Fitch debunks decoupling

A new Fitch and Oxford Economics report nicely models the global knock-on effects in the event of a US recession. And its bye bye decoupling, even though the assumptions used are quite conservative. To begin, Fitch lays out a moderate recession scenario:

Although a “double-dip” recession in the US is not Fitch’s base case, the agency has simulated the effects of this scenario using an economic modelling tool from Oxford Economics (OE). In the simulation, US growth falls to 1% in 2011, negative 0.6% in 2012, and 1.5% in 2013.

The stress test focuses on the direct effect of a US slowdown through trade channels, and does not seek to quantify second-round effects resulting from heightened risk aversion. Therefore, stress test results reflect the minimum likely impact of a US recession on the global economy. The policy response function in the model is also constrained for major advanced economies (MAEs), with interest rates already low and fiscal policy constrained by higher post-crisis debt.

The impact of the scenario on the world economy is material. Cumulative GDP over 2011-2013 would be a minimum of 2.1 percentage points (pp) lower compared with Fitch’s baseline scenario, with GDP growth 0.3pp lower in 2011, 1.2pp lower in 2012, and 0.7pp lower in 2013.

Like they said, no second round effects, the primary one being a huge flight of capital from risk assets back the US. That, in turn, will exacerbate the downturn in its early phases as US export revenue falls, emerging markets struggle for capital and equity markets fall everywhere. Fitch then goes on to examine the impact on oil:

A contraction in global demand for oil resulting from the downside scenario would lead to a decline in oil prices against Fitch’s baseline forecasts. The oil price is projected to decline to around USD90/barrel in 2012 and USD85/barrel in 2013, compared with the baseline projection of USD100/barrel for 2012 and 2013. Although Fitch expects the decline to ease the economic slowdown by boosting consumption for oil consumers (including in the US and euro area), it worsens the shock for oil exporters, who benefit from higher oil prices. Prices for other commodities also decline in the model as a result in softening global demand.

In my view, these are very conservative forecasts but you get the idea. At least 20% downside in commodities from current levels.

Next up, Fitch explores the likely fallout for China:

The impact of a downside US growth scenario on the Chinese economy would be significant, with repercussions extending to the rest of the world. According to 2010 data, 19% of US imports come from China, and total trade with the US represents around 8% of Chinese GDP.

At the same time, China’s contribution to the world economy has been growing rapidly, with its share of world GDP on a purchasing power parity basis rising from 2% in 1980 to nearly 12% in 2008. Contribution to global trade also increased, from a negligible 1% in 1980 to more than 8% over the same period. Continued robust growth in China is vital to the fragile and uneven recovery of the world economy.

If there were a “double–dip” recession in the US, Chinese GDP growth would slow to about 7% in 2012 and 2013. Although in absolute terms this is still robust, Fitch judges that this rate would be below China’s growth potential and so could lead to some weakening in labour markets. This could raise risks, whether through pressure to offset slowdowns through expansionary policies, or through social unrest.

But the likely fallout would go further still for Australia, because, according to Fitch, Australia’s other Asian trading partners be effected more seriously still:

Relatively small and open Asian economies with large trade links to the US and China are the most vulnerable to a US “double dip”. Singapore, the smallest of the emerging Asian economies, experiences the steepest cumulative negative shock to output of around 4pp from 2011-2013 compared to the baseline. Taiwan is also highly vulnerable, with trade links equivalent to around 14% of GDP, resulting in a cumulative output loss of 3.4pp against Fitch’s baseline. In light of the oil importer status of Asian economies, the negative impact is somewhat offset through lower oil and commodity prices, although as mentioned, second-round effects are likely to be significant.

Fitch also predicts Japanese growth remains positive but not by much at 2.2% in 2012 and .8% in 2013. So, two of Australia’s largest export markets enter recession whilst two others endure big slowdowns.

The conclusion for me is obvious. Australia also enters recession on a nasty terms of trade shock and collapsing consumer confidence.