From time to time, Morningstar publishes content from asset managers, educational institutions, and registered investment advisers under our "Perspectives" banner. If you are interested in Morningstar featuring your content, please contact Online Editor Holly Cook at holly.cook@morningstar.com. Here, Keith Wade, Chief Economist with Schroders, explains his outlook for the global economic recovery.
After little more than a year of recovery, markets have begun to fear that the world economy will go back into recession. For those who saw the recovery as little more than a policy induced boost, such concerns come as no surprise. From this perspective, fiscal policy could only provide a temporary offset to the downdraft created by de-leveraging and repair of the financial system. Now that policymakers are making plans to withdraw fiscal support, as endorsed at the recent G-20 meeting, the weakness of global demand has come back into focus.
Stepping Down a Gear
Recent economic data offers little comfort. The US housing market, so often an important engine of recovery, remains flat and continues to experience an L-shape profile having given back all the gains made earlier in the year when tax incentives boosted sales. Similarly, the latest US employment report showed a fall in payrolls as census hiring fell back and private sector job growth remained sluggish. Meanwhile, the crisis in the Eurozone has raised doubts about European growth as governments accelerate fiscal tightening to placate markets and ratings agencies. Even China, which had seemed immune to growth worries, is now showing signs of cooling after rapid growth over the past year.
In line with these developments, the widely followed manufacturing Purchasing Managers indices (PMIs) have weakened and our activity indicator for the G-3 has rolled over (chart 1).
Moving Into a New Phase of the Recovery
Whilst recognising that the global recovery is stepping down a gear, it is useful to look at the dynamics of the upturn so far. In our view, recent developments represent an end to the first stage of the recovery where growth was driven by the inventory cycle as companies brought inventories back into line with sales, having slashed them during the recession. For example, in the year to the first quarter of 2010, inventory changes accounted for 1.4 percentage points, or half the 2.4% rise in US GDP.
Such an outcome is typical of the early stage of any recovery, but as the boost from the inventory cycle begins to fade, the challenge for the world economy is to sustain growth from other sources. Going forward, activity will have to be driven by stronger final sales which, given the move toward fiscal austerity, means stronger private consumption and investment spending.
How well placed is the private sector to meet this challenge? For us the key lies with companies. In particular, we would highlight the significant improvement in the corporate sector’s finances which have swung from deficit to surplus as profits have recovered. In the US the gap between internally generated funds and investment spending is at its widest for 50 years, indicating that firms are in a strong position to begin spending again (chart 2).
One sign that this is already happening can be found in increased spending on capital equipment where orders have picked up sharply around the world (chart 3). Having cut capex to the bone, businesses in the US, Asia and Europe have started to invest in the future once more. US business investment rose at a double digit rate in the first half of this year and should match this over the next six months.
Importantly, there are signs that companies have begun to recruit again although anaemic payroll growth means that the upturn has been termed a “jobless recovery”. Alternatively though, recent developments could also be described as a productivity miracle. “Less is more” would seem to have become the mantra as firms have raised output with fewer workers. US employment is still 2% lower than in the first quarter of last year, even though real output is more than 2% higher.
Such a performance has driven the upturn in corporate profits and is likely to continue through 2010. Nonetheless, there are limits to how far companies can squeeze their workforce and we would see employment rising more closely in line with output in the second half of 2010 and into 2011. Higher employment is critical as it would boost incomes thus enabling household’s to increase their expenditure.
The strength of consumer spending will also depend on whether households are comfortable with their debt levels and the pace of de-leveraging. This is best gauged by the savings rate, which has risen significantly in both the US and UK. Should banks decide to make access to credit even more restrictive, or were the central bank to raise interest rates, it is possible that savings ratios would rise further and consumer spending weaken further.
However, in both economies savings rates are close to their highest levels for ten years and appear to have peaked (chart 4). Like the corporate sector, the household sector is running a surplus and this would suggest that there is scope for spending to rise at least in line with incomes, if not slightly faster in coming quarters.
Private Sector Spending to Offset Fiscal Headwind
In short, we believe that private spending should be sufficient to keep the global recovery on track as fiscal policy tightens in 2011 and beyond. Estimates for the drag from fiscal policy are shown in table 1, which suggest that governments will take around 1% of GDP out of the OECD economies in 2011. In effect, we expect private surpluses in the household and corporate sectors to decline as the government deficit narrows. Clearly, it will not be a strong recovery and growth is slowing, but we do not see this developing into another recession.
From a regional perspective this process would be made considerably easier if the emerging world also reduced its surplus of savings over investment at the same time. Such a move would boost demand for goods in the developed economies and result in a rebalancing of the world economy.
However, although China has recently announced increased flexibility on its exchange rate and we see a long run appreciation of emerging currencies, the process of adjustment is likely to be very slow given the adherence of many Asian and emerging economies to the mercantilist model of export led growth. Indeed, the latest trade figures show the US trade deficit with China has begun to widen again – grist to the mill for those in Congress who would like to raise tariffs on Chinese imports (chart 5).
What is Plan B?
Our outlook of a reviving private sector offsetting the withdrawal of government stimulus carries considerable risks. We are relying on the corporate sector to pull us through the next phase of the recovery, yet business spending is driven by animal spirits and if chief executives decide they would rather wait another six months before implementing plans to increase capex or recruitment we could be in for a very difficult period. The recent and ongoing crisis in the Eurozone is an example of one factor that would give companies pause for thought before increasing expenditure.
Alternatively, companies may decide to use their surplus funds to raise dividends or engage in mergers and acquisitions (M&A). Whilst such developments could be positive for shareholders in the near term, they would be at the cost of weaker growth further out.
Should growth stall, unemployment will begin to rise again, government borrowing is likely to deteriorate and deflationary pressure increase. The problem then faced by the world economy is that policymakers are running low on ammunition and so cannot respond: the big cannon, monetary and fiscal policy, has been fired.
From a financial market perspective this makes the macro environment more dangerous, as if things go wrong investors can no longer rely on being rescued by the authorities. For example, the US Federal Reserve may still be a friend toward equity markets, but with rates close to zero its options are limited. Although Bernanke may never have been as market friendly as his predecessor he is unlikely to have the opportunity to create his equivalent of the Greenspan put.
The Bank of England, European Central Bank, Swiss National Bank and others are in a similar position. All would struggle to regenerate growth should we experience a renewed downturn or double dip, and all fear that they will end up like the Bank of Japan – stuck in a deflationary economy with rates at zero.
It is not quite true to say that there is no plan B. There are some options. For example, the Fed and others could begin quantitative easing (QE) again – buying assets with printed money and expanding their balance sheets. This would help markets by creating liquidity and pushing up prices, but the effect would be limited if the banking sector did not increase its lending. If banks do not lend, the extra cash ends up in higher bank balances and all that would happen would be a further drop in the velocity of circulation of money without a rise in activity. All QE can do in these circumstances is rearrange the assets of the private sector and central bank, exchanging cash for bonds.
The only alternative beyond this is to print money and pump it directly into the economy – a true helicopter drop. One option would be to make tax cuts to households funded by printing money. Arguably this could also be saved, but by continuing to print money, inflation will inevitably follow. As Ben Bernanke noted before he became chairman of the Fed “in a paper money system, a determined government can always generate higher spending and hence positive inflation”.
Clearly, this would be a last resort and so, double dip or not, the assumption has to be that monetary policy stays as loose as possible for as long as possible as the economy negotiates the difficult period ahead. We are pushing out our first rate rises for the Fed and ECB to June and September 2011, respectively.
