Like the US, Germany has seen an improvement in its indicators in recent months and eurozone tensions have ebbed. However, our longer-term concern is that the lack of progress in the eurozone banking system means that the region is showing similarities to Japan and so, in contrast to the US, the risks are still tilted toward the downside.
To a large extent, this reflects the differences in financial structure between the two regions.
In the US, banks account for around 25% of financing compared to 75% in Europe. Banks are more important in Europe, but this also means that it takes longer for the economy to write-off bad debts. In the US a higher proportion of financing is marked to market, meaning that write-offs tend to be more rapid. While this creates the potential for a more violent adjustment and greater near-term downside, it also means that the US is better at wiping the slate clean than the European economy, which struggles with the legacy of past mistakes.
Without a properly functioning banking system, monetary policy will struggle to gain traction in Europe even though yields have fallen. The subsequent weakness of growth will mean that peripheral countries are likely to miss their budget targets, increasing tension between governments and their creditors in the EU and markets. Due to the German election most of these tensions are likely to be pushed under the carpet for much of this year. However, they could well resurface once the vote is over in September.
Our forecasts point to a sharper divergence between the US and Europe than the consensus (i.e. we are above on US growth and below on European activity). From a market perspective, this would suggest a stronger dollar and increasing divergence between treasury and bund markets. However, the prospect of an end to QE by the Fed may eventually challenge equity markets worldwide as investors anticipate the liquidity tap being turned off.
Partial break-up of the euro
It is the concern about growth in Europe which has kept the break-up of the euro as one of our risk scenarios. We have dropped the cataclysmic full break-up, but still see the risk of a partial break-up as the peripheral economies struggle to find an acceptable level of growth while reducing their debt to more sustainable levels.
It would not surprise us to see the ECB and EU returning to drive debt costs down even further over the forecast period either through activation of the outright monetary transactions programme or in some form of official sector involvement (i.e. write down of official loans).
Bigger fiscal hit in the US
On the downside is the danger of a bigger hit from the tightening of fiscal policy than is factored into the baseline. The baseline does assume that the sequester to cut public spending goes ahead as Republicans now see this as the only route to cutting government. This will bring the total fiscal squeeze to 1.5% of GDP.
The uncertainty is on how big the fiscal multiplier will be. The baseline assumes it is slightly less than one, however it could be significantly higher if households decide to cut spending, rather than dip into savings to maintain consumption. Growth would be weaker as a result with a danger of the economy tipping into recession. Another related scenario would be the possibility of a stand-off between Republicans and Democrats which results in a shutdown of government. We do not discount this, but see it as low probability as any party which triggered such an event would suffer in the polls.
US growth resurgence
On the upside there is the possibility that the US experiences a resurgence in growth. This scenario was introduced at the most recent quarterly update whereby the consumer shrugs off tax increases and starts to spend again. This quarter we would see the upside as revolving around corporate spending, for example through stronger hiring, or the government, with the possibility that the sequester is pushed further out over the horizon.
China financial crisis
This scenario revolves around the wealth management product industry which has provided increasing amounts of shadow finance to the economy as the banks have pulled back. The concern is that much of this is unregulated and creates the risk of a systematic implosion of this channel with adverse consequences for the real economy.
Oil shock
Finally, we have retained the oil shock scenario. Even though this risk may have faded, no agreement has yet been reached between the West and Iran over its nuclear programme. None is likely and while the West pursues alternative means of delaying the Iranian programme, there is still the risk that a military solution is sought.
