• Unity. The major central banks are in agreement: Yes, the economic outlook has improved appreciably of late; but no, this need not necessarily translate into a sustained upswing. The Fed, the ECB, and the BoE already issued statements to this effect recently. The BoJ and the SNB should also adopt this line next week and contradict a quick monetary policy reversal.

  • Criticism. We too still see no reason for excessive optimism, above all concerning the economy next year, when important temporary support factors expire but important structural problems still persist (page 2). Nevertheless, the criticism of the cautious wait-and-see stance adopted by the central banks should intensify when growth above potential is in some cases achieved right at the start of the economic recovery.

  • Comeback. On the heels of the recent rapid rise in the leading indicators, global trade is staging a comeback. In some Asian emerging markets, production levels have already returned to pre-crisis levels. This will take much longer in the industrialized countries. Nevertheless, many of them are also already reporting an initial strong industrial recovery after the steep decline. In Germany, for example, all the evidence suggests that the current quarter will bring the strongest export dynamic since reunification (page 6).

  • Further topics:

    – FX: Carry trades remain "en vogue" (page 8).

    – Data outlook: Disinflation runs out (page 10).

    – Market outlook: Yields remain subdued in the short term; Pressure on USD remains (page 13).


The Global Cycle: Adelante, con juicio! (Ahead, with caution!)

  • Back from holiday, we take stock of the last month of data to assess the health of the global economic cycle. Most evidence underlines the fact that the global recovery might have been faster than previously anticipated.

  • Recent improvements are genuine, but we remain cautious, as uncertainties still loom over the global cycle.

  • Inventory rebalancing and the revival of global trade are the most welcome news, as they have put a floor under the freefall in activity observed at the turn of the year and lay the basis for the recovery now.

  • However, the lagged effects on labor markets (in Europe and in the US), the rebuilding of the US savings rate and still tight credit standards call for great caution.


A bird’s eye view on 2Q GDP

The recent round of 2Q GDP releases has confirmed the impression that the global recovery might have been faster than markets had been anticipating before the summer.

In the eurozone, economic activity at the area-wide level contracted “just” a mere 0.1% on a quarterly basis (1Q: -2.5%), much less than expected, thanks to sizeable upside surprises in France and in Germany, where quarterly growth was already back in positive territory. Notably, the breakdown revealed that household consumption grew 0.2% qoq, although much of the increase should have come from national car scrapping subsidies. Fixed investment kept contracting (-1.3% qoq), albeit at a more moderate pace than in the previous two quarters, while inventories fell sharply again, shaving 0.7pp off growth. Finally, the positive contribution coming from trade should be considered with caution, as it stemmed from imports falling faster than exports.

In the US, the second release of 2Q GDP showed a 1.0% annualized contraction, while the UK was probably the only developed economy to have disappointed expectations, showing a 0.8% qoq decline. In Asia, the main emerging economies reporting quarterly figures (China, Indonesia, South Korea and Singapore) grew by an average annualized rate of more than 10%, while usually sluggish Japan rebounded by a solid 0.9% qoq, slightly less than expected, although this was somehow mitigated by an upward revision to 1Q figures. Elsewhere, the resilience of Latin America, especially Brazil, has positively surprised: while GDP figures are not available yet, industrial production expanded 14% (3M/3M, annualized) in the second quarter, after having collapsed at the turn of the year.


Dear Prudence

These developments did not come as a surprise. After having been on the brink of near collapse in 4Q08/1Q09, we were expecting the global economy to show first a slowdown in the pace of decline and then to recover, mainly thanks to a rebalancing of demand and supply in the manufacturing sector that would have boosted inventory rebuilding. However, we warned that such an improvement could have been short-lived, as it was boosted mainly by a sizeable fiscal stimulus, while significant uncertainties remained. After a few weeks and a round of additional data on hand, we maintain our constructive but prudent stance. We do not dismiss the recent encouraging data, and we actually welcome them as genuine signs that the worst is really over, but must acknowledge that the headwinds for the global economy remain powerful. Thus, while we took stock of better-than-expected data upgrading our near-term outlook for the eurozone, we left the overall growth profile for 2010 largely unchanged.

In May, we analyzed a set of economic indicators at the global level and developed a Global Cycle Index, i.e. a tool to measure the breadth of the recovery1. At that time, the index was signaling that the recovery was very ample in scope, although the real question was whether the global economy was heading for a robust recovery, a weak recovery or stagnation. Now our Global Cycle Index still points to a sustained diffusion of the improvement, with the most important contribution signs coming from the major exporters, clearly benefiting from a revival of trade at the global level. However, we should not look for a clean bill of health. With the US outlook still shaky, subdued credit growth and persistent fragilities in financial markets, even strong Asian growth might not be enough to guarantee robust and sustained global growth beyond the near-term rebound fuelled by fiscal stimulus.


Good news I: Inventory Rebalancing

The first good news is that a significant number of countries now have PMIs approaching or even above the 50-threshold, hinting that activity picked up some momentum. In the eurozone, the final reading for the Manufacturing PMI in August showed an increase to 47.9 from 46.3 in July, while in the US the ISM manufacturing index is back to its pre-Lehman levels at 52.9. The Services PMIs and non-manufacturing ISM confirm the improvement in firms' morale, picking up to 49.9 in the eurozone and jumping to 51.3 in the US. Elsewhere, UK, China and Singapore have already crossed the 50-threshold, while the PMIs in Sweden and Norway have displayed very strong orders (in Sweden it is now over 60).

When monitoring the global cycle, given the key role played by the imbalance in the industrial sector, a cornerstone of our analysis has always been the sales-to-inventories ratio, which we proxy via a survey-based measure based on the new orders and inventories components from the Purchasing Managers Indices. In fact, the ratio between new orders and inventories (NO/I ratio) has kept rising: in the eurozone, in August it reached 1.20, the highest level since January 2007, while in the US it has recovered steadily from its minimum of 0.58 touched in December 2008 and stands now at a whopping 1.89, which is the highest since 1975! The same pattern applies to China. As the NO/I ratio is usually a reliable leading indicator of the headline index, the recent pick-up clearly bodes well for business sentiment going forward.

Interestingly enough, in the eurozone, the finished stocks component of the Manufacturing PMI remained largely unchanged over the past three months. This is good news for two reasons. First, the improvement in the NO/I ratio came mainly from new orders. Second, this would suggest that the pace of inventory liquidation has stabilized. This is encouraging, as it is the change in inventories and not the level that enters GDP calculations. Thus, after having shaved 0.7pp off quarterly GDP growth both in 1Q and in 2Q, inventories should not act as a drag in the current quarter. Therefore, PMIs and other business surveys tell us that final demand has stabilized or rebounded after deep contractions late last year and into the start of this year.


Good News II: World Trade is back!

Back in March, we had showed that, even factoring in the positive effects from fiscal stimulus and lower interest rates, any recovery in the eurozone would need to come primarily though an improvement in world trade2.

To this extent, recent figures coming from Asian economies are encouraging: domestic demand performances in China, India and Indonesia have demonstrated strong resilience; industrial production in China is now trailing above 10% yoy, a sizeable pick-up from the 3% bottom touched this spring. Elsewhere, the Bank of Korea's business survey index of manufacturers' expectations climbed to 80 for August from 78 in July – the seventh straight monthly gain and the highest level since June 2008.

The eurozone, and Germany in particular, are benefiting from the stronger-than-expected rebound in Asia. The recent upward revision to our euro-zone growth forecasts reflects in good part a stronger expected contribution of net exports in the second half of this year. The Asian recovery story is a genuine and structural strength of the current global economic outlook. While China’s growth is in part inflated by excess credit growth, there is no doubt that we are witnessing the beginning of the rebalancing of Emerging Asian growth towards domestic consumption. To this extent, the fact that import growth in China lately has been much stronger than export growth implies that some rebalancing towards internal demand is in place. Moreover, on a more structural point of view, a number of Asian economies are now reaping the benefits of having entered the crisis with sound financial sectors and strong fiscal positions.

However, a word of caution is in order here. Asia is not yet strong enough to pull the rest of the world economy along, and thus it will be hard to ensure a sustained and robust recovery in Europe. To give an example, Germany, which is the eurozone’s export champion, depends on Asia for only 15% of its exports, compared to about 65% of German exports heading to the rest of the EU (including Central and Eastern European member countries).


Caution I: Household consumption

While the last GDP reports suggest that the recession is drawing to a close, there are reasons to keep a prudent stance. Recent evidence has showed that it is hard to decouple from the US economy. In turn, a lasting and self-sustaining recovery in the US would require a solid pick-up in private consumption. Recall that household consumption accounts for roughly 70% of total GDP and the last three recessions (1981/82, 1990/91 and 2001) were followed by solid rebounds in private outlays. However, in the current juncture, a sustainable rebound in consumption is made more difficult by a series of factors:

– The process of deleveraging of household balance sheets has led to a strong increase in the savings rate, now close to 4% of disposable income. Interestingly, as my colleague Harm Bandholz has showed3, the recent revision has showed a lower savings rate than previously thought. This would imply that households might not have adapted so quickly to the new adverse environment generated by the crisis, so that the deleveraging process still has some way to go. This will put further restraint on consumption in the US, especially after the “cash for clunkers” program has ended.

– Ongoing job losses: it is true that the pace of job contraction has finally eased. However, as showed by the 216K decline in August non-farm payrolls, US firms are still slashing jobs. As unemployment is a lagging variable, we should expect further increases in the unemployment rate, which will contribute to weigh on personal consumption. The same dynamics apply to the eurozone, where unemployment is currently 9.5%. In 2Q09, our employment indicator held broadly stable, and at 2.8 standard deviations below its long-term average, it still signals further deep job cuts. Faced with plunging demand, firms have shed jobs massively. The unemployment rate will rise steadily through 2010 when it will approach the 11% area.


Caution II: Credit and Banking

We have stressed several times that restoring decent credit growth is another key condition for the global recovery to become more sustainable, as it would break the feedback loop between a weakened economy and a still damaged financial sector. To this extent, figures from the ECB Bank Lending survey (BLS) published at the end of July and the Fed Senior Loan Officer Survey released in mid-August show some improvement with respect to last spring, but do not allow us to sound the all-clear on this front.

In the eurozone, the BLS keeps showing a net tightening in banks’ credit standards, but the good news here is that the figure is lower than in the first quarter, especially for enterprises, where the net tightening broadly halved, from 43% to 21%. Moreover, the survey showed that supply-side factors such as banks’ access to market financing and their liquidity position played a key role in lowering the degree of tightening. This is encouraging, as we have already voiced concerns that lending growth is bound to slow down further because of “elements of supply” taking the upper hand in driving credit dynamics.

However, we warn that credit growth tends to lag economic activity by 6-9 months, so that the trough in lending growth is usually reached at least 2-3 quarters after economic activity has actually bottomed. Recent data showed that lending to the private sector eased further from 1.5% to 0.6% yoy, driven by another sharp deceleration in lending to nonfinancial corporations (NFCs). We see the lending dynamics to both households and NFCs to slow down further in the remainder of the year, with a gradual recovery only in the second half of 2010. Both demand and supply drags will be at work and longer-term credit will be penalized more given that, in sympathy with the severe GDP contraction, loans at shorter maturities have already reacted.

In the US, the Senior Loan Officer Survey tells roughly the same story, showing that credit standards have continued to be tightened, although at a lesser pace than in April. The net tightening percentage fell to 31.5% (down 8.1 pp) for large and medium-sized firms and 34.0% (down 8.3 pp) for small borrowers. However, the greatest uncertainty comes from the question about the return of lending standards to longer-term norms. Horizons shorter than mid-2010 were assigned very low probabilities, while many banks saw tighter than average conditions beyond 2011.

A final note of caution: at the beginning of the year, we were impressed by the surge in lending in China, when the increase in money supply translated almost immediately into acceleration in loan growth. Recently, it became apparent that China’s central bank may rein in bank lending to avoid an asset price bubble. In fact, China's two largest state-owned commercial banks announced limits on their new loans in 2009. If this preliminary evidence will be confirmed in coming weeks, it may signal the end of the ultra-accommodative stance of the People's Bank of China.


Bottom line

As long as the recent improvement is mostly due to temporary factors, sustainability of global demand is clearly weakened. From spring 2010 onwards, export-dependent companies will face heavy headwinds once inventory rebuilding and fiscal stimulus will abate, so that the standard export-investment link that characterized former upswings will be hampered. Moreover, the extremely low level of capacity utilization implies that it might take a long time before investment will resume growth.