The global economic recovery, which began in 2009 and was confirmed in 2010, is set to continue into 2011. However, we expect this recovery to remain weak, weighed down by fiscal austerity plans. It should also continue to be very uneven, between emerging and developed countries but also among the developed countries themselves, especially within the Eurozone. Lastly, the recovery is vulnerable to persistent turbulences in sovereign debt and forex markets.

Tensions in sovereign debt and forex markets

Recent weeks have seen increased volatility in exchange rates and renewed turbulence in Eurozone government debt markets. First, the US Federal Reserve decided to further loosen monetary policy with large scale purchases of Treasury bonds. This decision, and even the anticipation of the decision, initially drove the dollar lower. Second, fears have resurfaced regarding the sustainability of debt in Eurozone countries leading to a bail-out package in Ireland, which came on the heels of the Greece deal. Consequently, the euro fell back and spreads on government debt widened appreciably between countries deemed safe (principally Germany) and those in the Eurozone periphery. In the coming months, these sources of tension are likely to persist, resulting in potentially erratic movements in financial markets.

Economic slowdown driven by fiscal tightening

These ongoing tensions in Eurozone debt markets will have two main consequences. First, the ECB is no longer expected to hike interest rates in 2011. Second, Eurozone countries (as well as the UK) will be under increased pressure to implement fiscal consolidation measures, in order to restore or maintain their credibility.

Combined with the end of stimulus plans in other economies -both developed and emerging - this fiscal stance will weigh on the global economy in 2011, causing it to slow down.

Uneven growth

This slowdown is set to remain very muted, however, for the main emerging economies, notably China, India and Brazil. Growth in these countries is forecast to be slower in 2011 than in 2010, but to remain buoyant, driven by investment but also consumption.

On the other hand, growth is set to remain weak in developed countries. Their restrictive fiscal policies are set to weigh not only on public spending but also on private consumption due to increased taxation. Household spending will also remain hampered by high unemployment in most countries, with the notable exception of Germany. In addition, the stimulus effect of inventory rebuilding is set to fade out, while the recovery in business investment is forecast to remain subpar due to the uncertain demand outlook and under utilized production capacity. Lastly, slowing global trade will drag exports down along with it. Inflation is foreseen to remain contained in most developed countries (if we exclude the effects of VAT hikes in countries such as the UK and Spain), owing to ample slack.

Growth differentials between developed countries are likely to persist in 2011. US real GDP is forecast to be up 2½%, (i.e. slightly slower than in 2010), while growth in the Eurozone and in the UK would be close to or just above 1½% Within the Eurozone, disparities are expected to be even more pronounced. On the one hand, German growth is poised to continue on a firm pace, driven not only by exports and business investment, but also by the long-awaited recovery in consumption. On the other hand, Spain should barely grow, while Greece and Ireland should remain in recession due to severe fiscal adjustment and high costs of financing.

Japan will likely continue to stand apart in 2011, still mired in deflation but with positive growth. The acceleration in business capital spending, triggered by the rebound in foreign demand, should partially offset the slowdown in consumption resulting from the end of government support measures.

Real estate markets and public finances are key risks to the recovery

In several countries, the real estate sector remains a serious risk factor. Housing prices have already endured a sizeable correction, notably in the United States, Spain, the United Kingdom and Ireland, but this adjustment might not be over yet. A new drop would further damage the construction industry and deteriorate the balance sheets of financial institutions.

The implementation of fiscal consolidation programmes is also a key source of risk. On the one hand, excessively restrictive fiscal policies could crush the fledgling recovery. On the other hand, countries failing to ensure the long-term sustainability of their public finances might suffer from brutal debt market reactions, as was the case in Greece and Ireland.

This text is an extract from the "Economic Scenario" survey. To read the report in full, click HERE.