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Friday Notes

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Private sector deleveraging to slow down economic recovery

Fri, Jun 19 2009, 12:51 GMT
by UniCredit Research

UniCredit Group

• Hope. The global economy is still contracting. There are, however, growing signs that global GDP will stabilize in the second half of this year and can return to a growth path in 2010. Hopes of a pronounced, V-shaped recovery are, however, still misplaced.

• Adjustment. The restructuring in the private sector has, namely, not yet been completed. Debt levels have to be reduced further, even though substantial progress has already been made in, for example, the US. For that reason, households and businesses will continue to curb their expenditures in the coming quarters.

• Drag. In light of the difficulties in obtaining credit and the severe erosion of net wealth, US consumers are simply compelled to save even more. The personal savings rate will increase by just over another one percentage point (cf. chart). That hampers growth! Our calculations suggest that private consumption will not increase by more than 1½%-2% in the first year of the upswing. That is substantially below the level of previous economic upswings (pages 4-6).

• U, not V. The same holds true for US investment. For that reason, we expect that the current recession will merely transition into a moderate, U-shaped recovery. The US economy will probably expand by only 1¼% in 2010 (consensus: roughly 2%). For the eurozone, we even expect little more than stagnation (consensus: +0.5%; ECB however: -0.3%).

• Further topics:

  – Weekly Comment: Time to reflect (page 2).

  – US: Non-Financial sector becomes more conservative (page 7)

  – Eurozone: Taking a walk on the bright side (page 9).

  – Data outlook: EMU purchasing managers more confident again; no new impulses from next week’s FOMC meeting (page 13).

  – Market outlook: A breather for EUR & government bonds (page 22).

Time to reflect

We have cautioned that enthusiasm about the signs of recovery was probably excessive, and the fact that markets have been taking a breather in the last few days is, in our view, a positive development. We do not mean to downplay the importance of the positive signs that have emerged in the global economy in recent months. Indeed, in our analysis, we have shown how these signs are extremely widespread, and this bolsters our confidence that the economy has indeed turned the corner. The risk of a global depression has, in our view, been averted, thanks largely to the timely and decisive policy response, and that is no small feat. A huge and loud sigh of relief is more than justified.

However, we do need to keep in mind that the economic data for Q2 looked especially good because they were being compared to a disastrous couple of preceding quarters: the globally synchronized slowdown had created a positive statistical effect across the world economy. As we start comparing Q3 data to Q2 data, we are extremely unlikely to observe the same pace of improvement. We will more likely see mixed data with more evidence of stabilization; but, as ECB President Trichet has cautioned, this is stabilization at an extremely low level. It seems very unlikely that the data will give unequivocal support to the idea of a strong V-shaped recovery.

The data in the coming months will also likely show more differentiation across countries. This will happen between developed and emerging economies, and also across developed economies and across emerging economies. This is also a sign of normalization: over the past several years, the global economy has experienced first a global credit bubble, and then a global financial shock, both of unprecedented proportions. Unsurprisingly, these shocks have overwhelmed all differences across countries, causing first a global boom in growth and then a global downturn. But as the situation normalizes and the global economy returns to a more sustainable growth path, differences across countries will come to play a more important role.

This week’s data have already given us a taste of these trends. Data have been mixed, and they have differed significantly across countries. In the UK, retail sales brought a major disappointment, and will give some perspective to the view that the UK might already be exiting from the crisis, a view that was starting to gain wider acceptance. At the same time, some of the US data were considerably more encouraging: initial jobless claims were well below their March peak, and the Philadelphia Fed index was significantly better than expected. Even the US numbers, however, can be seen from two different perspectives: on the one hand, they beat expectations and confirmed an improvement in the situation, but on the other hand, initial jobless claims were still above 600K, and even the Philadelphia Fed index remained in contractionary territory.

The difficulty of interpreting mixed data was evident also at the recent G-8 meeting, where policymakers had somewhat different views on how quickly an “exit strategy” should be developed and implemented. Our overall view here remains the same: the recovery is beginning, but it will be gradual, and for the time being both the global economy and the financial system remain fragile. As a consequence, we believe it would be way too early to start withdrawing monetary and fiscal stimulus right now. At the same time, however, we think that it is not too early to start preparing an exit strategy. This is more important for fiscal policy than for monetary policy. The latter can be tightened more quickly, by hiking rates and withdrawing liquidity – the main challenge is to get the timing right. Fiscal policy tightening might take a bit longer, but, more importantly, the quality of fiscal adjustment will be even more important than its timing. The main challenge as we exit the crisis will be to help the private sector to grow and gradually replace the push provided by the public sector. This will not be easy, and policy makers should take great care to avoid that the fiscal consolidation that they will need to implement does not simply consist of a sharp increase in taxes that could strangle an already struggling private sector. Governments will need to reduce public expenditures and make them more efficient, and this will require a number of very difficult political choices. Preparations should therefore start now.

The related, underlying question is what kind of rate growth the global economy can sustain after the crisis. In the years leading up to the crisis, US household consumption acted as the engine of global growth. Now, however, US households need to repair their balance sheets, and as Harm Bandholz shows in his Research Note, this implies that the US household savings rate will continue to increase further, to at least 7%, which will cause a drag on consumption throughout 2010. And while US firms are in better shape, Roger Kubarych shows that they also need to undergo some additional restructuring, which will likely limit the strength of investment expenditure. The bottom line is that the US will not grow as fast as it used to – households and firms will live more within their means, and the country will reduce its current account deficit. This is what many observers had been wishing for a long time. The less palatable implication, however, is that unless somebody else picks up the slack, global growth will be significantly lower than it used to be.

Eventually, a major push to global growth will come from private consumption in emerging markets, but this is a longterm project, which will play out over the next few decades rather than the next few years. The OECD has recently upped its forecasts for China’s 2009 growth, but also noted that most of it will be government-generated. Europe and Japan seem unlikely to be able to generate robust private growth soon. If that is the case, we might need to adjust to the idea of a much lower growth path – at least unless the Lisbon agenda works a miracle…

The next few months, therefore, will bring some disappointment, which should help keep some pressure off government bond yields. It will also be a time for some sober reflection on the future, and more than fretting about the timing of the exit strategy, policymakers should give some thought to what can be done to boost potential growth.

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Published on  Fri, Jun 19 2009, 13:02 GMT