Outlook 2011: Worst–case scenarios

Will the global economy succumb to these risks? A fear scorecard.

(To see this story in gallery format, click here. And for the rest of the Outlook 2011 special report, click here.)

Risk: High

Inflation already has China taking steps to cool its economy, but North American central bankers are not fighting rising prices yet. Canada’s annual rate of core inflation dropped to 1.4% late last year, and interest rates in this country are not expected to inch up before the second half of 2011. Meanwhile, the U.S. Federal Reserve is still trying to ward off deflation by stimulating the economy. Nevertheless, as a recent Fed paper noted, dramatically increasing a country’s monetary base is a proven “recipe for certain high inflation.” What’s more, the Fed’s balance sheet was already three times its pre-financial-crisis size when it announced a second round of quantitative easing in the fourth quarter. That’s why the risk of a U.S. inflation problem eventually hitting the world economy remains high.

California default
Risk: Elevated

New California Gov. Jerry Brown (right) inherited one hell of a mess on Jan. 3. Under Arnold Schwarzenegger, the issued IOUs to cover some bills, and projected deficits larger than most states’ budgets. Could California stiff its bondholders in 2011? The likelihood is low. Although the state has become the poster child for fiscal mismanagement, it is neither alone nor particularly remarkable. Most states are reeling from the steepest declines in tax receipts on record. TD recently assessed the most vulnerable: Illinois topped the list, while New Jersey and Rhode Island trailed closely behind; California came in at No. 10. Provided state economies continue to grow, TD contends that fiscal shortfalls will self-correct. California’s bonds are rated lower than those of any other state, but are still investment grade, and investors are still buying.

Global double dip
Risk: Elevated

Last fall, economist Nouriel Roubini (a.k.a. Dr. Doom) said there was a 40% chance of a double-dip recession hitting the U.S. “within the next 12 months.” Since then, worldwide growth has decelerated and China has moved to cool its economy. On the up side, however, the U.S. Federal Reserve has initiated another round of quantitative easing, and the Obama administration has extended Bush-era tax cuts to keep consumers spending. So while an American double dip could still trip up the world, there is a decent chance — providing the European banking system doesn’t implode — that the next recession is long enough away to be considered a new downturn when it hits. Scotiabank’s latest outlook sees world GDP growth dropping to around 4% this year, but economies still expanding in North America, Europe and Japan.

Trade war
Risk: High

Protectionist tendencies inevitably rise during economic turmoil. Leaders of G20 nations have vowed to avoid such tactics, but massive trade imbalances undermine that co-operative spirit. China continues to artificially depress its currency by buying up foreign assets, America grumbles even as it gorges on easy money, and resource nationalism, such as China’s reduced exports of rare-earth metals or Canada’s blocking of BHP’s Potash takeover, is escalating. Last year, some countries intervened in foreign exchange markets (Japan), while others imposed restrictions on capital inflows (Brazil). Germany’s Angela Merkel says protectionism is the largest threat to the global economy. Still, so far, the global trade war is a cold one, and the OECD says most investment measures introduced by governments last year support open markets.

Eurozone collapse
Risk: Severe

The EU’s Stability and Growth Pact was supposed to limit national deficits and debts to under 3% and 60% of GDP, respectively. Clearly, it didn’t work. Even with austerity programs in place, the eurozone’s collective budget deficit this year will exceed 4.5% of GDP. Creditor fears about sovereign debt defaults threaten to cripple banks throughout the EU. A failure to contain the problem in 2011 is so unthinkable that most market watchers think a solution, however painful, will be found. But to survive in the long term, the EU needs to become a stronger fiscal union with enforceable rules, which will require more public support, especially in Germany. This is why UBS analysts think the euro’s days are numbered.

Canadian housing crash
Risk: Elevated

Forecasts for Canada’s housing market are all over the map, especially in Ontario. But fears about an actual crash have subsided. That said, the Bank of Canada is clearly concerned about the real estate market if another financial crisis hits or inflation concerns force mortgage rates up faster than consumers can handle. After all, housing prices have outpaced inflation, and Canadian homes are generally considered to be overvalued (as much as 25%, by some estimates). The OECD projects that 7.5% of Canadian households could have mortgage trouble if rates rise this year.

Run on the greenback
Risk: Low

Obama’s decision to extend the Bush tax cuts bodes ill for a strong greenback in the long term. As noted by Camilla Sutton, a Scotia Capital currency strategist, the dollar is likely to resume a depreciatory trend because “its fiscal position is weak and, worse, there is only a limited plan in place to improve it.” That said, there is a good chance the greenback will rise this year due to European debt issues. After all, the euro’s days as a contender for global reserve currency are now on hold at best. And despite America’s spending habits, the greenback is still seen as a safe haven whenever financial crises — including ones caused by Americans — hit because most major countries want to maintain the value of their national reserves, which include dollar-denominated assets. As a result, the risk of a run on America’s currency has declined in recent months.

Triple-digit oil
Risk: Elevated

Most projections put the average price of a barrel of oil at around US$80 this year, but some market watchers see crude prices crossing into triple-digit territory. Jeff Currie, head of commodities research at Goldman Sachs — which correctly predicted oil would reach US$85 in 2009 — thinks crude has a good chance of hitting US$100 this year, primarily because “U.S. economic data has surprised to the upside.” Nevertheless, unemployment threatens the American economy, which is still on life support, and any gains in U.S. oil demand will have a tough time making up for ongoing stagnation in Japan, European austerity and Chinese curbs on inflation.

Flu pandemic
Risk: Low

Every once in a while, a nasty flu cuts a swath through humanity. It’s happened thrice in the past century: 1968, 1957 and the legendary Spanish flu of 1918. Although far less deadly than feared, H1N1 demonstrated yet again how rapidly disease can spread around the globe. This summer, the WHO officially declared us to be in a “post-pandemic period.” So when’s the next one coming? The risk of a pandemic in any given year is low, and betting on an emerging virus’s mortality is a mug’s game. But if a new pandemic does arrive, the world has never been better prepared. Telecommuting is increasingly easy, which bodes well for minimizing contagion while keeping crucial organizations functioning. Canada has been planning for a big one since 1983. But since every pandemic is different, the question remains: Have we prepared for the right kind?