http://www.portfolio-adviser.com/lwm/article/420
Recovery, but from a low starting pointby Richard Jeffrey
CIO, Cazenove Capital ManagementAs well as threatening to bring the world economy to its knees, the banking crisis has had two major impacts on the economic cycle. First, it has caused convergence in the cycles of all the major economies. Second, it has caused acceleration in various developments that normally take place over a longer period during the cycle.
The latter has been particularly evident in decisions taken in the corporate sector designed to defend cash and to afford some protection against the credit crunch. Most obviously companies have acted very rapidly to cut inventories and investment (together known as gross capital formation). The result has been an unprecedented collapse in manufacturing output, which has been accentuated by a lack of availability of trade credit.
Equity/fixed income markets
After a tough start to 2009, equity markets across the globe have subsequently made good progress and have begun to move into positive year-to-date territory. In the period ahead, it is likely that there will be evidence of greater uncertainty in market trends, as real data has so far underperformed expectations and it is likely that some of the more positive
hopes for the major economies, expressed in recent weeks, will prove premature. Indeed, the recent rally in equity markets can be regarded more as a recovery from severely undervalued levels (the result of the intense fear provoked by the banking crisis) than as a reflection of real optimism over future developments in the world economy.
In the area of fixed interest, the corporate credit market has seen a significant rally and we continue to favour corporate bonds over their government counterparts.
Economic outlook
The rapidity and steepness of the descent into recession have had a major influence on the way in which economic commentators have analysed contemporary developments and on their forecasts for the future. A consensus quickly emerged around the view that the world recession would be deeper and longer than the two more significant downturns that we have seen over the past 30 years – those at the start of the 1980s and 1990s. While this continues to be the most likely outcome, more recently there has been growing speculation that recovery might begin as soon as the third quarter.
This speculation has been prompted largely by surveys indicating that conditions in the manufacturing sectors of most major economies have improved. Almost certainly, this is because we are through the most severe phase of inventory reduction, with the result that there has been a modest improvement in order flow. Much less likely is that there has been any real recovery in final consumption, and it is this element of demand, in particular household spending, that will now determine how the cycle develops over the remainder of this year and further ahead.
Government policy
Another feature of this economic cycle that has contrasted with those preceding has been the reaction of finance ministries and central banks. Under the justification of ‘whatever it takes’, interest rates have been cut dramatically, fiscal policy has been loosened, and a number of countries have also begun quantitative easing. With regard to immediate prospects for activity, it is likely to be interest rates that will remain of most significance in the near term.
Looking at the situation in the UK, and comparing recent trends to previous downturns, it is evident that rates have come down much earlier, dramatically faster and almost inconceivably further. There is an interesting contrast to be made with the situation in the US. There, interest rates have also fallen quickly and to unprecedented levels. Crucially,
however, the process began after large numbers of households had found themselves in severe financial distress (this, after all, is why mortgage-backed debt became ‘toxic’). Not so in the UK, where interest rates were reduced before significant distress had emerged.
For many households with reasonable levels of debt, the impact of the financial crisis, to date, has been unambiguously positive. Indeed, the impact of falling mortgage interest payments was evident in a huge boost to household cash flow in the final quarter of 2008, and there is likely to have been a further improvement in the opening quarter of this year. The consequence for consumer confidence can be seen in the response to the question asked of households: “How do you expect the financial position of your household to change over the next 12 months?” (this is included in the GfK monthly survey of consumer attitudes). Initially, in the wake of the financial crisis, households showed understandably-extreme pessimism, with the reading dropping to a mean negative balance of -14. Most recently, the survey has shown a rebound to -1.
The obvious question is whether this change in household perceptions is justified. In large part, this is likely to be determined by developments in the labour market. In this context, there will be two important trends to watch. If unemployment continues to rise as fast over
the next few quarters as in the first, it is likely that this will cause a deterioration in consumer psychology, as well as have a more direct impact on demand. Simultaneously, a
weaker jobs market would put further downwards pressure on wage settlements and take-home pay, accentuating a declining trend that is just becoming evident. Together, these would tend to counteract the boost to disposable income from earlier cuts in interest
rates. They would also be likely to make consumers more risk averse in their behaviour.
On the basis of recent trends, it seems likely that increases in unemployment will remain high for some period. However, it is possible that the labour market cycle will show similar characteristics to the inventory cycle. In other words, that the initial rise in unemployment will prove the most extreme, with companies acting as quickly as possible to reduce labour
costs, before the rate of increase moves onto a more moderate path – with the latter development coming through somewhat earlier than expected.
It is currently very hard to call how households will respond to these divergent influences on behaviour; and, of course, there is the influence of trends in the housing market to take into account (although these will be subject to the same underlying financial and psychological forces that determine overall household behaviour, the negative wealth effect of falling house prices can cause a degree of negative feedback in the demand equation).
Clearly, there is a possibility that a damaging reaction to rising job insecurity, in particular, will be sufficient to create a double dip in the wider economic cycle. Currently, we do not think this is the most likely outcome. However, this does not mean that we are on the verge of a return to positive growth. Rather, it implies that the rate of fall in GDP is likely to moderate.
Recent data releases show that household spending has been contracting since (and including) the second quarter of last year. In the first quarter of this year, the real decline of 1.2% (compared to the previous three months) was the most significant over the period, and compared to the position at similar stages of previous economic cycles, consumer
spending has fallen appreciably more. It would be surprising were this to be reversed before the final quarter of the year. On the other hand, gross capital formation may begin to make a positive contribution to growth in the third quarter, and conceivably in the second. However, this will be after quarter-on-quarter declines of 10.9% and 7.9% in the fourth quarter of 2008 and first quarter of 2009, respectively (the latter being the fifth consecutive decline).
The risks to forecasting have never been higher. Our current numbers show a return to positive growth in the fourth quarter (which would not make this recession meaningfully longer than those in the 1980s or 1990s). However, we remain of the view that the medium-term outlook will involve a prolonged period of sub-trend growth, initially as
household spending behaviour is constrained by a prolonged (and necessary) increase in the savings ratio and then as the economy lumbers under the burden of huge public sector borrowing and debt.
Recovery, but from a low starting pointby Richard Jeffrey
CIO, Cazenove Capital ManagementAs well as threatening to bring the world economy to its knees, the banking crisis has had two major impacts on the economic cycle. First, it has caused convergence in the cycles of all the major economies. Second, it has caused acceleration in various developments that normally take place over a longer period during the cycle.
The latter has been particularly evident in decisions taken in the corporate sector designed to defend cash and to afford some protection against the credit crunch. Most obviously companies have acted very rapidly to cut inventories and investment (together known as gross capital formation). The result has been an unprecedented collapse in manufacturing output, which has been accentuated by a lack of availability of trade credit.
Equity/fixed income markets
After a tough start to 2009, equity markets across the globe have subsequently made good progress and have begun to move into positive year-to-date territory. In the period ahead, it is likely that there will be evidence of greater uncertainty in market trends, as real data has so far underperformed expectations and it is likely that some of the more positive
hopes for the major economies, expressed in recent weeks, will prove premature. Indeed, the recent rally in equity markets can be regarded more as a recovery from severely undervalued levels (the result of the intense fear provoked by the banking crisis) than as a reflection of real optimism over future developments in the world economy.
In the area of fixed interest, the corporate credit market has seen a significant rally and we continue to favour corporate bonds over their government counterparts.
Economic outlook
The rapidity and steepness of the descent into recession have had a major influence on the way in which economic commentators have analysed contemporary developments and on their forecasts for the future. A consensus quickly emerged around the view that the world recession would be deeper and longer than the two more significant downturns that we have seen over the past 30 years – those at the start of the 1980s and 1990s. While this continues to be the most likely outcome, more recently there has been growing speculation that recovery might begin as soon as the third quarter.
This speculation has been prompted largely by surveys indicating that conditions in the manufacturing sectors of most major economies have improved. Almost certainly, this is because we are through the most severe phase of inventory reduction, with the result that there has been a modest improvement in order flow. Much less likely is that there has been any real recovery in final consumption, and it is this element of demand, in particular household spending, that will now determine how the cycle develops over the remainder of this year and further ahead.
Government policy
Another feature of this economic cycle that has contrasted with those preceding has been the reaction of finance ministries and central banks. Under the justification of ‘whatever it takes’, interest rates have been cut dramatically, fiscal policy has been loosened, and a number of countries have also begun quantitative easing. With regard to immediate prospects for activity, it is likely to be interest rates that will remain of most significance in the near term.
Looking at the situation in the UK, and comparing recent trends to previous downturns, it is evident that rates have come down much earlier, dramatically faster and almost inconceivably further. There is an interesting contrast to be made with the situation in the US. There, interest rates have also fallen quickly and to unprecedented levels. Crucially,
however, the process began after large numbers of households had found themselves in severe financial distress (this, after all, is why mortgage-backed debt became ‘toxic’). Not so in the UK, where interest rates were reduced before significant distress had emerged.
For many households with reasonable levels of debt, the impact of the financial crisis, to date, has been unambiguously positive. Indeed, the impact of falling mortgage interest payments was evident in a huge boost to household cash flow in the final quarter of 2008, and there is likely to have been a further improvement in the opening quarter of this year. The consequence for consumer confidence can be seen in the response to the question asked of households: “How do you expect the financial position of your household to change over the next 12 months?” (this is included in the GfK monthly survey of consumer attitudes). Initially, in the wake of the financial crisis, households showed understandably-extreme pessimism, with the reading dropping to a mean negative balance of -14. Most recently, the survey has shown a rebound to -1.
The obvious question is whether this change in household perceptions is justified. In large part, this is likely to be determined by developments in the labour market. In this context, there will be two important trends to watch. If unemployment continues to rise as fast over
the next few quarters as in the first, it is likely that this will cause a deterioration in consumer psychology, as well as have a more direct impact on demand. Simultaneously, a
weaker jobs market would put further downwards pressure on wage settlements and take-home pay, accentuating a declining trend that is just becoming evident. Together, these would tend to counteract the boost to disposable income from earlier cuts in interest
rates. They would also be likely to make consumers more risk averse in their behaviour.
On the basis of recent trends, it seems likely that increases in unemployment will remain high for some period. However, it is possible that the labour market cycle will show similar characteristics to the inventory cycle. In other words, that the initial rise in unemployment will prove the most extreme, with companies acting as quickly as possible to reduce labour
costs, before the rate of increase moves onto a more moderate path – with the latter development coming through somewhat earlier than expected.
It is currently very hard to call how households will respond to these divergent influences on behaviour; and, of course, there is the influence of trends in the housing market to take into account (although these will be subject to the same underlying financial and psychological forces that determine overall household behaviour, the negative wealth effect of falling house prices can cause a degree of negative feedback in the demand equation).
Clearly, there is a possibility that a damaging reaction to rising job insecurity, in particular, will be sufficient to create a double dip in the wider economic cycle. Currently, we do not think this is the most likely outcome. However, this does not mean that we are on the verge of a return to positive growth. Rather, it implies that the rate of fall in GDP is likely to moderate.
Recent data releases show that household spending has been contracting since (and including) the second quarter of last year. In the first quarter of this year, the real decline of 1.2% (compared to the previous three months) was the most significant over the period, and compared to the position at similar stages of previous economic cycles, consumer
spending has fallen appreciably more. It would be surprising were this to be reversed before the final quarter of the year. On the other hand, gross capital formation may begin to make a positive contribution to growth in the third quarter, and conceivably in the second. However, this will be after quarter-on-quarter declines of 10.9% and 7.9% in the fourth quarter of 2008 and first quarter of 2009, respectively (the latter being the fifth consecutive decline).
The risks to forecasting have never been higher. Our current numbers show a return to positive growth in the fourth quarter (which would not make this recession meaningfully longer than those in the 1980s or 1990s). However, we remain of the view that the medium-term outlook will involve a prolonged period of sub-trend growth, initially as
household spending behaviour is constrained by a prolonged (and necessary) increase in the savings ratio and then as the economy lumbers under the burden of huge public sector borrowing and debt.
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