Paradoxically, the things that create the highest amount of doubts about near term growth, namely eurozone's earlier than expected forced austerity and China's aggressive proactive response to a growing housing bubble, also enhance the sustainability and health of the global recovery.

So where does that leave us?

Earlier we were inclined to give the benefit of the doubt to a global recovery despite the broad range of potential macroeconomic outcomes as the world emerges from a credit induced collapse. We highlighted that historically unprecedented activism by governments had increased the concentration of debt in the public sector to potentially unsustainable levels and transformed the world into a macroeconomic laboratory. Debt in developed countries along with potential for policy errors, in our view, were the two biggest factors that could result in a double dip in US and Europe and thus derail a broad global recovery.

We had pegged the chances of a global double dip at 10% (defined as less than 2% global growth). Since March this year, there has been a significant deterioration in the quality of the global recovery. So have we changed our mind about probabilities of potential outcomes?

The straight answer is, not yet -it is too early. While acknowledging that the risks of an adverse outcome have risen. The next 6 months will determine which way the global recovery is headed. The economy and the financial system have fundamental issues and confidence is fragile. However, recovery from a near collapse is underway driven by balance sheet and liquidity improvements -the exact opposite of the situation that prevailed in 2008.

Positive Factors

i. Signs of Global Economic Strength:

Some key global economic indicators are signaling an improvement -world trade volume, world industrial production, US and Euro area capital goods orders and Japan machinery orders. Chinese exports expanded 48% yoy for the most recently reported trade numbers. Fed's recently released Beige Book which is a timely and detailed account of what is happening at the grass roots level across regions and sectors was surprisingly strong. All 12 regions reported improved economic conditions and there were 3 sectors that were strong or improving for every one that was weak or deteriorating. The period corresponded to the six weeks up to May 28, precisely the period when global equity markets were correcting. Japanese machinery orders have now nearly regained their 2008 peak and Euro capital good orders are now 12.5% above their trough levels and steadily climbing.

Signs of Global Economic Strength

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Source: Netherlands Bureau for Economic Analysis


Your browser may not support display of this image. ii. Fiscal Consolidation in Eurozone Earlier than Expected

We get the sense that markets have over-reacted to the eurozone situation. It's not like these problems were unknown. While the sovereign crises has exposed the fault lines in the single currency structure and the dysfunctionality in the political and governing process, it has forced fiscal austerity much earlier than expected. Past evidence of fiscal consolidation in OECD countries has been positive for equities, especially when coupled with a depreciating currency as we see with the Euro. The weak Euro will benefit all eurozone countries by boosting exports and improve the competitive position of the PIIGS which is at the heart of the problem in the Euro area. Germany and France in particular are well positioned to benefit. It is estimated that the depreciation in the Euro will boost eurozone GDP by 1% in 2011.

iii. Corporate Profits and Valuations:

These remain robust with upward profit revisions. Valuations for equities are in the buying range. Consensus bottoms up S&P 500 earnings estimates are 82 and 96 respectively for 2010 and 2011 respectively implying forward P/E ratios of 13.4 and 11.4. Top down earnings estimates of investment strategists are about 10% lower but even with that valuations are reasonable. Equities in Europe and Japan are even cheaper than in US. Undistributed profits are at a high -it should lead to hiring or capex which provide an economic boost or dividends and M&A which boosts markets. Even as return on capital is at its zenith, the cost of capital is at a nadir.

iv. Favorable Monetary Policy

The absence of inflation in developed countries gives the Central Banks in US, Euro area and Japan the leeway to keep monetary policy accommodative for an extended period of time. Even China and other emerging countries are likely to push back plans for policy tightening given the fragility in financial markets. These accommodative policies are likely to be favorable for emerging market assets and commodities in particular.

Risk Factors

i. Debt and Funding:

The attached chart shows the extent of funding required in the public and corporate sector. Clearly this funding needs to happen at reasonable interest rates that don't cause a debt spiral. That depends on the credibility of the sovereigns and the confidence of bond investors. That credibility and confidence has taken a hit in the past couple of month. We are entering the era where developed country debt may require higher interest rates to fund than similarly rated corporate debt.

Government & Corporate Debt Explosion

Gross Global Bond Issuance ($'000bn)

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Source: Financial Times


ii. Sustainability of US Demand:

Demand sustainability depends on income, employment, credit and asset values. All of which are question marks even though Retail sales in the US have shown an improvement. The weak employment picture more than a year into the recovery is the single biggest cause for concern. A rebound in labor share of GDP in the US will give a big boost to the economy and sustainability of the recovery. Income and recent spending has come from a combination of transfers, tax breaks and reduced savings that are not sustainable. House prices may fall further and global equity markets have fallen about 15% jarring confidence and sentiment. Because confidence is weak and uncertainty high, it has given rise to very high volatility in markets. Market confidence in the stewardship of our leaders is low. Witness the variety of topics that made headlines across the world, fraying investor confidence the past few months:

The question is whether the world is entering a period of unusual tensions and upheaval between countries over trade and resources, and between interest groups, that will make governance difficult and policy mistakes more likely. (IPA)