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Global economic recovery - could be dull and boring

Added on 29 May 2009 @ 12:00 AM

A week or so ago, the TED spread, a key measure of credit market health returned to pre-crisis (August 2007) levels. There is also talk of the ‘green shoots' of recovery everywhere. Leading indicators (confidence surveys, purchasing managers' indices, equity markets) worldwide are stabilising, i.e. not falling as fast as before, and should turn positive over the next few months, signalling a coming economic recovery. But what will the recovery look like?

The first thing to point out is that even when GDP growth rates recover, the lost output and income will not be replaced. Given how fast economies contracted in late 2008 and early 2009 it could take a while for GDP, i.e. the volume of economic activity to return to pre-crisis levels. Put differently, a 4% contraction followed by a 4% expansion doesn't quite get you back to where you were before the contraction. And as discussed below, it is unlikely that the pace of the global recovery will be as quick as the pace of the contraction.

We identify four areas of concern for the global economy, without attaching probabilities to the potential outcomes.

1. The nature of the downturn

Already, the IMF has warned in a recent report that this time round, the recovery is likely to be muted. Recessions caused by higher interest rates as monetary authorities attempt to fight inflation, such as the last major US recession of 1982, can be undone by cutting rates again. Recessions caused by banking crises, as the current one has been, are more difficult to combat as widespread deleveraging makes lower interest rates ineffective - no one is interested in borrowing and banks aren't lending. Savings rates are rising as people use the benefit of lower fuel prices and interest rates to save, rather than spend. The IMF also pointed out that, historically, globally synchronised downturns are far worse than when individual countries are in recessions at different times. During past economic crises, affected countries could export their way out of the recession (often with the help of a weaker currency). When virtually all countries are affected, an export-led recovery is not an option. Historic evidence suggests the combination of a globally synchronised recession and a banking crisis results in a very deep recession and a very weak recovery. In the process, public debt balloons as governments use fiscal policy to fight the recession (monetary policy being largely ineffective). The synchronised nature of the downturn also poses the question whether recovery will be synchronised.

2. The fear of inflation

Already, the response from authorities in many affected countries has been to slash interest rates (in some cases to nearly 0%), to print money to buy assets from banks (quantitative easing) and to spend more in order to boost economic activity. To put it in simplistic terms, they have been throwing money at the problem. At the moment, a lot of this money is being hoarded by nervous banks. But there is a fear that the money will eventually end up fuelling another speculative bubble(perhaps a green energy bubble?), like the dotcom and property bubbles that got us where we are. At the very least, there serious concerns that this avalanche of global liquidity could fuel inflation.

The fears are probably unfounded, though. Lets just look at the US for now. The Federal Reserve has been expanding its balance sheet (i.e. increased loans) because banks were contracting theirs. The net effect, then, is not quite an avalanche. As for inflation, it would in many respects be the better of two evils: the bigger fear is deflation, as experienced during the Great Depression. The combination of debt and deflation is particularly nasty, since the ability to repay debts (i.e. income) falls in a deflationary environment. Also, as noted above, to fight inflation, monetary authorities can continue to hike interest rates. To fight deflation, they cannot cut below 0%.

A global recovery will no doubt lead to some inflationary pressures as commodity prices pick up. Already, crude oil prices hovering levels around $60/barrel having fallen to $37/barrel in December, and a spike in the oil-price could ,take the wheels off an already derailed world economy, in the words of the Saudi oil minister. But with oil inventory levels still high, these price gains might be temporary. More importantly, monetary authorities have the fire-power to combat inflation, as long as they have the will to do so. This is another issue entirely of course, seeing that the Fed is taking a lot of flak for keeping rates too low for too long after the dotcom bubble burst.

3. Government Debts

Government borrowing to finance bank bailouts and fiscal stimulus packages has increased substantially. The problem for the US and UK specifically is that they went into this recession with sizable budget deficits. Now tax revenues have fallen, and spending requirements increased, meaning enormous projected deficits of 12% and 9% of GDP respectively. Thus while the world entered the crisis with highly leveraged companies and households, it will exit it with highly geared governments. To finance these deficits, governments have to increase tax rates - we've seen top marginal tax rates climb to 50% in the UK - or turn to the bond market. The problem is that higher tax rates are deeply unpopular and politically difficult. It is easier to issue bonds, but it could become progressively more expensive to do so. Already there have been suggestions that the UK (and by implication the US and others) could have the outlook on its AAA credit rating changed from ‘stable' to ‘negative'. Meanwhile, bond yields have already risen, partly in response to the flood of new issuance, but partly also because bonds acted as a safe-haven investment during the darkest weeks of the credit crisis, so the bond sell-off reflects, to an extent, a demand for riskier assets. Either way, rising yields will make borrowing more expensive for governments and private loans benchmarked to government bonds (especially US Treasuries).

Along with US bonds, the dollar (and yen) was a major beneficiary of safe-haven status (probably robbing gold of its traditional role). But if investors lose confidence in the dollar - more specifically in the purchasing power of the dollar - a dollar sell-off could result. A slightly weaker dollar - as we've seen over the past few weeks - could probably be seen as a welcome sign of increased risk appetite. But a tumbling dollar could lead to soaring commodity prices (especially oil) and further disruption to the global financial system.

4. Will it be sustainable?

A final concern is over the sustainability of any recovery. De-stocking by firms has been a main cause of the rapid fall in GDP. From present low levels, an improvement in inventory levels as firms re-stock is almost inevitable, and could lead to positive GDP growth for a quarter or two. However, high levels of unemployment and ongoing consumer indebtedness and deleveraging could lead to a ‘double-dip' recession, especially if authorities, fearing inflation as discussed above, raise interest rates or attempt to balance budgets too early. This was a mistake made during the Great Depression. The other grave mistake of the 1930s was rising protectionism, which choked off international trade. Even if we don't see a ‘double-dip' or W-shaped recovery, and most forecasts currently don't reflect this view, unemployment in the US and elsewhere probably represents the biggest economic challenge for the immediate future, with the worst of the credit crisis (hopefully) behind us.

Lastly, one might then ask how South Africa is positioned in respect to the above concerns. Fortunately, we went into the recession with a balanced budget (a slight surplus actually) meaning that our projected budget deficit over the next financial year is only around 4% of GDP (although the -6.4% first quarter GDP figure implies the deficit will be larger). Our authorities have plenty of fiscal and monetary fire-power. South African consumers are also less indebted than their foreign counterparts, and our banks are in better shape. Our relative dependence on commodity exports has hurt us, as the latest GDP numbers show, but a recovery in demand from the likes of China and India will benefit our mining sector. There is also no fear of deflation in South Africa and indeed, our medium-term outlook contains some risks with large infrastructure-related tariff increases looming. However, dollar weakness and increased risk appetite could continue to translate into rand strength, benefiting the inflation outlook. Overall, then, our economy should recover sooner and better than others. Realistically though, we shouldn't expect to immediately return to the 5% p.a. local GDP growth rates of 2004-2007. Similarly, investors should have realistic views of returns - especially from equities. Fortunately, returns are also dependent on the price you pay for an asset, and it is here where investors have opportunities that they didn't necessarily have a 12 - 18 months ago.

Fairbairn Capital | Old Mutual

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