Emerging countries recovering faster than developed countries

The financial markets and the real economy have returned to normal - at least on the surface. All the major economies have emerged from their recessions. However, it is still too early to break out the champagne.

Various major macroeconomic imbalances will likely play a significant role in the months and years ahead. Plus, there are no historical precedents for some countries' fiscal and monetary policies. That makes it extremely difficult to make plausible predictions about the future.

The 2008 financial crisis plunged the world's major economies into a synchronized downturn. The recovery, however, shows clear signs of decoupling. China's ultra-expansive public spending policies already supported growth in the first quarter of 2009. The UK, by contrast, was still mired in a recession in the third quarter of 2009. By carefully analyzing worldwide economic trends, we can schematically group the countries into four categories: emerging countries, commodity producers, indebted countries and other developed nations.

Dynamic emerging countries

Emerging countries – particularly China and its South-East Asian neighbors – have returned to pre-crisis growth levels. China's stimulus package flooded the economy with more money, relative to gross domestic product, than the US's own program to kick-start its economy. That quickly put China back on the growth track in early 2009. And this growth is now no longer being fed solely by the government. Consumer demand is very robust. By the end of 2009, lending was up 33% year-on-year in China, prompting officials to take action to slow down the recovery and increase bank reserve requirements by 0.5%. We believe this to be the first step towards a tighter monetary policy that could result in a somewhat more flexible Yuan-US dollar exchange rate in the next 12 to 18 months.

The Chinese upswing has improved the economic situation for many of China's neighbors relatively quickly. However, other emerging economies – particularly major countries such as Brazil, Russia, India, Indonesia and Mexico, who were relatively sheltered from the financial crisis – now represent an island of stability and cyclical robustness. Even Dubai's crisis in December did not have a lasting impact on other emerging countries.

Fortunate commodity producers

The emerging countries' momentum has spilled over to commodity-producing countries. Australia, for example, is the only developed country that did not nose-dive into a recession after the financial crisis. In fact, its economy is already showing signs of overheating. In response, the Australian central bank has been raising interest rates since mid-2009. The central bank of Norway, another commodity exporter, has been pursuing tighter monetary policy since October 2009.

Uncertain indebted developed countries

The US found its way out of recession in the third quarter of 2009 and should show annualized trend growth rates of up to 5% in the first half of 2010. However, some skepticism is in order. America's growth remains propped up by two major factors: a positive restocking cycle and massive government stimulus programs. Private, non-government subsidized consumer demand remains in the doldrums. Restocking – i.e. refilling warehouses with products – should continue apace in the first half of the year and then gradually ebb away, right when the government stimulus package is due to expire in mid-2010. Private consumption and private investment will then have to step in and support the economic cycle. Yet, it is far from clear if this will happen. US households are deep in debt and working to reduce their debt levels. Plus, many workers – and thus consumers – are concerned about the rapid increase in unemployment (which has doubled since 2007). Business investment will probably also be lackluster, as capacity utilization is close to its all-time low.

This leaves the US economy dependent on government spending. A lack of public spending would raise the risk of a major downturn in the second half of the year. However, government debt is creeping closer to 100% of the gross domestic product. As the recent elections in Massachusetts show, US voters are increasingly concerned about the sustainability of US fiscal policies. This atmosphere will likely make it harder to pass an additional fiscal stimulus.

However, the risk of economic weakness in the second half of 2010 could prompt the Federal Reserve to delay its first interest rate hike. In principle, we expect the Fed to raise rates around the middle of the year. Delaying the interest rate decision for too long would significantly increase inflationary pressures. The US money supply has more than doubled in the past 18 months, fueling an enormous potential for inflation.

Other countries whose debt levels rose sharply during the housing bubble – such as the UK, Spain and Ireland – are in the same boat. They too are struggling with fast-rising unemployment and highly-indebted households and against this background are facing the risk of a sharp downturn in the second half of 2010.

Other developed countries are subdued, but solid

Those developed countries that did not succumb to the housing and credit problems – namely the big economies of continental Europe, Germany, France and Italy – are in relatively better shape than the US or the UK, in our view. Not that the recession did not have lasting effects. In Germany, the growth rate was -5% in 2009. Interestingly, however, this decline had little to no effect on unemployment. Households in continental Europe – except for Spain – are also much less indebted than in the US or the UK. While we are forecasting that the Eurozone will grow more slowly than the US, we expect the growth to be more broadly based, especially in the second half of 2010. As such, we are more confident that the Eurozone forecasts will not have to be revised downward in the months ahead than we expect the case to be for the US.

Right now, the Eurozone's greatest risk comes from Southern European countries and Greece in particular. The uncertainty surrounding a possible delay of payments by the Greek government is weighing on the single currency and could lead to political friction among the various European countries.

Japan once again defies all categorization. It is again battling powerful deflationary pressures. And its government debt levels will soon exceed 200% of the GDP. On the other hand, the rapid aging of Japan's population prompts people to draw down their savings as they grow older. In this situation the only medium-term solution is to allow higher interest rates and/or higher inflation. Japan could thus shift fairly quickly from a deflationary to a highly inflationary environment, resulting in a weaker yen.

Significant imbalances remain

In addition to the risks of an economic downturn in the second half of 2010 as well as the efforts by governments and central banks to find the perfect time to unwind their fiscal and monetary expansions, economists are also concerned about the resurgence of economic imbalances. If the trade deficit of the US rises again – as seems likely – Americans might be tempted to take more protectionist measures, with all the negative consequences this would entail.