran; and now Iran is lashing back with terrorist attacks against Israeli diplomats. The Islamic Republic, with its back to the wall as sanctions bite, could also react by sinking a few ships to block the Strait of Hormuz, or by unleashing its proxies in the region – the pro-Iranian Shia in Iraq, Bahrain, Kuwait, and Saudi Arabia, as well as Hezbollah in Lebanon and Hamas in Gaza.
Moreover, there are broader geopolitical tensions in the Middle East that will not ease – and that might intensify. The Arab Spring has produced a relatively favourable outcome in Tunisia, where it started, but developments in Egypt, Libya, and Yemen remain far more uncertain, while Syria is on the brink of civil war. In addition, there are substantial concerns about political stability in Bahrain and Saudi Arabia’s oil-rich Eastern Province, and potentially even in Kuwait and Jordan – all areas with substantial Shia or other restless populations.
Beyond the countries affected by the Arab Spring, rising tensions between Shia, Kurdish, and Sunni factions in Iraq since the US withdrawal do not bode well for a boost in oil production. There is also the ongoing conflict between the Israelis and the Palestinians, as well as strains between Israel and Turkey.
In other words, there are many things that could go wrong in the Middle East, any combination of which might stoke fear in markets and lead to much higher oil prices. Despite weak economic growth in advanced economies and a slowdown in many emerging markets, oil is already at around $100 per barrel. But the fear premium could push it significantly higher, with predictably negative effects on the global economy.

With so many risks in so many places, investors, not surprisingly, will eventually prize liquidity in their portfolios, while shunning riskier fixed assets again when these tail risks materialize. That is yet another reason to believe that the global economy remains far from achieving a balanced and sustainable recovery.