The global economy is likely to be stuck in the "twilight zone" of sluggish growth in 2013, Morgan Stanley has warned, but if policymakers fail to act, it could get a lot worse.
The bank's economics team forecasts a full-blown recession next year, under a pessimistic scenario, with global gross domestic product (GDP) likely to plunge 2 percent.
"More than ever, the economic outlook hinges upon the actions taken or not taken by governments and central banks," Morgan Stanley said in a report.
Under the bank's more gloomy scenario, the U.S. would go over the "fiscal cliff" leading to a contraction in U.S. GDP for the first three quarters of 2013. In Europe, the bank's pessimistic scenario assumes a failure of the European Central Bank (ECB) in cutting rates and a delay of its bond-buying program.
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But the bank says investors should also be nimble, in case policy action is "convincing and decisive," leading to a big uptick in growth.
"Importantly, investors should keep an open mind and be prepared to switch between the scenarios as policy developments unfold."
The bank's most optimistic scenario forecasts GDP growth of 4 percent in 2012 compared to around 3.1 percent this year.
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Morgan Stanley isn't alone in warning about a recession next year. Noted bear, Nouriel Roubini warned on Monday that certain key developments would exacerbate the downside risks to global growth in 2013.
"Until now, the recessionary fiscal drag has been concentrated in the euro zone periphery and the U.K.. But now it is permeating the euro zone's core," Roubini wrote. "And in the U.S., even if President Barack Obama and the Republicans in Congress agree on a budget plan that avoids the looming "fiscal cliff," spending cuts and tax increases will invariably lead to some drag on growth in 2013 – at least 1 percent of GDP."
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Roubini said the rally in global markets that begun in July was now running out of steam as global growth slows and valuations look stretched.
"Price/earnings ratios are now high, while growth in earnings per share is slackening, and will be subject to further negative surprises as growth and inflation remain low. With uncertainty, volatility, and tail risks on the rise again, the correction could accelerate quickly."