Global Economic Outlook

 
 
 
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The Economic Situation for Retailers

The global economy is decelerating, with growth in 2012 likely to be slower than was experienced in 2011 in many of the world’s leading markets.

In Europe, the crisis of the euro has led to the tightening of credit markets. In an effort to rebuild investor confidence, governments across the continent are cutting spending and raising taxes, the net effect of which is to weaken economies and, in the process, further undermine confidence. Meanwhile, the European Central Bank engages in a relatively neutral monetary policy aimed at suppressing inflation. As of this writing, the risk remains that the Eurozone will crumble, leading to an even worse economic downturn.

In the United States there are signs of accelerating economic activity, yet the failure of the government to agree on a path toward fiscal rectitude has wreaked havoc with investor confidence, hurting equity prices and employment creation. While the U.S. economy may accelerate in 2012, it will probably not grow at a pace sufficient to significantly reduce unemployment.

The world’s second-largest economy, China, is slowing following a tightening of monetary policy combined with the negative effects of slow growth in Europe and the United States. In addition, the remaining BRICs face slower growth resulting from the lagged effects of tight monetary policy and weak global growth.

Only in Japan is economic growth in 2012 widely expected to exceed that of 2011. The reason is that 2011 was so awful following the devastating earthquake and tsunami, andreconstruction expenditures are likely to provide a temporary jolt to the Japanese economy.

Retailers may find some silver linings in this otherwise cloudy environment, however. One positive effect of slower global growth will be continued dampening of commodity prices. For retailers, this means some improvement on the cost side of the ledger. Meanwhile, a number of countries, including the United States, Japan, several in Western Europe and many leading emerging markets, are seeing higher retail price inflation. Combined with stagnant input prices, this suggests the possibility of improved profit margins, even in the context of slow top line growth.

In many of the slowing markets, a disproportionate share of the growth of consumer income is accruing to the relatively affluent. This is especially true in the United States and China. Hence, for retailers targeting upscale consumers, the environment might not be so bad. As for retailers targeting everyone else, the ability to offer low prices to uncertain consumers will be a clear competitive advantage.

The most significant silver lining can be found on the long-term horizon. Even though the economic environment in 2012 will be difficult, the long-term outlook for the global economy remains good. Global growth in the coming decade is expected to be strong, with particular strength coming from leading emerging markets other than China. Of course China will grow, but it faces some headwinds, both demographic and structural. Other emerging markets like India, Brazil, Turkey, Indonesia, the Andean region of South America and much of sub-Saharan Africa offer the possibility of stronger growth and new opportunities for the world’s leading retailers.

Let us now consider the outlook for the world’s leading retail markets:

Western Europe
It is difficult to provide a helpful roadmap to a situation that, as of Q4 2011, still seemed to be changing daily. So perhaps it is best to look back at how it came to this.

The Eurozone project was intended to bind the economic and political fortunes of Europe’s economies in perpetuity, yet the architecture of this union was always lacking. Countries were required to maintain fiscal discipline, but there was never a credible vehicle for ensuring it. The first countries to violate the rules were Germany and France, and it is not surprising that others soon followed. Indeed, the existence of the euro enabled the countries of Southern Europe to borrow with abandon. Investors were happy to extend credit at low interest rates with the expectation that bonds denominated in euros were a safe asset.

Still, the absence of fiscal rectitude alone was not the biggest problem. The biggest problem was that several Mediterranean economies lost their competitiveness. Over the past decade, their wages rose far faster than their productivity, with the result that it became less feasible for them to generate the strong export revenues needed to service their external debts. Normally, a country with a competitiveness problem will devalue its currency. However, because these countries no longer have their own currencies, they cannot restore competitiveness unless they dramatically accelerate productivity growth and/or cut wages – both tall orders.

When Greece was unable to roll over its considerable debts and the EU bailout was deemed insufficient to correct Europe’s ailments, investors became fearful. Governments faced difficulty in rolling over debts, and banks that held such debts faced problems raising funds. Risk spreads increased, credit market activity declined and Europe faced a new recession.

Following the summer of 2011, Europe’s governments agreed on various measures to calm markets, but to no avail. Banks agreed to take a haircut on Greek debt, enabling Greece to reduce its borrowing requirement. The banks were then required to raise capital, most likely by reducing lending and selling assets. The EU established a large fund to provide liquidity to troubled sovereign lenders. Intended as a confidence-building measure to assure investors that sovereign debt was safe, the fund failed to calm markets.

There are three possible scenarios as to what might happen next. In the first, Europe agrees to engage in greater integration in order to avoid disintegration. This could entail using the European Central Bank (ECB) to backstop sovereign debtors and create a fiscal union with large transfers of resources from richer to poorer nations within the union. This would enable the Eurozone to succeed and ultimately prosper. The problem with this scenario is that it requires individual countries to give up sovereignty and abide by conditions set by the richer countries in the EU.

The second scenario is that the Eurozone fails. While this could happen, the short-term costs of disintegration would be catastrophic. It can be argued that, in the long run, some of the troubled countries would be better off outside the Eurozone, but much of Europe would suffer grievously during the transition. The Mediterranean countries would face problems in gaining access to global credit markets, while the northern economies would see their currencies rise rapidly, thereby hurting exports.

The third scenario, then, seems to be the most likely: Europe manages to hold the Eurozone together but fails to take action that would guarantee its success. This could be called the “muddling along scenario” and would likely involve a prolonged period of slow economic growth, political turmoil and periodic crises.

What does this scenario mean for retailers? It means continued fiscal contraction across Europe, in part through higher taxes, and tight credit market conditions. Consumer spending would grow slowly, if at all. Consumers would be highly price sensitive and uncertain about the future. For retailers, it would mean a severe market share battle. It would also means that, for retailers that are financially healthy, there would be good reason to accelerate the process of globalization in order to find growth outside of Europe.