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Labor markets impeding upswing

Fri, May 15 2009, 11:21 GMT
by UniCredit Research

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• Light. The recession in the eurozone worsened further at the beginning of the year. At -2.5%, GDP posted its highest ever q-o-q decline. However, contrary to the chilling view in the rearview mirror, the latest economic indicators now no longer rule out a more rapid and stronger improvement (page 2).

• Shade. Despite the potential for positive surprises in the short term, we must overall probably expect only a gradual recovery. One of the biggest obstacles to a strong upswing is the labor market. The numbers continue to show massive layoffs, and the drastic slump in investment activity points initially to a “jobless upswing” once the economy has stabilized.

• US. The same also holds true for the US. While there are already increasing glimmers of hope that the pace of the job losses is slowing, the declining number of layoffs compares with an increasing lack of job openings. As a result, the unemployment rate should remain at a very high level well into next year (page 5).

• Germany. The weakness on the labor market is also having a negative impact on the German housing market, even though it exhibits no signs of a price bubble. In fact, our analysis reveals no excessive but a nevertheless perceptible undervaluation. Regular declines in house prices during earlier labor market downswings do, however, clearly argue for a further drop in house prices in the short term (page 8).

• Further topics:

  – Data outlook: EMU: Purchasing managers again less pessimistic; US: Recession in the construction industry decelerating (page 12).

  – Market outlook: Little likelihood of new yield lows (page 18).

Germany: V, W, L

• At 3.8%, the decline in GDP in the first quarter was the highest ever recorded. More recent economic data for March (new orders, exports) were, in contrast, a positive surprise.

• Our analysis of historical recession phases reveals: In the last 40 years, a "V"-shaped recovery was not the exception but the rule. In most cases, the increase in GDP after the recession was even more pronounced than the preceding decline.

• Alongside the empirical evidence, the rapid destocking by companies and the second fiscal stimulus package also argue for a strong recovery. This, however, compares with a further massive deterioration in employment on the German labor market.

• We are, therefore, sticking to our baseline scenario of a sluggish recovery. The recession will probably end by fall 2009. The potential for positive surprises has, however, increased appreciably of late.

Even though the slump in GDP released today for the first quarter was a record-breaking -3.8%: Recent economic numbers for March were a positive surprise. On the heels of an unprecedented slump, new orders and exports posted their first increase again. But the latest data were not only the reason for hope. They have also fueled the debate over how the German economy will perform going forward. Will the recovery now come more quickly and be stronger than anticipated so far? In the following, we discuss three scenarios and their plausibility: V, W and L.

Scenario 1: The "V"-shaped recovery

Above all, four reasons could argue for a surprisingly strong recovery as early as the second half of 2009:

1. Historical evidence. It may sound surprising, but a "V"- shaped recovery in Germany was not the exception but the rule. This is illustrated by our analysis of recession phases in the last 40 years (see chart). After the first oil price shock in 1973, real GDP fell by close to 2½%. Once the recession ended, in contrast, GDP increased by 4% in the four subsequent quarters. Similar patterns can also be observed in later periods. De facto, this is, therefore, a sort of "asymmetrical V": The German economy did not move up and down at the same pace. In fact, its performance was dominated by jumps in growth after recession phases. It was only at the beginning of the 80s that the GDP losses and gains were roughly in balance. The primary force driving the strong asymmetry was exports, which posted disproportionate gains.

2. Rapid destocking. Because of the slump in global demand, German companies were compelled in recent months to drastically reduce their inventories (see chart). According to surveys conducted by the Ifo Institute, they posted their strongest decline ever since German reunification. While it is currently too soon to sound the all-clear, the destocking now appears to be winding down. The survey readings ("excessive inventories") did not deteriorate further in March and April. A slight increase in domestic and foreign demand could, therefore, suffice to ramp up production again.

3. Fiscal programs. The government spending packages could provide such a demand impulse as early as the second half of the year. At that point in time, part of the global infrastructure programs will probably be implemented and increasingly feed through into the economy.

4. "Animal spirits". The two economists Robert Shiller and George Akerlof recently pointed to the major role played by psychological factors for the economy and financial markets1. They contend that economic cycles are triggered by fluctuating corporate and investor confidence. In recession phases, confidence declines and a sort of selfsustaining effect kicks in. If, in contrast, there are signs pointing to improvement, more and more businesses “instinctively” regain confidence. The idea behind this concept stems from John Maynard Keynes, who described such behavior as "animal spirits".

Scenario 2: Flash in the pan ("W")

In the alphabet, "V" is of course followed by "W". This could also be what is facing the German economy in the coming year. Under this scenario, the recovery triggered by the government fiscal packages quickly runs out of steam. The reason: The multiplier effects prove to be too small. One additional euro in government demand triggers only a slight increase in personal consumption and investment. One key reason for this could be the fear of tax hikes. Since publicsector debt is being reduced again, households hold back on additional expenditures. Investment activity also does not accelerate; the situation on the labor market remains tight. The upshot is a "jobless recovery" lasting only a few months. It would also be conceivable that the government itself contributes to the economic slowdown next year. The recovery results after some time in a strong slowdown in public-sector spending. In this way, the upswing could be (involuntarily) choked again. An additional factor also urges skepticism: the further decline in global imbalances. In the short term, this process will probably be slowed by the stabilizing effect of the fiscal packages. But once the government spending programs come to an end, the US current account deficit could contract further. The global economy and, therefore, the world export champion Germany would come under strong pressure again.

Whether the flash-in-the-pan scenario actually materializes is ultimately a question of faith. The private sector may, for example, fear tax hikes – or not. For that reason, even only a rough quantification of future multiplier effects is literally a "mission impossible".

Scenario 3: "L"

The "L" scenario (meltdown with no recovery) has become much less probable recently. This is suggested primarily by the across-the-board improvement in leading indicators around the globe. Above all the export-oriented German economy should profit from this at least to some extent after the summer break. On top of that, there are the factors already mentioned, such as a trend reversal in inventories and the second economic stimulus package.

Baseline scenario: Sluggish recovery with significant upside risks

Our baseline scenario still calls for neither a "V" nor a "W". In fact, the German economy is currently in a transition stage. The "brutal recession" with slumping export and order numbers is a thing of the past. The recession is, however, not over yet. Instead, it has “only” lost substantial momentum. The biggest hurdle to a strong economic recovery after the summer break is the development emerging on the labor market. The extremely strong decline in employment will namely probably continue in the coming months – and this despite the short-time work benefit that acts as a sort of airbag. This is suggested by the latest hiring plans of companies (see chart). So far, there is still no sign of a bottom emerging in the surveys. Rising unemployment triggers a shortfall in private demand. Consequently, the economic upswing will probably be dampened in the coming months. Such a development is basically nothing unusual. The labor market is a typical lagging indicator, which in the last 40 years did not stand in the way of strong recovery phases. However, the unprecedented slump in hiring plans in manufacturing argues for a stronger drag on private demand than in earlier cycles.

In a nutshell: Our baseline scenario of a gradual economic recovery from fall 2009 onwards is intact. From that point in time, the "soft recession" under way should be over. Subsequently, the economy as a whole will then probably post slight growth again. There can, however, be no doubt: The potential for positive surprises has increased substantially in recent weeks. If GDP growth were to really increase strongly after the summer break, the danger of a flash-in-the-pan is high. Sooner or later, namely, US households will have to reduce their debt even more strongly. The upshot is persisting consumption restraint. The positive spark from the government spending programs might, therefore, not have a lasting impact on the global economy.

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Published on  Fri, May 15 2009, 11:43 GMT

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