Outlook 2011: What lies ahead?

Markets started 2010 with a fear of a “double dip” recession. Investors feared a repeat of the Great Depression of the 1930s. Even in faster growing regions like Asia there was pessimism. Economists’ predictions of positive growth were dismissed as fantasy.
Of course, economists were right (economists normally are). Growth came back. The world economy grew around 4 percent in 2010, just above its trend growth rate of 3.5 percent. The world economy should grow around trend in 2011, with a 3.7 percent rate of growth.
Growth in 2010 was led by policy stimulus. Fiscal policy helped growth in the OECD in the early part of the year. A limited inventory restocking led to stronger growth in global trade (most economies export to inventory demand, not to consumer demand). Neither of these trends is likely to continue in 2011.
Fiscal policy is tightening in many OECD economies. Inventory restocking is largely completed. The decline in inventory to sales ratios is already generating disappointing export numbers from countries like South Korea, Taiwan and (recently) Germany.
So what issues are likely to matter in 2011? From the maelstrom of events, six potential trends for investors suggest themselves.
1.  The return of the consumer
Growth, particularly in the United States, will depend on consumer demand. Those US consumers who have a job (which is most Americans) are generally doing well. Incomes are rising, and job security is good. This group should spend a rising proportion of their rising income, which will support growth. In emerging markets, domestic demand will also be important. Export growth will play less of a role in 2011 than it did in 2010, so domestic demand is the focus.
2. The Euro crisis is not over
The sovereign debt crisis in the Euro area is a symptom of a bigger problem — the Euro does not work.
The solution (fiscal union) will take several years. In the meantime, the Euro area is likely to have periodic crises. Greece and Ireland have already been bailed out. Markets are skeptical about Portugal.
The positions of Spain, France and others are questioned. This matters to Asia. With each crisis, there will be risk aversion. Risk aversion can affect capital flows into Asian markets. Moreover, if the sovereign crises generate banking system concerns, there may be disruption to trade credit.
3. OECD interest rates will stay low
Inflation in OECD economies is likely to remain very benign. Inflation in the OECD is driven by labor costs (around 70 percent of CPI is due to labor), and labor costs should remain subdued. Most advanced economies still have high unemployment, which is unlikely to fall rapidly. The risk of deflation is probably greater than the risk of inflation, so interest rates will remain low. Liquidity injections (quantitative policy) will be dictated by the needs of the financial system. It seems safe to assume that liquidity injections will remain in place at least for the first half of 2011.
4. Emerging economies’ inflation will be in focus
For emerging economies, inflation pressures are likely to be greater than in developed economies. This is because emerging markets, generally speaking, have less spare capacity in their labor markets (and thus less downward pressure on labor costs). Moreover, commodity prices are generally a larger part of an emerging economy’s inflation basket than is the case in a developed economy.
5. Capital controls could increase
Although there is a lot of focus on trade protectionism — and rightly so — restrictions on capital flows can be just as significant to markets. Economies that have fixed or semi-fixed exchange rate regimes against the US dollar may be tempted by capital controls. OECD monetary policy is run for the benefit of OECD economies. Fixed exchange rates mean some economies risk importing inappropriate policies. Capital controls are a solution (if not necessarily the best solution).
6. Political risk is back
Capital controls, trade protectionism, bank regulation, fiscal policy issues, geopolitical tensions — political risk is back on the financial market agenda. This perhaps is the greatest risk for investors in 2011. The economic course is relatively easy to predict. The unpredictable element is politics. Politics can change not just economic outcomes, but the rules of the game. Capital controls, or regulation of financial markets, can dramatically alter the investment landscape overnight. Markets sometimes believe that they are more powerful than politicians. They are not.
What does this all mean?
Unless there is a major accident or policy mistake, the world economic recovery should continue in 2011. The problems of the 2008/2009 recession are not being cured, but at the same time they are not being made any worse. The course for financial markets is likely to be less smooth, however. Political risks and uncertainties will create volatility for investors. The year ahead may be difficult for investors.
Good luck.


The writer is deputy head, of Global Economics, UBS Investment Bank.

Opini The Jakarta Pos 27 Desember 2010