This is an extended version of the article that appeared in the December 2012 issue of Investment Advisor.
The eurozone and its politicians continue to face many unresolved and highly important issues. This makes the path ahead rocky and volatile. But important structural improvements have already been made. If—and it’s a big if—the international environment remains fairly benign, 2013 could be the year Europe moves on.
Good news has been scarce in Europe during 2012, but next year could prove a turning point. It has been a very tough year from a fiscal retrenchment perspective and the impact this has had on growth and the real economy. Despite the hurdles still ahead, a shift toward recognizing the need to promote growth bodes well for next year. What is particularly encouraging is that 2012 could represent the “peak” year for austerity in the eurozone.
Over the last two years, big fiscal adjustments have been made: The average primary budget deficit for Greece, Italy, Ireland, Portugal and Spain fell from 9.4% of GDP to 1.6% of GDP. Meanwhile, according to Deutsche Bank, the aggregate euro area fiscal deficit fell from 6.5% of GDP in 2009 to 4.2% in 2011 and should fall again to 3.2% this year.
There is now a change of tone among leaders and economists. Politicians are showing signs of a slight shift in stance toward measures that promote growth without undermining the important progress of the last two years. In a report in mid-October, Deutsche Bank estimates that in absolute terms, the fiscal stance in the region will tighten in 2013, but the pace of discretionary fiscal consolidation will slow.
The IMF has been especially vocal in its warnings against cutting too far and too fast—a distinct change from previous messages. As the same report argues, a more subtle change is occurring in that leaders are recognizing that it is more important to reduce the structural deficit than the headline deficit. This is important as the need to make long-term changes to adjust to a more sustainable economic model is as important as ever, but austerity that chokes growth is self-defeating.
The change has not just been in political rhetoric. For example, in Portugal, the troika—the IMF, the EU and the European Central Bank (ECB)— recently increased the program deficit targets to allow automatic fiscal multipliers to run more freely, letting the cyclical deficit rise and avoiding piling austerity on austerity which, while reducing the headline deficit, may do more harm than good.
This is not happening everywhere. The French budget announced in September shows that not all governments have grasped the need to find growth-enhancing structural reforms. With plans to fill two-thirds of the 30 billion euro gap through tax increases, French President Francois Hollande has reneged on his election proposal to focus on growth instead of austerity. The plan especially targets the large corporate sector, which will hinder companies in regaining confidence and creating badly needed jobs. What’s more, by hitting a broad section of society, the policies risk being socially as well as economically unsustainable.
There are, therefore, exceptions. Because of a time lag, many of the austerity measures introduced this year will start to bite in 2013. But overall, 2013 could mark a turning point. An escalation in the social unrest witnessed this year across peripheral Europe is one of the key risks facing the eurozone: How much austerity populations will take before governments and their reform programs are cast aside is a big unknown. A softer position on austerity across the continent will likely be a force for social stability as well as economic growth.
Of course, the eurozone will only begin the long road to recovery next year if the international economic environment allows it. The good news is that the world’s two largest economies are showing encouraging signs.
The slowdown in Chinese growth has been a significant source of market concern for much of this year. Its third-quarter growth came in at 7.4% - its slowest rate of growth since early 2009. This is likely to be the bottoming of growth. Much of the third-quarter slowdown came in the first half when there were external headwinds, and policy stimulus measures had yet to take effect. There was a significant improvement in the second half of the quarter, and September data were strong across the board. Exports, monetary aggregates, industrial production, fixed asset investment and retail sales all rebounded and beat consensus estimates. Importantly, seasonally-adjusted GDP growth ticked up to 2.2% quarter-on-quarter.
Unlike in other countries, Chinese policymakers have been reluctant to add too much stimulus for fear of re-creating the overhang of liquidity that followed the expansion in 2009. Low inflation means there is room for more substantial measures, but we expect the People’s Bank of China to wait until the leadership transition is complete in November before taking more substantial action. As Chinese growth stabilizes and starts to tick up, this will be a boost to the global economy and will remove a key source of uncertainty.
The United States, meanwhile, remains the bright spot in the developed market world. The S&P 500 has seen its fourth longest rally without a 5% correction since 2002. Underpinning this is an improvement in the housing market, a key barometer of U.S. economic health, with sales and prices picking up.
The impending “fiscal cliff” is a strong reason for caution. Unless changes to current law are enacted, fiscal tightening worth around 4% of nominal GDP will occur in early January, pushing the United States back into recession. The most likely scenario is a compromise involving a fiscal consolidation worth between 1% and 1.5% of GDP, which would dampen growth but is unlikely to push the economy back into recession. However, this will require both compromise and haste from politicians. Depending on the outcome of the election (which at the time of writing is unknown), the highly partisan nature of U.S. politics will not help. The lack of visibility is already affecting sentiment, with 45% of businesses in one poll saying fiscal uncertainty is preventing hiring.
However, if the global economy can successfully move beyond the two big uncertainties of the fiscal cliff and the slowdown in Chinese growth, this will provide a decent backdrop for progress in Europe.
This is not to say 2013 will be an easy year: There are many difficult obstacles, and eurozone growth will struggle to reach positive numbers. European leaders are still too far apart on the important issues facing the eurozone to move on meaningfully. For this reason, the obstacles ahead are as much political as they are economic. This was in evidence at the October European summit where politicians—lacking imminent market pressures—achieved little of great substance.
The main achievement was the agreement to create the framework for a banking union, in which the ECB will have authority to supervise the region’s 6,000 banks, by Jan. 1, 2013. This is progress, but the details of the bank supervision are yet to be thrashed out, and Germany’s support is lukewarm. What happens in Spain is crucial, too. At the time of writing, if and when Spain will ask the ECB for help—and if it does, what impact it will have on how markets view Italy—are important questions. Greece is making more progress in its agreement with its creditors than many may have expected at this stage, but the possibility of a Greek exit must still be considered.
But despite all the challenges, if Europe can achieve the balance of creating meaningful structural reform without stifling growth in the short term, this will be vital progress. It is a tricky task requiring flexibility and fine judgement, but at least we may be witnessing a move in the right direction.