what is the new normal

UBS Investment Research

Tectonic Economics

What is the new normal?

Quantifying normal The ‘new normal’ has become an established economic concept, reflecting thewidely-shared view that global growth and asset returns will be lower for an extended period of time relative to the history preceding the financial crisis.However, there have been few studies that have tried to quantify the ‘new normal’.This note fills that gap.

New global trend growth is 3%, not 4% Our model-based estimates suggest that global growth will average 3% over thenext decade, about a percentage point slower than in the previous decade. Thisoutcome is both supply- and demand-side driven. Weaker trend growth will be theby-product of slower world population growth and ageing workforces. But it isalso the result of continued de-leveraging and weaker productivity growth in manydeveloped economies. Tighter financial market regulation and the associatedimpact on the cost of capital may also restrain potential output growth.

Market divergence In some ways the ‘new normal’ won’t be so new—divergent trend growth between emerging and advanced economies will endure. Emerging Asia and the MiddleEast are likely to be the fastest growing regions of the world economy over the next ten years. India, China, and Vietnam enjoy the best longer-term growth prospects in Asia, while Qatar, Egypt and Saudi Arabia lead the pack in the MiddleEast. Still, Asia will slow somewhat in the next decade, whereas the Middle East has the potential to accelerate. Latin America may also do better in the comingdecade.

The risks Of course, nothing is assured. Downside risks range from the possibility of moresevere sovereign debt crises, heighted protectionism, more restrictive financial market regulation, or a hard landing in China. On the other hand, to the extent thatadvanced economies undertake structural adjustments to mitigate the impact ofageing populations or boost investment in productivity-enhancing endeavours, faster trend growth relative to our base case is possible.

Implications Overall, our estimates suggest that consensus forecasts for trend growth are toohigh. If investors have to adjust downward trend earnings estimates, valuationmultiples are unlikely to expand, even from relatively compressed levels. Finally,on our numbers for trend growth in developed economies, long-bond yields of around 3% do not look particularly out of step.

Global Economics Research

Global

Singapore

3 September 2010

www.ubs.com/economics

Andrew Cates

[email protected]

+65 64952584

Larry HathewayEconomist

[email protected]+44-20-7568 4053

This report has been prepared by UBS Limited ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 26.

ab

mailto:[email protected]

mailto:[email protected]

Tectonic Economics 3 September 2010

UBS 2

What is the new normal? There is much discussion at present about the ‘new normal’, reflecting the widely-shared view that global growth and asset returns will be weaker for considerably longer relative to the ‘norms’ experienced in the years leading up to the financial crisis. However, there have been few studies that have tried to quantify the ‘new normal’. This note is our attempt to fill that gap.

Specifically, we build on our earlier work that quantified probable trend global growth. We extend that work to include more recent data and some adjustments to our models. In addition, we have extended our analysis to include economies in the Middle East and sub-Sahara Africa. Finally we deploy our revised model for scenario analysis to address key issues and risks confronting the world economy.

The key conclusions are as follows:

- Global growth will average roughly 3% over the next decade, about one percentage point slower than in the previous ten years. Weaker global growth will be the by-product of slower world population growth, ageing workforces and slowing productivity growth in developed economies, as well as the impact of further balance sheet de-leveraging. Tighter financial market regulation may also inhibit productivity-enhancing investment by lifting the cost of capital. Our model-based estimates suggest that developed economies will muster growth of just 1.3% over the next ten years, which is also about a percentage point lower than their previous ten-year growth average.

Model-generated trend GDP growth estimates for the world economy by region

0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%8.0%

WorldAdva

nced e

conom

ies USEuro

zone

Japan

Develop

ing ec

onomies Asia

Latin A

merica

Eastern

Europe

Middle E

astSub-

Saharan

Africa

10 year historic trend, 1998 - 2008 Model-generated trend, 2010-2020

Source: UBS estimates

- Developing economies are expected to achieve growth of around 5% in the next decade. Faster growth relative to the developed world will be the product of superior labour productivity potential, more favourable demographics, stronger balance sheets, and ‘catch-up’ (i.e., the ability to reap technology-related efficiency gains).

Much discussion at present about the ‘new normal’

We build on our earlier work that quantified probable trend global growth

Our work suggests that global growth will average roughly 3% over the next decade

Developing economies are expected to achieve growth of around 5% in the next decade


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- Asia and the Middle East will be the fastest growing regions of the world economy over the next decade. Within Asia, India, China, and Vietnam are likely to enjoy the best longer-term growth prospects. Qatar, Egypt and Saudi Arabia will lead the pack in the Middle East. Nevertheless, Asia will slow in the coming ten years compared with the previous decade, unlike the Middle East which may accelerate (conditional on stable-to-higher oil prices). Latin America is another region that may do better, notwithstanding a weaker outlook in some of its principal export markets (e.g., to the US).

- Downside risks include the possibility of more severe sovereign debt crises, greater protectionism, more restrictive financial market regulation, or a hard landing in China. If advanced economies can tackle structural labour market issues, including demographic challenges, and can boost productivity-enhancing investment, they may do better than we envisage in our central case.

- Consensus long-term forecasts—where available—appear too high relative to our conclusions. If investors have to ratchet down earnings expectations, equity multiples are unlikely to expand even from already low levels. And if policy makers over-estimate trend growth, they may make errors as well. Structural budget deficits are likely to be larger. And central banks may underestimate longer-term inflation risk.

In the sections that follow we explore the evidence behind our conclusions. We then present in greater detail our empirical analysis and move on with some scenario and risk analysis. We conclude with some implications for financial markets.

Demographics One of the critical factors that will shape the ‘new normal’ is demographics. Global population growth will slow. That, alone, is not new. World population growth has been slowing since the mid-1960s (see first chart below). Rather, the new development is the ageing of the global workforce, particularly in developed economies. Insofar as ageing populations and rising dependency ratios restrain growth of labour supply, they result in slower rates of economic growth (see second chart below).

Asia and the Middle East will be the fastest growing regions of the world economy over the next decade

Downside risks include the possibility of more severe sovereign debt crises, greater protectionism, more restrictive financial market regulation, or a hard landing in China

Consensus long-term forecasts—where available—appear too high relative to our conclusions

One of the critical factors that will shape the ‘new normal’ is demographics


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Global population growth

0

0.5

1

1.5

2

2.5

1951

1955

1959

1963

1967

1971

1975

1979

1983

1987

1991

1995

1999

2003

2007

2011

2015

2019

2023

2027

Total world population growth Total working age population growth

Source: United Nations

Change in dependency ratio versus GDP growth

VIE

VENURG

UAE

UKR

SRI

SVN

SAU

QAT

PER

PAR

PAK

NGA

MOR

MCDLTU LAT

KEN

KAZ

ISR

EST

EGY

ECUCOL

CAM

ALGALB

TUR

THA

TWN

SAFSVK

SGP

RUSROU

POL PHP

MEX

MALKORIDN

IND

HUN

HK

CZE

CRO

CHN

CHL

BUL

BRA

ARG

USUK

SWISWE

ESPPORNOR

NZ

NLD

JPN

ITA

IRL

ISL GRC

GERFRAFIN

DNK

CANBEL

AUT

AUS

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

-3.5%

-3.0%

-2.5%

-2.0%

-1.5%

-1.0%

-0.5% 0.0

%

0.5%

1.0%

1.5%

Change in dependency ratio (%YoY, 1989-2009)

Real

GDP

grow

th (%

YoY

1989

-200

9)

Source: UBS/Haver/United Nations/IMF

Balance sheets The second factor restraining global growth is balance sheet repair. High levels of public and private sector indebtedness in many developed economies (and several developing economies) suggests continued de-leveraging efforts, which will act as an impediment to public and private sector spending relative to the ‘norms’ of recent decades. Quantifying the degree of deleveraging is problematic, but we suspect that the process will run for considerably longer insofar as current measures of leverage in the developed economies remain high relative to long-term averages.

The next factor restraining global growth is balance sheet repair


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UBS financial risk index, 2009

Total financial risk index, 2009

0123456789

China

Hong

Kon

gSi

ngap

ore

Thail

and

Malay

siaPh

ilippin

esMe

xico

Taiw

anEg

ypt

Qatar

Arge

ntina

Chile

Peru

Saud

iInd

ones

iaVe

nezu

elaPa

kistan

Nige

riaCz

ech

Japa

nSl

ovak

Russ

iaInd

iaCo

lombia UA

EMo

rocc

oTu

rkey

Sri L

anka

S.Af

rica

Croa

tiaBr

azil

Polan

dKa

zakh

stan

Austr

alia

Austr

iaVi

etnam

Germ

any

Israe

lNZ

Kore

aNo

rway US

Cana

daFin

land

Nethe

rland

sBu

lgaria

Switz

erlan

dFr

ance

Swed

enRo

mania

Hung

ary

UKUk

raine

Lithu

ania

Italy

Eston

iaDe

nmar

kBe

lgium

Slov

enia

Portu

gal

Latvi

aSp

ainGr

eece

Irelan

d

Source: UBS calculations. The UBS financial risk index is a measure of the relative domestic financial fragility of an economy and is based on several macro-prudential risk indicators, including the private sector credit to GDP ratio, the banking sector’s loan to deposit ratio, and the public sector debt to GDP ratio. A higher level for the index indicates higher leverage and greater financial risk.

To some extent, however, de-leveraging in the advanced economies will be offset by re-leveraging in much of the developing economy bloc where the starting position for domestic balance sheets is healthier. That may boost private consumption and investment, but also offers policymakers greater leeway to offset the impact of diminished export growth potential on their economies via looser monetary and fiscal policies.

Change in financial risk index versus GDP growth

US UK

SWISWE

ESP

POR

NOR

NZNLD

JPNITA

IRL

GRC

GER

FRA

FIN

DNK

CAN

BEL

AUT

AUS

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

-2 -1 0 1 2 3 4 5 6 7 8

Change in financial risk index (2008 vs 1997)

Real

GDP

grow

th (%

YoY

1998

-200

8)

Source: UBS/Haver/IMF.

To some extent de-leveraging in the advanced economies will be offset by re-leveraging in much of the developing economy bloc


UBS 6

Financial risk index versus GDP growth

VIE

VEN

UAE

UKRSRI

SVN

SAU

QAT

PERPAK

NGA

MOR

LTULAT

KAZ

ISR

EST

EGY

COL

TURTHA

TWN

SVKSGP

RUS

ROUPOL

PHP

MEX

MALKOR

IDN

IND

HUNHKCZECRO

CHN

CHL

BUL

BRAARG US UK

SWI

SWE ESP

PORNORNZ NLD

JPN ITA

IRL

ISLGRC

GERFRA

FIN

DNK

CAN

BELAUT

AUS

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0

Financial risk index, 1997

Real

GDP

grow

th (%

YoY

1998

-200

8)

Source: UBS/Haver/IMF

Investment and productivity The next factor is investment activity, or capital accumulation. Additions to the quality of the capital stock are arguably the single most important driver of trend growth in the world economy. For economies at the ‘cutting edge’ of technology, this is the primary determinant of supply-side led growth. But another key issue is the proclivity of developing economies to continue “catching-up” with the developed world, as they apply ever more and higher quality capital to boost comparatively low labour productivity. Many Asian economies, most notably China, have been very successful in reaping productivity gains from investment, but it seems probable that the rate of growth is likely to slow somewhat. Many Latin American and several East European economies, on the other hand, have been less able to match China’s productivity growth, perhaps because of less-sound balance sheets or a less-conducive macroeconomic environment for investment. That may be changing—the environment in Latin America, for example, appears more conducive to capital investment.

The next factor that will shape the new normal is investment activity, or capital accumulation


UBS 7

Gross domestic investment rate versus GDP per capita growth

VIE

VEN

URG

UAE

UKR

SRI

SVN

SAU QAT

PER

PAR

PAKMOR

MCD

LTULAT

KEN

KAZISR

ESTEGY

ECUCOL

CAM

ALG

ALB

TUR

THATWN

SAF

SVK

SGP

RUSROU

POL

PHP

MEX

MAL

KOR

IDN

IND

HUN

HK

CZE

CRO

CHN

CHL

BUL

BRA

ARG

USUK

SWISWE

ESPPOR

NOR

NZ

NLD

JPN

ITA

IRL

ISL

GRC

GERFRA

FIN

DNKCAN

BEL

AUTAUS

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%13

.0%

18.0%

23.0%

28.0%

33.0%

38.0%

Investment to GDP ratio (%, 1988-2008)

Real

GDP

per c

apita

gro

wth

(%Yo

Y, 19

88-2

008)

Source: UBS/IMF/Haver

Relative real GDP per capita (versus US in 1988) versus subsequent real GDP per capita growth

TUR

THA TWN

SAF

SVK

SGP

RUS

ROU

POL

PHP MEX

MAL

KOR

IDN

IND

HUN

HK

CZECRO

CHN

CHL

BUL

BRA

ARG USUK

SWI

SWE

ESPPOR NOR

NZ

NLD

JPNITA

IRL

ISL

GRC

GERFRA

FIN

DNK

CANBELAUTAUS

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

-10.0

%

10.0%

30.0%

50.0%

70.0%

90.0%

110.0

%

130.0

%

Relative real GDP per capita (%, 1988)

Real

GDP

per c

apita

gro

wth

(%Yo

Y, 19

88-2

008)

Source: UBS/Haver/IMF

The risk, however, is that overly stringent financial market regulation may raise the cost of capital and choke off marginal investment in productivity-enhancing endeavours. Presently, that would appear to be a greater risk in advanced economies, but the matters nevertheless bears close monitoring.


UBS 8

Change in investment rate versus average spread between deposit and lending rates

UK

SWE

ESP

POR

NORNZ

NLD

JPN

ITA

IRL

GRC

GER

FRA

FIN

DNK

CAN

BEL

AUTAUS

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%16

.0%

18.0%

20.0%

22.0%

24.0%

26.0%

28.0%

30.0%

Investment rate (%, 1988-2008)

Inte

rest

rate

spre

ad (%

, 198

8-20

08)

Source: IMF/UBS/World Bank/Haver

A final consideration concerns the potential for investment-related efficiency gains, otherwise known as total factor productivity growth (TFP). Many factors, in theory, determine TFP but academics typically emphasise things such as the level of investment in (and deployment of) new technology, as well as scientific innovation and invention, the openness of an economy, and its access to cutting-edge external technology via foreign direct investment inflows. Education, political stability, and flexible labour markets also feature prominently.

Our previous work 1 has indicated that the health of domestic balance sheets, the diffusion of existing as well as new technologies, along with the pace of domestic innovation are important determinants of total factor productivity trends. Economies that enjoy low balance sheet stress and a high relative level of technology achievement should accordingly achieve solid total factor productivity gains in the future. Asian and Latin American economies appear best-placed to reap those rewards.

1 See Tectonic Economics, 14 October 2009

A further consideration concerns the potential for investment-related efficiency gains

Asian and Latin American economies appear best-placed to reap those rewards


UBS 9

Average change in balance sheet stress index versus total factor productivity growth

US

UK

TUR

THA

SWE

ESP

SGP

SAFRUS

POR

PHP

NZ

NOR

NLDMEX

MAL

KOR

ITA

IDN

IND

GRCGERFRA

FIN

DNK

CHN

CHL

CAN

BEL

AUT

AUS

ARG

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%-2

0% 30%

80%

130%

180%

230%

Average change in balance sheet stress

Tota

l fac

tor p

rodu

ctivi

ty g

rowt

h (%

YoY,

1988

-200

7)

Source: UBS. The average change in balance sheet stress is measured by the average change in the current account to GDP ratio, the budget balance to GDP ratio and the private credit to GDP ratio with the sign on the current account reversed.

UBS Technology Achievement index versus total factor productivity growth

US

UK

TUR

THA

SWE

ESP

SGP

SAFRUS

POR

PHP

NZ

NOR

NLDMEX

MAL KOR

JPN ITA

IDN

IND

GRCGER

FRA

FIN

DNK

CHN

CHL

CAN

BRABEL

AUT

AUS

ARG

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

3% 4% 4% 5% 5% 6% 6% 7% 7%

Aggregate UBS technology achievemnt index

Tota

l fact

or p

rodu

ctivi

ty g

rowt

h (%

YoY,

1988

-200

7)

Source: UBS/World Development Index The Technology Achievement index is based on several indicators of scientific innovation, the penetration of recent technology, and the penetration of older technology. The methodology draws from ‘Global Economic Prospects,’ Chapter 2, The World Bank, 2008. Each indicator is indexed to 100 in a base year (1994). The aggregate index is an un-weighted average of the change in each index from 1994 though to 2007.


UBS 10

Exports A final factor that enters our framework is exports. In previous work we have tended to downplay the role of exports in trend growth rate determination. The correlation between the openness of an economy and average GDP growth, for example, is not particularly high. That is partly because rapid export growth tends to elicit rapid import growth meaning—in a national income accounting sense—that the GDP-related impacts are offsetting. Rapid export growth also tends to put upward pressures on the exchange rate, which over time may erode competitiveness. Put differently, export gains may not necessarily add to an economy’s stock of human or physical capital and so there are no obvious links with trend productivity performance.

Nevertheless, we consider exports to be of some importance in shaping the longer-term outlook for individual economies because the theoretical considerations have not always applied well in practice. Many Asian economies, for example, have achieved robust export-related growth. Moreover, the scope for intra-regional trade growth among Asian economies and, more generally, between developing economies is potentially quite large. That could well boost gains from trade for a considerable period of time.

Change in export to GDP ratio versus real GDP growth:

VIE

VEN

URG

UAE

UKR

SRI

SVN

SAU

QAT

PERPAR

PAK

NGA

MOR

MCDLTU LAT

KENKAZ

ISR

EST

EGY

ECUCOL

CAM

ALG

ALBTUR

THATWN

SAFSVK

SGP

RUS ROU

POLPHP

MEX

MALKOR

IDN

IND

HUN

HK

CZECRO

CHN

CHL

BUL

BRA

ARG

US

UK SWISWEESPPOR

NORNZNLD

JPNITA

IRL

ISLGRC

FRA FINDNK

CAN

BELAUT

AUS

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

-40.0

%

-30.0

%

-20.0

%

-10.0

%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

Change in exports to GDP ratio (%, 2009 vs 1989)

Real

GDP

grow

th (%

YoY,

1989

-200

9)

Source: UBS/IMF/Haver

The model To bring the preceding discussion together we estimated a cross-country growth regression model. Specifically, we related average rates of real per capita GDP growth from 1999–2009 to the factors highlighted in the sections and charts above, including changes in dependency ratios, changes in balance sheets,

A final factor that enters our framework is exports

We estimated a cross-country growth regression mode


UBS 11

investment rates, relative per capita GDP levels, and the change in the export-to-GDP ratio. The results are illustrated in the table below.

The cross-country model for trend GDP growth

Regressor Coefficient T-Ratio

Constant -0.018 -1.7

Change in dependency ratio -0.552 -2.6

Relative per capita GDP level -0.008 -1.5

Investment rate 0.197 4.5

Change in financial risk 0.001 1.8

Change in export to GDP ratio 0.008 0.7

R-Squared 0.59

Standard error 0.01

Durbin Watson 1.56

Source: UBS

They indicate that the dispersion of average economic growth rates seen in the world economy in recent decades can be explained pretty well by our chosen variables. The statistical results from the model nevertheless suggest that around 40% of the world economy’s growth performance cannot be explained by those factors. That unexplained residual is in all likelihood the consequence of country-specific factors such as institutional arrangements, policy choice, and national differences in the structure of labour, product and capital markets. Our global modelling approach—by definition—cannot easily capture these national differences. Nevertheless, our approach still allows global consistency in the assessment of economic trend growth patterns.

Model-generated forecasts In this next section we use the model to project trend GDP growth rates based on what we know about demographic profiles, relative incomes, de- or re-leveraging tendencies and capital investment activity.

The demographic aspect is quite straightforward, inasmuch as projections of population growth and dependency ratios are readily available from the United Nations. They suggest that many Asian economies (though not China) and many African and Middle Eastern economies will enjoy a demographic advantage for the foreseeable future. European economies in both the West and the East are poorly placed, particularly relative to the developed economy bloc.

We use the model to project trend GDP growth rates

Many Asian economies and many African and Middle Eastern economies will enjoy a demographic advantage for the foreseeable future


UBS 12

Population growth

-1%-1%0%1%1%2%2%3%3%

Bulga

riaLit

huan

iaUk

raine

Latvi

aRo

mania

Russ

iaJa

pan

Hung

ary

Croa

tiaGe

rman

yPo

land

Eston

iaMa

cedo

niaPo

rtuga

lSl

ovak

iaIta

lyGr

eece

Denm

ark

Slov

enia

Czec

hAu

stria

Kore

aFin

land

NLD

Belgi

umUr

ugua

ySw

itzFr

ance

Swed

enS.

Afric

aTh

ailan

d UKAl

bania

China

Taiw

anKa

zakh

staSr

i Lan

kaBr

azil

Norw

aySp

ainMe

xico NZ HK

Chile

ARG US

Sing

apor

eCa

nada

Indon

esia

Austr

alia

Vietn

amTu

rkey

Peru

Ecua

dor

Moro

cco

Irelan

dInd

iaCo

lombia

Icelan

dIsr

ael

Alge

riaMa

laysia

Vene

zuela

Para

guay

Egyp

tPH

PCa

mbod

iaSa

udi

Unite

dQa

tarNi

geria

Pakis

tanKe

nya

Population growth, 2010-2020

Source: UBS/Haver/United Nations

Change in dependency ratio, 2010 – 2020

-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%

Saud

i Ara

biaBr

azil

India

Mexic

oNi

geria

Para

guay

Vietn

amInd

ones

iaPa

kistan

Ecua

dor

Peru

PHP

Camb

odia

Turke

yMa

laysia

Keny

aEg

ypt

Unite

d Ara

bCo

lombia

Vene

zuela

Urug

uay

Moro

cco

ARG

S.Af

rica

Alba

niaIsr

ael

Alge

riaCh

ileQa

tarMa

cedo

niaTh

ailan

dKo

rea

Portu

gal

Austr

iaGe

rman

yIce

land

Lithu

ania

Norw

ayRo

mania Ita

ly UK NZGr

eece

Denm

ark

Irelan

dCh

ina USSp

ainSw

itzKa

zakh

stan

Croa

tiaAu

strali

aBe

lgium NL

DFr

ance

Sri L

anka

Hung

ary

Latvi

aUk

raine

Swed

enCa

nada

Slov

akia

Bulga

riaSi

ngap

ore

Russ

iaPo

land

Japa

nEs

tonia

Slov

enia

Finlan

d HKCz

ech

Change in dependency ratio (%YoY, 2010-2020)

Older populations

Younger populations

Source: UBS/Haver/United Nations

The inputs into our forecasting exercise for leverage and financial risk are illustrated in the chart below. We assume that highly stressed economies will continue de-leveraging their balance sheets in the coming years and by a sufficient margin that returns their financial risk index to the level that existed in 1997. Conversely, we assume that low-stress economies in the developing world will re-leverage their balance sheets in the period ahead, and thereby assist in some re-balancing of the world economy, returning their financial leverage indicators to levels that existed some 12-13 years ago. Inasmuch as their capital markets will be deeper and more liquid and their other institutional and productivity-related fabric that much stronger, this emerging economy re-leveraging does not necessarily carry crisis- or bubble-related connotations that some observers might otherwise suppose.

We assume that highly stressed economies will continue de-leveraging their balance sheets in the coming years


UBS 13

Expected change in UBS financial risk index, 2010 – 2020

-500%-400%-300%-200%-100%

0%100%200%300%400%

HKCh

inaTh

ailan

dEg

ypt

Indon

esia

Taiw

anSi

ngap

ore

Chile

PHP

Mexic

oVe

nezu

elaSa

udi

Pakis

tan ARG

Malay

siaPe

ruQa

tarSr

i Lan

kaRu

ssia

Czec

hCo

lombia

Austr

alia

Japa

nSl

ovak

iaNi

geria

S.Af

rica

India

Turke

yKa

zakh

stan

Israe

lMo

rocc

oBr

azil

Ecua

dor

Keny

aMa

cedo

niaPa

ragu

ayUr

ugua

yNZ

Switz

Croa

tiaPo

land US

Unite

dNL

DGe

rman

yIce

land

Alba

niaAl

geria

Camb

odia

Bulga

riaKo

rea

Austr

iaCa

nada

Swed

enFin

land

Vietn

amNo

rway

Roma

niaHu

ngar

yFr

ance

Eston

iaDe

nmar

kUK

Belgi

um Italy

Lithu

ania

Spain

Ukra

ineSl

oven

iaGr

eece

Portu

gal

Latvi

aIre

land

Change in financial risk index, 2020-2010

De-leveraging impulses

Re-leveraging impulses

Source: UBS

The most difficult factor to forecast in this framework is average capital investment. Investment is highly correlated to several of the other factors that enter our regression, including balance sheet stress, per-capita income and demographics. We have therefore chosen to model investment activity as a function of these other variables and applied some additional judgement about how investment activity may evolve relative to its starting position and its average level over the past decade. That judgement involved lowering investment rates by around one percentage point of GDP in developed economies to take account of the probable adverse impact on the cost of capital of tighter financial regulation.

The specific inputs from this exercise are illustrated in the chart below. Notwithstanding weaker demographic potential Asian economies, including, China, Vietnam and India should continue to chalk up rapid investment rates as they enjoy ‘catch-up’ with the technology frontier achieved elsewhere in the world and as they take advantage of strong balance sheet positions. Much less favourable investment dynamics exist in many mature economies, partly because of previous over-investment and associated balance sheet stress along with less favourable demographic trends.

Asian economies should continue to chalk up rapid investment rates


UBS 14

Average projected investment rate, 2010 – 2020

0%5%

10%15%20%25%30%35%40%45%50%

Nige

riaIce

land

Germ

any

Lithu

ania US

Irelan

dSw

itzFr

ance

Para

guay

Finlan

dPH

PJa

pan

Braz

ilGr

eece UK

Urug

uay

Belgi

umTu

rkey

Austr

iaPa

kistan HK

Camb

odia

Ukra

ine Italy

Denm

ark

Mexic

oPo

rtuga

lCa

nada

Hung

ary

Peru

Chile

Eston

ia NZNo

rway

Austr

alia

Keny

aIsr

ael

S.Af

rica

Swed

enMa

laysia

ARG

Colom

biaTh

ailan

dPo

land

Alge

riaSi

ngap

ore

Spain

Roma

niaUn

ited

Latvi

aEg

ypt

Vene

zuela

Sri L

anka

Bulga

riaTa

iwan

Saud

iEc

uado

rIn

done

siaCz

ech

Russ

iaNL

DCr

oatia

Mace

donia

Slov

enia

Slov

akia

Kore

aKa

zakh

stan

India

Alba

niaMo

rocc

oQa

tarVi

etnam

China

Average investment rate (projected), 2010-20

Source: UBS

Relative per capita real GDP level (versus US)

0%20%40%60%80%

100%120%

Keny

aNi

geria

Camb

odia

Vietn

amPa

kistan Ind

iaInd

ones

iaUk

raine

Sri L

anka

PHP

Para

guay

Moro

cco

Ecua

dor

Egyp

tAl

bania

Mace

doni

Alge

riaKa

zakh

stBu

lgaria

Thail

and

Roma

nia Peru

Colom

biaCh

inaRu

ssia

S.Af

rica

Braz

ilTu

rkey

Malay

siaVe

nezu

elLit

huan

iaLa

tvia

Chile

Polan

dHu

ngar

yMe

xico

Croa

tiaEs

tonia

Czec

hSl

ovak

iaUr

ugua

yAR

GSa

udi

Portu

gal

Slov

enia NZ

Gree

ceKo

rea

Spain

Taiw

an Italy

Israe

lFr

ance

Austr

alia

Belgi

umGe

rman

yUn

ited

Cana

daAu

stria

NLD

Sing

apor

eFin

land UK

Qatar

Irelan

dDe

nmar

kSw

eden HK

Icelan

dUS

Switz

Japa

nNo

rway

Relative per capita real GDP level (vs US), 2008

US = 100%

Source: IMF/Haver

The inputs that are illustrated in the charts above are combined with assumptions concerning export shares to generate the forecasts that appear in the charts below. On the basis of our analysis, India, Vietnam and China will be three of the best-performing economies in the world economy over the next ten years. Morocco, Qatar, Kenya, Saudi Arabia and Egypt also score well among African and Middle Eastern nations. Several Western and East European economies along with Japan bring up the rear. Indeed, our model-generated trend growth forecasts for many of these economies are below 1%.

India, Vietnam and China will be three of the best-performing economies in the world economy over the next ten years


UBS 15

Model-generated 10 year trend growth rates by country

0%1%2%3%4%5%6%7%8%

Lithu

ania

Japa

nGe

rman

ySw

itzFin

land

Gree

ceUk

raine

Fran

ceIce

land

Austr

iaBe

lgium US HK

Denm

ark

Italy

Portu

gal

UKIre

land

Eston

iaHu

ngar

yLa

tvia

Polan

dSi

ngap

ore

Cana

daNo

rway

Swed

enBu

lgaria

Roma

niaSl

oven

iaUr

ugua

yRu

ssia

NLD

Spain NZ

Austr

alia

Croa

tiaBr

azil

Czec

hKo

rea

Thail

and

Chile

Slov

akia

Mace

donia

S.Af

rica

Taiw

anTu

rkey

Mexic

oSr

i Lan

kaPa

ragu

ayIsr

ael

Nige

riaAR

GPH

PPe

ruCo

lombia

Camb

odia

Alge

riaMa

laysia

Kaza

khsta

nUA

EEc

uado

rIn

done

siaAl

bania

Vene

zuela

Pakis

tanEg

ypt

Saud

iKe

nya

Qatar

Moro

cco

China

Vietn

am India

Predicted 10 year trend growth rate

Source: UBS estimates. These estimates were obtained by applying the model that we estimated above to the inputs that we laid out above for dependency ratios, per capita GDP levels, financial risk, and investment rates and some further assumptions about likely changes in export to GDP ratios. We then added back projected population growth rates to the per capita GDP growth rates that were backed out of our model.

Our model implies that the world economy will register an average growth rate of around 3% over the next decade. This is about one percentage point below the trend in the previous ten years. That slowdown is the product of ebbing world population growth, ageing workforces in developed economies, the impact of further balance sheet de-leveraging, and weaker rates of trend productivity growth in many developed economies.

The model-based estimates suggest that developed economies will record growth of just 1.3% per annum over the next decade, while developing economies achieve growth of around 5% p.a. A growth gap of between 3.5 and 4 percentage points should continue between the developed and developing economies over the medium term.

Asia and the Middle East will be the fastest growing regions of the world economy over the next ten years according to our estimates. Still, Asia will record slower trend growth rates, whereas the Middle East should see stronger average growth assuming, as we do, that real oil prices remain elevated. Latin America is another region that should see slightly faster rates of growth in the coming decade, notwithstanding the weaker outlook in some of its principal export markets (e.g. the US). Perhaps the biggest scope for disappointment will emerge in Eastern Europe, where growth is projected to average just 2.5% over the next decade, about half the rate witnessed over the past decade. Finally, sub-Saharan Africa may achieve a respectable growth rate of over 4% in the next decade, albeit slightly slower than in the previous decade. The deceleration is almost entirely due to weaker growth in South Africa. Other economies such as Kenya and Morocco should perform well.

Our model implies that the world economy will register an average growth rate of around 3% over the next decade

Developed economies will record growth of just 1.3% per annum over the next decade while developing economies achieve growth of around 5%

Asia and the Middle East will be the fastest growing regions of the world economy over the next ten years


UBS 16

Model-generated trend GDP growth estimates for the world economy by region

0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%8.0%

WorldAdva

nced e

conom

ies USEuro

zone

Japan

Develop

ing ec

onomies Asia

Latin A

merica

Eastern

Europe

Middle E

astSub-

Saharan

Africa

10 year historic trend, 1998 - 2008 Model-generated trend, 2010-2020


Some scenario analysis In this section we take a look at some of the risks that confront the world economy and deploy our model for scenario analysis in order to understand how those risks might impact the base-case forecasts that we laid out above.

Severe sovereign debt crisis

In the first scenario we consider a severe and prolonged sovereign debt crisis in the developed economies. We assume that this crisis derails not just some of the well-known peripheral European economies that have highly leveraged public balance sheets. Rather we assume that nearly every major developed economy succumbs to heightened investor risk aversion, intense financial market aftershocks, and associated balance sheet and investment constraints. In this scenario we assume that investment rates fail to climb above the levels they attained in 2009 in the developed economies and that more significant de-leveraging occurs. Global growth averages just 2.2% over the next ten years in this scenario with advanced economies achieving growth of just 0.6%. Developing economies are hit as well as export growth potential is curtailed and investment slows. Average emerging growth rates in this scenario fall to 4.3% from 5% in the baseline forecasts above.

What are the risks?

We consider a severe and prolonged sovereign debt crisis in the developed economies to be a risk


UBS 17

The impact of a severe sovereign debt crisis on trend GDP growth estimates

0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%

World

Advance

d econ

omies US

Eurozon

eJap

an

Develop

ing ec

onomies Asia

Latin A

merica

Eastern

Europe

Middle E

ast

Sub-Saha

ran Afric

a

Baseline scenario Severe sovereign debt crisis


Heightened protectionism

Another worry is protectionism amid tough economic times across much of the world economy. As we have noted above, the role of export-related activity in determining an individual economy’s growth potential appears over-stated. Still, protectionism could clearly derail trade activity and depress growth, particularly in export-sensitive economies. Our risk scenario assumes that the world trade share of GDP falls by 3 percentage points, shaving slightly more off potential growth rates in developing countries but less in developed countries. Global growth potential falls to 2.7% in this scenario, 0.3 percentage points lower than in the base case.

The impact of greater protectionism on trend GDP growth estimates

0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%

World

Advance

d econ

omies US

Eurozon

eJap

an

Develop

ing ec

onomies Asia

Latin A

merica

Eastern

Europe

Middle E

ast

Sub-Saha

ran Afric

a

Baseline scenario Heightened protectionism


Another worry is protectionism


UBS 18

China collapse

The next risk factor we consider is a hard landing in China. We assume that China’s investment rate falls by 10-15 percentage points with knock-on effects for other Asian economies’ export growth and re-leveraging. This would have a meaningful impact on Asian growth, lowering trend estimates by 1.5 percentage points primarily because China’s growth tumbles from around 7% in the baseline to 4.5% in the risk scenario. Global growth falls to 2.5% from 3%.

The impact of a hard landing in China on trend GDP growth estimates

0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%

World

Advance

d econ

omies US

Eurozon

eJap

an

Develop

ing ec

onomies Asia

Latin A

merica

Eastern

Europe

Middle E

ast

Sub-Saha

ran Afric

a

Baseline scenario China collapse


Active policies designed to deal with ageing

The final risk factor we consider is policies that restrain the impact on developed economies of population ageing. If governments pursue policies that encourage longer working lives the trend slowdown in the world’s labour force will not be as severe in the next decade (though the effect is postponed, not eliminated) and funding pressures on public balance sheets are not as acute. In this risk scenario we have assumed that the advance in dependency ratios in developed countries is restrained to one-third of the projected rate assumed in United Nations projections. We have also increased the export and investment assumptions that underpin our forecasts for the developing world. Global growth potential is lifted by 0.2 percentage points as a result. Advanced economies achieve growth of 1.8% in this scenario versus 1.3% in the baseline.

Another concern is a hard landing in China

An upside risk relates to policies that mitigate the impact of population ageing


UBS 19

The impact of policies that restrain demographic pressures on growth

0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%

World

Advance

d econ

omies US

Eurozon

eJap

an

Develop

ing ec

onomies Asia

Latin A

merica

Eastern

Europe

Middle E

ast

Sub-Saha

ran Afric

a

Baseline scenario Model-generated trend

Source: UBS

Policy implications One of the biggest implications of the work above is that consensus forecasts for the world economy’s long-term growth potential are too high. It is admittedly difficult to obtain these estimates, particularly for developing countries. But where they are available for developed economies, they are typically above those that our model-based forecasting exercise generated above (see chart below).

Model-generated trend growth rates versus consensus forecasts

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

USJap

an

Germany

France UK Ital

y

Canada

Netherla

ndsNorw

aySpai

n

Sweden

Switzerlan

d

Model-generated trend growth rate Consensus forecast

Source: UBS and Consensus Economics

In short, consensus long-term growth forecasts appear optimistic. That is also reflected in the downward trend in our global growth surprise index (see first chart below). The persistent tendency, in other words, over a prolonged period of time, for forecasters to over-estimate economic activity is an indication that consensus forecasts for growth potential have been over-stated.

Consensus forecasts for the world economy’s long-term growth potential are too high relative to our forecasts


UBS 20

Global growth surprise index

100

105

110

115

120

125

130

135

140

Mar-0

5

Jun-

05

Sep-

05

Dec-0

5

Mar-0

6

Jun-

06

Sep-

06

Dec-0

6

Mar-0

7

Jun-

07

Sep-

07

Dec-0

7

Mar-0

8

Jun-

08

Sep-

08

Dec-0

8

Mar-0

9

Jun-

09

Sep-

09

Dec-0

9

Mar-1

0

Jun-

10

Global growth surprise index

Source: UBS

This has further ramifications as the inflation debate is concerned. If global growth potential is over-estimated, the margin of spare capacity in the world economy may not be as big as is commonly believed. Does that mean that we should not worry about the threat of deflation?

The critical element is the policy response. If policymakers also over-estimate their potential growth rates there is some danger that they will keep policy settings too loose for too long and thereby unleash higher inflationary pressures some point. For now that danger seems very low, but it may present itself at some future date.

Global inflation surprise index

74

76

78

80

82

84

86

88

90

Mar-0

5

Jun-

05

Sep-

05

Dec-0

5

Mar-0

6

Jun-

06

Sep-

06

Dec-0

6

Mar-0

7

Jun-

07

Sep-

07

Dec-0

7

Mar-0

8

Jun-

08

Sep-

08

Dec-0

8

Mar-0

9

Jun-

09

Sep-

09

Dec-0

9

Mar-1

0

Jun-

10

Global inflation surprise index

Source: UBS/Bloomberg


UBS 21

Investment implications Our analysis of trend growth also lends itself to several investment implications. The first set of implications derives from the differential trend growth rates between emerging and developed economies. This ought to manifest itself in gradual appreciation pressure for emerging economies. To the extent that pressure is resisted by policy makers, it suggests greater inflation risk in emerging economies over time.

In equity markets, the better outlook in developing economies for productivity and return on equity implies that emerging market risk premia should continue to shrink relative to advanced economies. This implies that benchmark weights for emerging equities in multi-asset portfolios may also rise in line with their increasing share in global earnings.

Emerging vs. advanced economy equity valuations EM share of equity capitalisation and earnings

-80%

-60%

-40%

-20%

0%

20%

40%

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10EM P/BV relativ e WorldEM RoE relativ e World (forw ard earnings)

0%2%4%6%8%

10%12%14%16%18%

88 90 92 94 96 98 00 02 04 06 08EM equity market cap % World EM earnings % World

Source: UBS, Bloomberg, DataStream Source: UBS, MSCI

Similarly, in sovereign bond markets, we would expect risk premia in emerging markets to shrink over time. Relatively healthy sovereign balance sheets and lower financial risk scores (compared to advanced economies) and improving liquidity in many emerging bond markets should support this trend going forward.

These changing asset allocation trends may increase the risk that emerging market asset markets rise above levels that can be justified by fundamentals alone – i.e., they may be prone to form bubbles as speculative capital flows increase over time. Policy makers may seek to re-dress this shift by diversifying accumulated reserves away from domestic asset markets, and by using other policy tools such as capital controls and sterilisation to dampen any adverse domestic impacts from these flows.

A second set of investment implications centres on the potential impact of lower trend growth on markets. A reduction in trend growth implies a reduction in trend earnings growth. In earlier work, our asset allocation team have shown that equity multiple expansion/compression is typically a function of swings in long-term earnings expectations. In a world of slowing trend growth (and probable downward revisions to trend earnings estimates), equity multiples are unlikely to expand, even from already compressed levels.

Greater exchange rate appreciation pressures in emerging economies

Benchmark weights for emerging equities in multi-asset portfolios may continue rising

Risk premia in emerging economy sovereign bond markets to continue shrinking over time

A reduction in trend growth implies a reduction in trend earnings growth


UBS 22

In terms of bond markets, lower productivity growth has an ambiguous impact on yields. On the one hand, the spectre of lower trend growth implies that real yields should be lower. However, structurally lower productivity growth may also imply that inflation expectations increase over time, as discussed above, calling for higher inflation risk premiums. Our sense is that markets will likely concentrate on the former in the near term, keeping nominal bond yields low. On our estimates of trend growth for developed economies over the next ten years at just over 1%, and naively assuming trend inflation will remain at around 2%, long-bond yields of around 3% do not look particularly out of step.

Equity valuations and real earnings growth Bond yields and nominal growth in G7 economies since 1950

-100%

-50%

0%

50%

100%

150%

200%

30 35 40 45 50 55 60 65 70 75 80 85 90 95 00 05 10Real earnings grow th P/E change

60m rolling change

-10

-5

0

5

10

15

20

25

30

0 5 10 15 20Nominal bond y ield

Nom

inal G

DP g

rowt

h

45 degree line

Source: UBS, P/E is based on price-to-trend earnings available at: http://www.econ.yale.edu/%7Eshiller/

Source: UBS, DataStream

A final set of investment implications stems from our conclusions regarding the demographic shifts already underway in the global economy. Ageing populations, especially in the advanced economies, but also in some emerging markets, will put a strain on government finances via increased healthcare and welfare age-related spending demands. This could lead to increases in sovereign risk premia and also tend to exacerbate any move in bond markets driven e.g., by a sovereign debt crisis (as discussed previously).

Finally, the impact of baby boomers on financial and real asset prices is also worth consideration. As the ageing segment of the population progresses through retirement, a preference for safe and liquid assets may drive a de-leveraging of balance sheets creating selling pressure in equity and housing assets, and a natural demand for e.g., US Treasuries. Extending this logic across borders, capital flows may be influenced by relative differences in regional demographic trends, with countries with young productive workforces attracting investment flows.

Long-bond yields of around 3% do not look particularly out of step

http://www.econ.yale.edu/%7Eshiller/


UBS 23

Appendix Country acronyms in selected charts

ALB Albania LTU Lithuania

ALG Algeria MAL Malaysia

ARG Argentina MCD Macedonia

AUS Australia MEX Mexico

AUT Austria MOR Morocco

BEL Belgium NGA Nigeria

BRA Brazil NLD Netherlands

BUL Bulgaria NOR Norway

CAM Cambodia NZ New Zealand

CAN Canada PAK Pakistan

CHL Chile PAR Paraguay

CHN China PER Peru

COL Colombia PHP Philippines

CRO Croatia POL Poland

CZE Czech Republic POR Portugal

DNK Denmark QAT Qatar

ECU Ecuador ROU Romania

EGY Egypt RUS Russia

ESP Spain SAF South Africa

EST Estonia SAU Saudi Arabia

FIN Finland SGP Singapore

FRA France SRI Sri Lanka

GER Germany SVK Slovakia

GRC Greece SVN Slovenia

HK Hong Kong SWE Sweden

HUN Hungary SWI Switzerland

IDN Indonesia THA Thailand

IND India TUR Turkey

IRL Ireland TWN Taiwan

ISL Iceland UAE United Arab Emirates

ISR Israel UK United Kingdom

ITA Italy UKR Ukraine

JPN Japan URG Uruguay

KAZ Kazakhstan US United States

KEN Kenya VEN Venezuela

KOR Korea VIE Vietnam

LAT Latvia

Source: UBS


UBS 24

Notes:


UBS 25

Notes:


UBS 26

Analyst Certification

Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers; and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report.


UBS 27

Required Disclosures This report has been prepared by UBS Limited, an affiliate of UBS AG. UBS AG, its subsidiaries, branches and affiliates are referred to herein as UBS.

For information on the ways in which UBS manages conflicts and maintains independence of its research product; historical performance information; and certain additional disclosures concerning UBS research recommendations, please visit www.ubs.com/disclosures. The figures contained in performance charts refer to the past; past performance is not a reliable indicator of future results. Additional information will be made available upon request.


UBS 28

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what is the new normal

Documents

global growth

new global trend growth

weaker trend growth

newdivergent trend growth

weaker productivity

faster trend growth

new normal wont

potential output growth