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Black clouds lifting, grey clouds at the horizon

Fri, Sep 18 2009, 06:24 GMT
by UniCredit Research

UniCredit Group

One year after Lehman’s collapse, the mood has changed across the board—the very fact that these days are dominated by analyses of the impact and lessons of the Lehman’s debacle suggests we all feel the worst has been avoided, and we can now afford the luxury to sit back and take stock of the situation. Yet policymakers are remarkably united in maintaining a very prudent and cautious stance, in large part because they have learnt the lesson of another mistake, Japan’s premature policy tightening in 1997. Is such prudence justified? Or is it that policymakers, shocked by the post- Lehman terror, are now underestimating the strength of the recovery? I believe this recovery has genuine strength, and will continue to look like a V-shaped rebound through year-end and into 2010, with more upside surprises in the data.

Today’s improvement in initial jobless claims, housing starts and the Philly Fed index confirm that storm clouds begin to lift over the US sky as well, following the lead of Asia and Europe. The quick revival of global trade is the main positive surprise, the turnaround in the inventory cycle is just kicking in, and we have powerful policy stimulus still in the pipeline. In the wake of Lehman’s collapse, policymakers threw all they had at the global economy, hoping something would work—it is now all working at the same time, and the effect is bound to be impressive. But it will not last. Policymakers are right to be cautious. Policy stimulus will fade, and private demand is not ready to take over. The headwinds against consumption are well known, but we are particularly worried about the investment outlook. Concerns are centered on the risk of adverse feedback loops between the financial sector and the real economy, and the emphasis tends to be on the still fragile state of the banking sector with the attendant threat of a late-stage credit crunch.

Relatively less attention though is given to the financial health of corporations. During the credit bubble years, European corporates— with the notable exception of Germany—have substantially increased their leverage to fuel investment in the face of a marked decline in internally generated funds. The weaker financial position of corporates will inevitably influence banks’ risk assessments and lending policies. Independently of credit supply, however, the European corporate sector looks overdue for a deleveraging, which combined with record low levels of capacity utilization will slow the recovery in investment. So let us enjoy the upswing while it last, but be prepared for a reality check down the road—black storm clouds are lifting, but there are still grey rainclouds at the horizon.

Investors have become more optimistic, as reflected in a gradual rise in risk appetite which has benefited equities, commodities, and higher-yielding currencies, while ample liquidity supports safer bonds—the current favorite “sweetspot” theory. Analysts and financial experts begin to see a brighter future, and have started revising upwards their growth forecasts—the latest improvement in the ZEW index in Germany was a further indicator of returning confidence. This change in sentiment has pushed policymakers to quickly change hats, or at least emphasis: in Europe, where positive data surprises have been stronger, ECB President Trichet and Bank of England Governor King have sounded a decidedly dovish note—while in the depth of the crisis they sometimes acted as cheerleaders trying to support confidence, now they act as prudent family-heads, cautioning against premature enthusiasm. In the US, where data surprises have not yet gained the same momentum, Fed Chairman Bernanke is still trying to strike the right balance between reassuring consumers that the recession is finally over and warning them that the recovery will be slow and gradual. International institutions like the IMF are similarly stressing the uncertainties and unfinished business in terms of deleveraging and rebalancing of the global economy.

The cautious and dovish consensus of policymakers in the face of a rather reassuring wave of stronger data is noteworthy, and can be attributed to several causes: first and foremost, a determination not to repeat the Japanese mistake of premature tightening; second, a genuine concern over the temporary nature of some elements of the recovery and over the remaining fragilities in the economy and the financial sector; finally, in some cases, perhaps an understandable reluctance to relinquish the prominent role acquired as policy action achieved primacy over private sector dynamics.

I am also cautious, but we have to recognize one thing: this recovery is genuine enough to dispel fears of a double-dip recession, and in coming months will continue to look V-shaped. Europe has provided some of the better surprises, with France and Germany exiting the recession already in 2Q, and the eurozone as a whole now likely to display positive qoq growth in 3Q. In Europe as elsewhere, policy stimulus has played a key role, but it is global trade that has become the main engine of the recovery: the acceleration in economic activity has started most decisively in Asia, and its robust pace has helped turn net exports into an important contributor to growth—together of course with the ongoing contraction in imports.

This is hugely important: the collapse in global trade had been one of the most vicious features of the recession, and there were serious concerns that an intensification of protectionist pressures would dampen global growth in a fundamental and durable way. This risk now appears to have been averted. The prompt recovery in global trade might also bring a very quick end to the debate and soul-searching on Germany’s export-driven growth model: its dependence on exports condemned Germany to one of the deepest yearly contractions within the Eurozone this year, but as trade revives it will allow the country to enjoy a faster and more robust recovery than many of its neighbors.

The positive momentum of data surprises is likely to continue through the end of the year and possibly into early 2010, pushed by three main drivers: (1) global trade will continue to provide support; (2) the inventory cycle is only now kicking in with gusto, and will start showing up in the GDP growth data beginning in 3Q (inventories subtracted as much as 0.7pp from Eurozone growth in 1Q and 2Q); and (3) already enacted policy stimulus will continue to come on line and propel the economy. It has the making of a perfect storm, albeit a short-lived one: in the direst period of the crisis desperate policymakers threw all they had at the ailing global economy, hoping that something would work. It is now all working at the same time, and the effect is, unsurprisingly, exceeding expectations. The fact that policymakers are determined to keep loose policies in place for the time being is a further reason to believe that the positive momentum will be maintained for several more months. For the rest of this year and into the next, this will look like a V-shaped recovery.

Yet, growth momentum is fated to fade into 2010. Even though supportive policies will remain in place, policymakers will not provide fresh stimulus as the economy improves, and the policy impulse will therefore abate. Private sector demand will need to gradually take up the baton, but both investment and consumption face important headwinds. Eurozone consumers do not face the same deleveraging task as their US counterparts, but the persistent rise in unemployment will limit income growth and significant dissaving seems unlikely. As for investment, historically low capacity utilization rates suggest that corporates have plenty of scope to increase production before they need to put additional capital in place.

The nexus between corporates and banks and its possible “feedback loops” are a major source of concern. Attention tends to be focused on the risk of a credit crunch, and even the ECB, which through most of the crisis characterized the deceleration in credit growth as a welcome demand-driven correction from excessively high rates, is now voicing fears of possible constraints to credit supply. The underlying argument is straightforward: while the banking sector has strengthened its capital ratios to healthier levels, the projected rise in nonperforming loans could lower them again and trigger a new round of deleveraging through a reduction in credit to the private sector. Relatively less attention though is given to the other side of the equation, namely the financial health of corporations.

In our Euro Compass published today, my colleagues Davide Stroppa and Loredana Federico take a detailed and hard look at the financial health of the European corporate sector, and the results are sobering. After a period of balance sheet restructuring from 2002 to mid-2005, Eurozone corporates have seen a strong increase in indebtedness, as healthy operating profits were absorbed by a generous dividend policy and rising interest expenditures.

In other words, since mid-2005 Eurozone corporates experienced a reduction in internally generated funds for investment, and relied increasingly on external financing to fuel investment. As a consequence, Eurozone corporates now find themselves in a significantly weaker financial position then in the 2002-mid 2005 period. This deterioration is confirmed by indicators of debt service capacity, such as the ratio of earnings to interest expenses. Two caveats are in order before drawing conclusions: first, Eurozone corporates have accumulated substantial cash holdings compared to previous periods; second, there are significant crosscountry differences, with Italian corporates in a substantially weaker financial position than German corporates.

The picture that emerges is that of a corporate sector that has substantially increased its leverage during the credit boom years, and looks now somewhat stretched in terms of indebtedness and debt servicing capacity. This is in line with the ECB’s assessment at the beginning of the crisis, when the central bank noted that credit to the private sector had been growing at alarmingly high rates. What Davide and Loredana’s analysis clearly shows is that while the flow (of credit) problem has been quickly eliminated by the crisis, the stock problem remains. This in turn has two interlinked implications. The first is that prudent lending behavior on the part of banks will necessarily have to factor in the risk posed by already high levels of corporate debt, irrespective of any balance sheet pressures experienced by the banks themselves. The second is that Eurozone corporates probably face a period of cyclical deleveraging (albeit not as extreme as for US consumers), which seems likely to have a restraining effect on investment.

The sobering conclusion is that a lively acceleration of investment seems very unlikely in the near term. Relatively high corporate debt combined with record low capacity utilization points to the need for deleveraging rather than strong capital expenditures. With consumption also hampered by high unemployment, the unavoidable consequence is that as policy stimulus fades the recovery will experience an early soft landing before setting on a more sustainable, self-generating growth path towards end-2010/early-2011.

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Published on  Fri, Sep 18 2009, 06:33 GMT