From time to time, Morningstar publishes investment commentary and insight from asset managers, educational institutions, and registered investment advisers under as part of our third-party "Perspectives" feature. If you are interested in Morningstar featuring your content, please contact Online Editor Holly Cook at holly.cook@morningstar.com. Here, Schroders Chief Economist and Strategist Keith Wade takes a look at the new cycle for the world economy and outlines the investment management firm's new economic forecasts.
- After the deepest and longest recession in post war history one might have thought that an extended period of expansion was on the cards. This was the pattern in the 1980s and 1990s as the economy had plenty of slack to grow without creating inflation.
- However, whilst there would seem to be ample capacity for the economy to grow today, there are doubts about whether we will see an extended cycle. Concerns about structural unemployment and the growth ofd emand suggest we are in for a shorter, more volatile expansion. Constraints on fiscal and m onetary policy indicate that the scope for countercyclical policy is limited.
- On this basis, even though we continue to forecast growth for the rest of this year and 2011, the next recession may be closer than expected. With the Federal Reserve now becoming concerned about inflation being too low, the tightening cycle, when it comes, could be very short lived.
New Cycle For the World Economy
Some good news: the National Bureau for Economic Research (NBER) has announced that the US recession officially ended in June 2009. The economy troughed in that month and the expansion began. Whilst it may seem incongruous that academics at the NBER are making such an announcement at a time when markets are focussed on the risk of a double dip, it certainly provides a measure of the impact of the financial crisis.
Activity peaked in December 2007 thus making the last recession 18 months in length and the longest since World War II, just ahead of the downturns in 1973-75 and 1981-82. In terms of lost output it was also the most severe during that period. Real GDP fell 4.1% compared with 3.2% in the 1970s and 2.6% in the 1980s.
Long Recession = Long Expansion?
Arguably a long deep recession should be followed by an extended period of growth. The economy has plenty of spare capacity to absorb the pick up in demand without hitting the inflationary buffers. This was the pattern in the 1980's expansion which followed the deep inflation-busting recession at the beginning of the decade (sometimes known as the “Volcker recession” after the then chair of the Federal Reserve, now a member of the Obama administration), and in the 1990’s expansion. Subsequent recessions were shallower, but the lack of inflationary pressure in the world economy, often attributed to globalisation, meant that expansions were long.
From trough to peak the US economy grew for 92 months in the 1980s, 120 months in the 1990s and 73 months in the 2000s. The average expansion since 1854 lasted 42 months, so recent expansions have been more than twice as long as the historical average. The period as a whole from the end of the Volcker recession until 2007 has been described as a golden age for growth.
An End to the Golden Age
Today there are doubts about whether we will see a repeat of the long expansions which have characterised recent decades. There are concerns on both the supply and demand sides of the equation.
The structural nature of the downturn means that the amount of spare capacity in the economy is not as great as suggested by headline unemployment rates. For example, following the financial crisis many jobs in construction and finance will not be coming back. Consequently workers will have to retrain and relocate to find employment, a process which will take time and mean higher structural unemployment for a period.
There are concerns that such an effect can already be seen in the UK where inflation has consistently surprised on the upside over the past two years, taking CPI inflation above 3% and causing the Governor of the Bank of England to increase his correspondence with the Chancellor. In the last Inflation Report the Bank attributed part of the overshoot of inflation to temporary factors such as higher oil prices and a weaker pound, but acknowledged that a lack of spare capacity may have also played a role.
We recognise these arguments, but given the weakness of wage growth in both the US and UK, we still believe that there is substantial spare capacity in the labour markets of those economies. US and Eurozone inflation remains weak and is expected to moderate in the UK.
The greater threat to the cycle is the lack of demand. The post crisis economy is characterised by a period of de-leveraging as households, and now governments seek to repair their balance sheets and reduce gearing. The build up of debt which fuelled growth during the great moderation is now reversing, leaving a shortfall in demand. Monetary policy is severely constrained and while we expect another round of Quantitative Easing (QE2) from the US Federal Reserve the impact on growth is, in our opinion, expected to be negligible.
This suggests an economy where growth is primarily driven by corporate investment spending and exports, rather than consumer and government expenditure. If monetary policy is ineffective and fiscal policy constrained by concerns over the level of debt, we face an economy where the authorities are less able to offer counter cyclical support. So not only is growth likely to be slower but it will also be more volatile, being driven by swings in investment and world trade. Investment spending in particular tends to be one of the most volatile components of demand. That suggests activity will be more vulnerable to swings in business sentiment, making for a world of shorter cycles.
Rather than the economy expanding until inflationary pressures rise such that policy tightening brings an end to the cycle, we are more likely to see cycles ending as demand slows, either naturally through the ebb and flow of the investment cycle or as a result of an external shock.
New Forecasts
The current situation gives an immediate example of this changing balance of growth with the corporate sector set to play a major role in the recovery as the increase in profitability feeds through into capital expenditure and higher employment. Our updated forecasts assume that this effect is sufficient to offset the headwind from fiscal tightening and continued de-leveraging in the household sector, so avoiding a double dip. Consumer spending grows, but only in line with income growth whilst government spending, particularly on investment is expected to slow. The risk to this forecast is that animal spirits fail and the corporate sector decides to sit on its cash, rather than spending and supporting growth.
On the basis that we are in a world of shorter cycles the next recession may not be far off. For example, if we were to take the long run average cited above of 42 months from trough to peak, the expansion would end in December 2012 and the next recession begin in January 2013. That would be considerably earlier than the experience of recent decades.
Markets In a World of Shorter Cycles
Monetary policy would move in line with the shorter economic cycle. The policy tightening, which we have forecast to begin in September 2011, would be drawing to a close just over one year later. Central banks would be easing again in 2013 as growth slows. Inflation is not likely to be a problem as the short period of expansion will make little impact on unemployment. Indeed deflation could be the bigger worry given the low starting level of inflation. As a consequence, low bond yields may be with us for some time as the market continues to discount a lower profile for rates. Such an outcome would be reinforced if central banks hold back from tightening too aggressively for fear of causing deflation.
As for equity markets, a period of slower, but more volatile growth would suggest that a higher risk premium will be required relative to cash or government bonds. Some western companies may escape the limitations of their domestic economic cycles by tapping into overseas demand, particularly in the emerging markets where growth should be stronger and more consistent. Others will be more constrained. Markets are already beginning to price companies with emerging market exposure more highly than those with a domestic bias.
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