Europe: What Could Go Wrong?

The macro and financial outlooks for 2008 look grim for European economies. The repricing of risky credit assets and the rebalancing of the global economy are allegedly good news for the longer term, since they are prerequisites for sound and sustainable growth in the future. Yet in the nearer term, the process is painful and full of uncertainties. This is why we see little upside to our already below-consensus growth forecast and, on the contrary, more negative possible outcomes. As I see it, two key parameters will shape next year’s economic outlook: 1) the duration of the credit crisis, i.e., the time it will take for markets to reprice risky assets and banks to write off their losses, 2) the inflation outlook beyond 2008, as seen by central banks. A third, more exogenous parameter, the price of oil, could of course interfere.

Main case: soft rebalancing

Our main case scenario is based on what we believe are the most likely outcomes for each of these parameters: the credit crisis settles in the first half of the year, central banks welcome the slowdown of the global economy as reducing significantly inflationary risks for 2009 and beyond, and, last, crude oil stabilises around $80/bbl. In these conditions, we anticipate a soft patch for the euro area, with GDP growth slowing by about one full point to around 1.5%. Corporate profits, which tend to amplify the real economic cycle, would experience an even sharper slowdown, leading to an earnings recession for listed companies. International institutions such as the OECD, the IMF, or the European Central Bank all have more positive views, with growth projections around 2%, just slightly below trend. Because pent-up demand, both for consumer and capital goods, is large in Europe, and also because the personal savings rate is quite high (14% of disposable income), these ‘official’ scenarios cannot be excluded. Yet, in our view, they underestimate the fallout of the credit crisis on banks. That is why I will call them ‘rosy’ and focus on two other credible and much more negative scenarios.

Alternative 1: Conflict of interest for central banks; ECB hikes

If inflation remains stubbornly high in early 2008 and inflation expectations continue to rise in the US and in Europe, central banks would face a serious conflict of interest. Despite the risk of a downward spiral for domestic demand initiated by the fall of house prices, the Fed would probably cut interest rates by less than we currently anticipate, and the ECB, which is not facing a generalised housing slump in the euro area, would probably pre-emptively raise the refinancing rate, even if money market spreads remain elevated. The outcome would be a serious recession in the US and a mild one in Europe, where higher unemployment would eventually tame wage pressures. Commodity prices would probably fall as well, helping to cut inflation. Emerging markets where growth is largely driven by domestic demand (Asia, Middle East and CIS) would slow, but only moderately.

Alternative 2: Credit and oil crunch; Global recession

The credit crisis, inasmuch as it is leading to a credit crunch, is tantamount to a supply shock. If another, independent supply shock hits the real economy, the mix would prove quite toxic for both OECD and emerging economies. Oil is the obvious candidate for another supply shock: there is not enough spare capacity in the system, both for crude production and for refineries, to absorb a significant supply disruption. For instance, a 2.5mb/d reduction in crude supply, i.e. the volume of Iranian exports, would trigger a large price increase. Sensitivities estimated on historical data would suggest a 10% increase, but this is probably a conservative floor, tight as the market is. I would not exclude a 25% rise. The combination of a credit crunch and an oil price shock would initiate a vicious circle of rising credit defaults, thus deepening the credit crunch, and higher inflation, raising the risk of more than temporary stagflation. Keeping in mind the lessons of the late 70s, central banks would probably choose to lean against the price wind in order to choke inflation expectations. A global recession would most likely result. In the end, commodity prices would fall sharply, initiating a transfer of income from producers to importers and thus helping OECD economies recover later.

Handicapping the risks

Since the global recession scenario would be triggered by an exogenous shock, it is difficult to assess its probability on pure economic parameters. I will thus leave it to the reader’s judgment. By contrast, the odds of our ‘soft rebalancing’ vs. ‘conflict of interest’ scenarios are directly linked to the probability distribution of expected inflation. As far as the euro area is concerned, the recent history of inflation is quite revealing in this respect. The probability distribution of euro area inflation since 1998, i.e. since the ECB is in charge, has two modes. It is a mix of two distributions, one centred around 1.1%, the other on 2.2%. Because of various measurement biases, the low one is close to deflation and is mostly related to the 1998-1999 deflationist period. It is thus more relevant to focus on the second one, which is slightly above the ECB’s comfort zone (below but close to 2.0%), enough to keep the ECB on alert, but probably not to trigger a countercyclical tightening in a context of slowing aggregate demand. At this stage, I would set the odds for ‘soft rebalancing’ vs. ‘conflict of interest’ at two to one.

By Eric Chaney London
Morgan Stanley
December 16, 2007