More Growth, Less Fear: 2013 Global Economic Outlook

Editor's note: The following is an excerpt of an in-depth economic research report recently published by J.P. Morgan's Corporate & Investment Bank. To read the complete report, please visit www.jpmorganmarkets.com.

Global growth momentum is building, and we forecast faster growth in the coming quarters. The bar for improvement is not very high as global gross domestic product (GDP) rose at a meager 2.1 percent last year, a percentage point below our estimate of trend. This year growth is projected at a 2.5 percent pace in the first half of 2013, accelerating to a 3.3 percent rate during the second half of the year. If right, the global recovery will mark a turning point in 2013 following two years of subpar performance.

The impetus for stronger growth comes as businesses turn more expansionary. Companies became cautious in 2012 against a backdrop of slowing profit growth and heightened uncertainty about the euro area and China. Spending on business equipment contracted in the middle two quarters of last year (see figure 1). Combined with a slowing in hiring and efforts to adjust inventories, business caution pushed global growth to the lowest pace of the expansion. However, global final demand was supported during this period on the back of continued growth in consumer spending. With profits still expanding and policy actions successful in stabilizing euro area stress and Chinese growth, business sentiment began to lift last quarter. The upturn in sentiment will be amplified by the recent aversion of the worst of the U.S. fiscal cliff.

Figure 1: Global Business Equipment Spending
%q/q, saar; excludes China

The anticipated rebound in investment spending and a turn in the inventory cycle points to better times for the beleaguered global manufacturing sector. After stagnating for much of last year, global manufacturing is expected to rise at a 3.5 percent pace in 2013 (4Q/4Q). Asian economies that lie at the center of the global technology and manufacturing cycle will benefit most.

As the year begins, the growth lift will be constrained by two factors. First, the developed market (DM) economies face a large, front-loaded fiscal tightening. In the U.S. an early year drag associated with the expiration of the payroll tax holiday will hold back the economy despite significant private sector healing and improving credit and financial conditions. Our forecast anticipates that a setback in U.S. consumption growth will limit lift in the first half of this year, followed by a return to above-trend global growth during the second half of 2013. In Europe, while we expect fiscal drags to ease some in 2013, austerity will still weigh on growth.

Second, credit conditions are expected to remain somewhat restrictive in Europe and emerging market (EM) economies. A tightening in credit terms and standards was a major factor in the global economy's poor performance last year. It also helps explain the relative outperformance of the U.S. where credit conditions improved. We believe these drags on the euro area and EM are starting to fade, particularly in the euro area where the European Central Bank's Outright Monetary Transactions (OMT) program is anticipated to help lift the region out of recession. However, euro area bank deleveraging and the unwinding of easy EM credit in the aftermath of the global financial crisis will take time and is expected to limit the pick up in global growth.

ALTHOUGH GROWTH IS EXPECTED TO QUICKEN, THE LEGACY OF TWO YEARS OF SUBPAR PERFORMANCE LOOMS LARGE, CREATING SIGNIFICANT CHALLENGES FOR POLICYMAKERS.

Although growth is expected to quicken, the legacy of two years of subpar performance looms large, creating significant challenges for policymakers. Global inflation is expected to move lower this year, largely as a result of declining core inflation in the DM. Inflation has proved sticky in some DM economies because of institutional rigidities and well-anchored inflation expectations. A sharp increase in goods price inflation, reflecting previous overheating in the EM economies and strong manufacturing activity, also played an important role. This latter source of inflation is now unwinding, with DM import price inflation forecast to slide to near zero over the coming year. With excess slack persisting, DM inflation is set to fall well below central bank objectives this year.

The projected tension between low underlying inflation and the constraint posed by the zero-interest-rate bound represents a unique challenge for DM central bankers. Aggressive fiscal tightening in the U.S. and Europe in the face of high unemployment represents another. Not surprisingly, institutional and political tensions have escalated amid widespread concerns about the high cost of continued subpar performance on potential output and/or growth, inflation dynamics and debt sustainability. These pressures are particularly acute in Europe and Japan.

DM central banks are responding to these challenges in a number of ways. Central bank balance sheets will expand significantly more. Moreover, there is a major new initiative underway as central banks experiment with communication policy—the signals they send about their objectives and how they will react to changing economic circumstances. The active use of communication policy, with balance sheet activities used to reinforce messages, will be the defining feature of the G-4 central bank landscape in 2013. Recent months already have set the ball in motion. The liquidity backstop provided by the ECB's OMT program introduced a risk-sharing mechanism that changed the nature of sovereign debt in the region. Last month, the Fed tied its rate guidance explicitly to observable economic conditions in an attempt to augment the perceived diminishing returns of asset purchases. Next up to the plate is the Bank of Japan (BoJ), which is on the cusp of beginning an unprecedented battle against deflation.