The year of betting conservatively

21 November 2012
Nouriel Roubini

The upswing in global equity markets that started in July is now running out of steam, which comes as no surprise: With no significant improvement in growth prospects in either the advanced or major emerging economies, the rally always seemed to lack legs. If anything, the correction might have come sooner, given disappointing macroeconomic data in recent months.

Starting with the advanced countries, the euro zone recession has spread from the periphery to the core, with France entering recession and Germany facing a double whammy of slowing growth in one major export market (China/Asia) and outright contraction in others (southern Europe).

Economic growth in the United States has remained anaemic, at 1.5-2 per cent for most of the year, and Japan is lapsing into a new recession. The United Kingdom, like the euro zone, has already endured a double-dip recession and now, even strong commodity exporters - Canada, the Nordic countries, and Australia - are slowing in the face of headwinds from the US, Europe, and China.

Meanwhile, emerging-market economies - including all of the BRICs (Brazil, Russia, India and China) and other major players like Argentina, Turkey and South Africa - also slowed this year. China's slowdown may be stabilised for a few quarters, given the government's latest fiscal, monetary and credit injection; but this stimulus will only perpetuate the country's unsustainable growth model, one based on too much fixed investment and savings and too little private consumption.

LIQUIDITY HOSES TURNED ON

Next year, downside risks to global growth will be exacerbated by the spread of fiscal austerity to most advanced economies. Until now, the recessionary fiscal drag has been concentrated in the euro zone periphery and the UK. But now it is permeating the euro zone's core.

And in the US, even if President Barack Obama and the Republicans in Congress agree on a budget plan that avoids the looming "fiscal cliff", spending cuts and tax increases will invariably lead to some drag on growth next year - at least 1 per cent of GDP. In Japan, the fiscal stimulus from post-earthquake reconstruction will be phased out, while a new consumption tax will be phased in by 2014.

The International Monetary Fund is thus absolutely right in arguing that excessively front-loaded and synchronised fiscal austerity in most advanced economies will dim global growth prospects next year. So, what explains the recent rally in US and global asset markets?

The answer is simple: Central banks have turned on their liquidity hoses again, providing a boost to risky assets.

The US Federal Reserve has embraced aggressive, open-ended quantitative easing (QE). The European Central Bank's announcement of its "outright market transactions" programme has reduced the risk of a sovereign-debt crisis in the euro zone periphery and a break-up of the monetary union. The Bank of England has moved from QE to CE (credit easing), and the Bank of Japan has repeatedly increased the size of its QE operations.

Monetary authorities in many other advanced and emerging-market economies have cut their policy rates as well. And, with slow growth, subdued inflation, near-zero short-term interest rates, and more QE, longer-term interest rates in most advanced economies remain low (with the exception of the euro zone periphery, where sovereign risk remains relatively high).

It is small wonder, then, that investors desperately searching for yield have rushed into equities, commodities, credit instruments, and emerging-market currencies.

GLOBAL market CORRECTION UNDERWAY

But now a global market correction seems underway, owing, first and foremost, to the poor growth outlook. At the same time, the euro zone crisis remains unresolved, despite the ECB's bold actions and talk of a banking, fiscal, economic and political union. Specifically, Greece, Portugal, Spain, and Italy are still at risk, while bailout fatigue pervades the euro zone core.

Moreover, political and policy uncertainties - on the fiscal, debt, taxation and regulatory fronts - abound. In the US, the fiscal worries are threefold: The risk of a "cliff" next year, as tax increases and massive spending cuts kick in automatically if no political agreement is reached; renewed partisan combat over the debt ceiling; and a new fight over medium-term fiscal austerity.

In many other countries or regions - for example, China, Korea, Japan, Israel, Germany, Italy and Catalonia - coming elections or political transitions have similarly increased policy uncertainty.

Yet, another reason for the correction is that valuations in stock markets are stretched: Price/earnings ratios are now high, while growth in earnings per share is slackening, and will be subject to further negative surprises as growth and inflation remain low. With uncertainty, volatility and tail risks on the rise again, the correction could accelerate quickly.

Indeed, there are now greater geopolitical uncertainties as well: The risk of an Iran-Israel military confrontation remains high as negotiations and sanctions may not deter Iran from developing nuclear-weapons capacity; a new war between Israel and Hamas in Gaza is likely; the Arab Spring is turning into a grim winter of economic, social and political instability; and territorial disputes in Asia between China, Korea, Japan, Taiwan, the Philippines and Vietnam are inflaming nationalist forces.

As consumers, firms and investors become more cautious and risk-averse, the equity-market rally of the second half of this year has crested. Given the seriousness of the downside risks to growth in advanced and emerging economies alike, the correction could be a bellwether of worse to come for the global economy and financial markets next year. PROJECT SYNDICATE

Nouriel Roubini is Chairman of Roubini Global Economics, Professor at New York University's Stern School of Business, and co-author of Crisis Economics.