Forget recessions, we’re amidst an economic paradigm shift: Scotiabank

Scotiabank's recently released "2012-13 Economic & Market Outlook" warns of ongoing market volatility in currency, equity and bond markets as the global economy becomes less U.S.-centric.

Warren Jestin, senior vice-president and chief economist at Scotiabank Group, states for debt- and deficit-heavy nations, the magnitude of the structural adjustments required for meaningful fiscal repair will dampen growth through mid-decade.

For instance, output growth in 2012 will struggle to reach 2 per cent stateside even if interest rates remain near historic lows and fiscal retrenchment is postponed. Overall growth among Eurozone nations will be non-existent and economic momentum in many emerging markets will be moderate through 2012. By the end of this decade, China may surpass America as the world's largest economy, the report states citing The Economist magazine.

"The central theme is very clear. We think of the economy in cyclical terms when we talk about recession, recovery and the like. But the fact is what we're going through is a very large structural change in the global economy," Jestin says. "The outcome is going to be less U.S.-centric, less euro-centric, and much more centred on demand coming from the emerging world."

Combine the fact that risks to financial outlooks have increasingly become political in nature and market volatility becomes the new normal.

"You see this in Europe with respect to debt deals and controlling deficits," he says. "At the end of the day, the political risks remain very substantial . . . you end up with a lot of volatility in the markets.

How will Canada fare?

Overall Canadian growth is likely to be similar to the U.S. in 2012. Domestic demand will be supported by resource sector mega-projects and public infrastructural investments but Canadian household consumer debt remains a concern. Consumer debt is now at record levels relative to disposable income.

"Next year, Canada and the U.S. will have a hard time reaching that (2 per cent growth). We think growth in Canada will fall slightly short of 2 per cent. Same thing in the U.S.," he continues. "The following year, 2013, we may well move into that range but it is a slower growth reality."

There will be no growth in Europe next year. "At the end of the day, next year is going to be one of enormous adjustment."

For so-called emerging economies, Jestin says in good and bad years their growth is going to be a multiple of what we're likely to see in the developed world.

"As long as the emerging world is recording solid growth, even if it's diminished from a couple of years back, we'd expect a broad range of commodities to remain at prices that are profitable and that encourage investment," he says. "Oil, copper, zinc, iron ore, coal, potash, uranium. Coincidentally, products Canada has an abundance of."

Though the global economy is a challenging one to say the least, Canada remains one of the best places to work and to do business, the report adds. "Unlike the U.S. and Europe, Canada has fully regained the jobs lost during the financial crisis and recession of 2008-09. The buoyancy in our housing and commercial real estate markets contrasts sharply with the depressed conditions evident in the U.S. and much of Europe."

"Our fiscal situation is dramatically better than in the U.S. In the U.S., the deficit is 8 per cent of GDP and there's no talk about balance the books at all," he says. "In Canada the deficit is roughly 2 per cent of GDP and we're concerned that the federal government may not be able to balance the books until 2017.

"Our fiscal advantage, which has created the ability to bring taxes down and become very competitive, is a strategic, national advantage and one that is very positive for our currency."

Eurozone output is already shrinking. It's make or break time for the European Union (EU) and it has only two choices the report states: the authorities pull out all the stops and turn things around or they hold back and watch the Eurozone unravel.

In a best case scenario, EU governments will agree on steps towards greater fiscal unity, supervision, automatic sanctions, and perhaps e-bonds, writes Alan Clarke, director, fixed income strategy, Scotiabank Group. In a worst case scenario, "When we run scenarios for the euro exchange rate, equities and bond yields according to a messy Eurozone breakup, it points to PMI readings in the 20s and GDP contracting by around 4 per cent quarter-over-quarter. This should be avoided at all costs, the authorities know this and we think they will do everything possible to do so."

Outlook for investors

Regarding the portfolio strategy outlook, the markets are currently pricing much weaker year-ahead growth. Negative revisions to 2012 profits could support further bond outperformance early in 2012 and China slowdown fears could sustain macro uncertainty. Ultimately, 2012 market leadership will be dictated by the extent of the pending slowdown, the degree of "landing" in China, and the 2013 recovery.

"For investors, 2011 has been a very challenging year. But what's getting increasingly frustrating is the toolkit that worked in the 80s, 90s, and 2000s isn't working now," says Vincent Delisle, portfolio strategist, Scotiabank Group. "By the second half of 2012, what hurt emerging market indices on the TSX this year is likely going to be over and we'll have more supportive conditions."

On the subject of currencies, Camilla Sutton, chief currency strategist at Scotiabank Group, says though most valuation tools suggest that currencies are overvalued, it is impossible for all currencies to weaken together.

"Of the themes we've seen this year to date many will be carrying into next year. Essentially those themes are really the overall European crisis. We also have general fiscal problems across the globe and spikes in risk aversion that continue to recur," she says. "All in all, we haven't had dramatic moves in currencies from the end of last year to the end of this year."

The environment for Canada is challenging and the risks are significant, the report states. But the drivers for the loonie remain the same. With near-term risks high, the bias is for the Canadian dollar to weaken into year-end. However once in 2012, the combination of a soft landing in China, oil prices averaging $95 (Scotia Economics' forecast), and Canada's triple-A status should help support the currency pushing it back through parity.

"Flow and sentiment is a very important story for Canada next year . . . in a shrinking universe of triple-As, there's 14 countries left with a triple-A rating by all three ratings agencies. Of that, Canada is the fourth largest bond market," Sutton remarks. "In terms of Scotia's forecast for the Canadian dollar, we have it closing next year at US$1.02 so a stronger Canadian dollar than what we have today."