WEEKEND ECONOMIST: Gloomy global growth

Over the next two weeks I will be visiting our corporate and institutional customers in North America. Below I present the key executive summary of the views that will be discussed on that visit.

We have retained our somewhat downbeat forecast for global growth in 2012 at 2.8 per cent. That will be driven by US growth of only 1.7 per cent, a mild recession in Europe (minus one per cent) and the slowest growth in China (7.8 per cent) since the Asian financial crisis.

For the US, we expect that promising market-based perceptions that the US is moving into a higher growth phase are overlooking clear evidence from our perspective that consumer spending is losing momentum; income growth remains constrained; fiscal support to income growth has faded and fiscal policy can be expected to be a one to two per cent drag on growth through the year. Household savings rates will need to rise again following a recent pause in the deleveraging process. Recent improvements in confidence measures are unlikely to be sustained while global developments are unlikely to provide external support.

In Europe, inappropriately severe fiscal austerity; along with credit constraints; waning support from the external sector and the need for the household and corporate sectors to deleverage will all represent significant headwinds. The interaction between a newly enlightened European Central Bank providing generous liquidity support for the banks and, indirectly, the peripheral sovereigns, with governments imposing unrealistically severe austerity packages on the periphery will result in ongoing market volatility. These pressures will be exacerbated through the year as it becomes clear that growth prospects for the periphery have been overestimated and debt challenges are intensifying. Policy will need be more expansionary to allow progress towards sustainable European stability.

In China, we assess that growth momentum will reach its nadir in the first half of 2012 with both infrastructure and commercial housing activity simultaneously suppressed. With the construction cycle being the key driver of growth in China, the expected ongoing downturn in private construction will dominate activity data. A ramping up of public housing construction; some recovery in the pace of infrastructure building; progressively easier credit conditions and an eventual stabilisation of private construction is likely to see a gradual improvement in activity through the year.

Under these circumstances, we expect the following policy responses: a third phase of balance sheet expansion in the US (QE 3) to begin in the June quarter as it becomes clear that the FED's own growth/unemployment/inflation forecasts are on track and a policy response is required; a second "instalment" of the long-term refinancing operation (LTRA) by the ECB within weeks to be eventually supplemented by a genuine quantitative easing policy beginning in the September quarter – probably in response to a further bout of financial instability in Europe and a further slowdown in inflation. A modest extension of the easing policy that the Chinese authorities have recently begun is likely, with assistance to banks to support local governments and the private construction sector. Expansionary fiscal policy to support public construction projects and consumer spending is also in prospect.

Given this global backdrop, the Australian economy is expected to grow a little below trend, although the make up of the growth will be heavily tilted towards mining investment. Key headwinds for the non-mining sectors will be: ongoing deleveraging by the household sector in response to its world class debt; caution by the corporate sector in response to a conservative consumer; some blunting of the effectiveness of monetary policy as Australian banks deal with the high cost of rolling over long term debt; maintenance of a relatively high Australian dollar (despite some cyclical fluctuations that will largely reflect the global developments discussed above) and fiscal tightening by the authorities as a fiscal surplus for 2012-13 remains a policy priority. There will be considerable leakage to the external sector as export volume growth disappoints, commodity prices weaken in the first half of 2012 and the imported components of mining investment dominate.

With this global backdrop in mind we expect commodity prices to weaken in the first half of 2012, but recover through the second half in response to the policy actions envisaged above. That momentum is likely to follow through to 2013 as the developing world eases policy and focuses on stimulating domestic demand in the face of ongoing lacklustre growth performances in the developed world. World growth in 2013 can be expected around 3.5 per cent to 4 per cent, although maintenance of that pace in 2014 is likely to be insufficient to absorb the ongoing build up in commodity supply. We expect a downturn in commodity prices in 2014.

In late 2011, markets were too optimistic around the likely profile for Australia's monetary policy outlook. Westpac assessed the need for an easing cycle of 100 basis points (bps) back in July 2011 and we have retained that view despite the market pricing in up to 175 bps back in November-December. With 50 bps of the 100 already having been delivered, we expect the second 50 bps by mid year. Economist consensus, Reserve Bank rhetoric and now the market look like doubting that profile. With labour markets expected to weaken markedly (despite a strong employment report for January, inflation to remain benign and the transmission mechanism for monetary policy being weakened, we expect that if our rate profile is to be wrong it will be on the downside rather than, as expected by consensus, on the upside.

With this overall background in mind, our preferred profile for the Australian dollar is measured weakness through to mid year (USD 1.07 to 1.02), solid recovery to year's end (to USD 1.06) and then ongoing strength through 2013. A sharp correction can be expected in 2014, reflecting the supply-driven falls in commodity prices (to USD 0.95).

New Zealand is currently off the radar for markets. We expect New Zealand will be a more prominent story for much of this year and in 2013. Markets are currently underestimating the stimulus from the rebuilding of earthquake damage in Christchurch. To be sure, despite policy being highly stimulatory, the Reserve Bank of New Zealand is not in a position to pre-empt the building surge now, but this is likely to change well before markets currently expect.

Bill Evans, is Westpac's chief economist.