World economy in freefall

Fund Strategy - 24 Sep 2012 | By Ben Hunt

In 2009, huge government spending enabled the world economy to rebound from the deepest recession since the 1930s. Confidence was high that a full recovery was on the way, reflected in the optimistic growth forecasts of the time.

Today, after a difficult three years, the world economy seems to be suffering from a new relapse. Although far from an outright recession, this is a more rapid slowdown than was expected.

At the level of GDP, the eurozone as a whole is now thought to be in recession for the first time since 2009.

China’s growth of 7.6 per cent in the second quarter was the slowest for three years. If it finishes the year at 7.5 per cent, as many forecast, it will be the lowest annual growth since 1990. Meanwhile, the growth rate of the US has not been strong enough to batter down its unemployment rate, nor act as any kind of engine for the world economy.

Perhaps the most striking turnaround is Germany. After growing by about 3.7 per cent in 2010 and then 3 per cent last year, the OECD earlier this month forecast recession for the end of this year.

At the business level, global logistics firm FedEx, typically seen as a barometer for the world economy’s health, issued a profit warning in early September, citing the slowdown. Elsewhere, profit warnings from Hong Kong-based firms serving the Chinese market have been on the rise.

In a world economy full of interdependencies, the major regions seem to have been ground down one after the other.

China’s stimulus of 2009 helped Germany, other advanced industrial nations, and commodity producers in emerging markets to rebound. The US stimulus, such as it was, helped Asian and European trade.

But Europe always seems to have been the weak link in the chain, dragged down by its eurozone debt crisis. Whereas the US has been treading water, Europe has more clearly deteriorated. Chinese exports have slowed, in turn dampening prospects for China-bound exporters. Concern has mounted in the US regarding its manufacturing and export sector, seen as one of the bright spots of the economy.

Policymakers over the course of the year had warned about a new phase of fragility. Speculation intensified about renewed monetary stabilisation and stimulus, and the policy response came earlier this month, with the sovereign-debt-buying programme of the European Central Bank – the Outright Market Transactions or OMTs – and a third round of quantitative easing from the US Federal Reserve. China has contributed with new interest rate cuts and has brought forward infrastructure spending, and Japan recently boosted its QE efforts.

While markets as usual have welcomed this, monetary stimulus in general is increasingly viewed as a ‘stop-gap’ measure that ‘buys time’ and provides liquidity, but cannot alone lead to lasting solutions for recovery and growth.

A widespread feeling is that governments need to take more initiative. In Europe’s context, that translates into action over banking recapitalisations, and addressing solvency not just liquidity issues; banking and fiscal unions; and addressing underlying trade and competitiveness imbalances.

For their part, investors are far from pressing the panic button over the slowdown.

Dan Morris, a global market strategist at JP Morgan Asset Management, is “cautiously optimistic”. Equities have done well this year, and he expects the trend to hold up.

He says: “The new ECB proposal is a good one. The other key area is China. It is still a soft landing in our view but just ‘softer for longer’. Overall, things seem manageable at this point, but we are now looking to political decisions in Europe.”

Julien Seetharamdoo,a senior economist/investment strategist at HSBC Global Asset Management, sees “the ‘risk on/risk off’ environment continuing for some time.”

Periods of policy stimulus and optimism will see ‘risk-on’ with equities and commodities bought, while periods where the data worsens, or where there are concerns about global slowdown, will see sell-offs and bonds favoured.

This presents challenges but also opportunities. “You can get attractive entry points for assets that you like, whether that is emerging market equity or corporate credit in both the advanced and emerging markets.”

Investors have been so concerned about a slowdown, they have bid prices down too far, he says.

Richard Turnill, the co-manager of the BlackRock Global Income fund, says that “the big story in the world economy at the moment is that we are adjusting to a slower pace of growth than the last few decades.” The recent slowdown for him is not the main event.

People canmistake low global growth with low returns, he says. “Investment can still be very successful in a low-growth environment. You can still find very attractive high-quality stocks with good valuations.”

For the world economy as a whole, however, the slowdown raises many difficult questions. Is this a cyclical phenomenon? To what extent is it bound up with the deeper ‘crisis’ conditions seen for five years now? Is a new global recession on the cards?

“The slowing momentum in the world is real,” says Michala Marcussen, the head of global economics at the French bank Societe Generale.

However, she characterises it as a problem of ‘stall-speed’.

“We are not falling off a cliff - except in some parts of the eurozone periphery. But nor are we seeing a strong dynamic for growth. This is a difficult ‘grey patch’ that is neither sunshine nor a storm.”

US bank Morgan Stanley describes it as a ‘twilight zone’ – neither expansion nor recession, but with either still possible.

Marcussen says that a new global recession will need some kind of trigger. A greater crisis in the eurozone could be one – although she sees the risk of a eurozone break-up as low.

The more immediate problem for her is “the absence of something that can rebuild momentum in the world economy. For that, you need confidence. The question becomes, where does that strong lift come from?”

Senior investment manager at Aberdeen Asset Management, Mark Parry, also says that “most recessions are caused by a shock, and in light of the latest liquidity injection, we find it difficult to see where one will emanate from.”

He says that some fear a potential recessionary catalyst could be spending consolidation resulting from the US ‘fiscal cliff’ – the package of automatic tax increases and budget cuts that will kick-in from 2013 if Congress cannot agree on a reduction of the budget deficit.

The general consensus however says Parry is that disaster will be averted.

More broadly, however, a world of lower growth and financial fragility is less resilient and more vulnerable to shocks.

Not surprisingly, the main short-term focus for everyone has become Europe – widely seen as the critical problem area in the world economy at present.

“The crisis is global, and so are the reasons for its global acceleration” says Yanis Varoufakis, economist and author of The Global Minotaur, a recent book on the world economy’s current travails (see box).

But “Europe is of course the sick man of the planet, exporting its austerity-driven recessionary effects worldwide.”

According to Ruth Lea, an economic adviser at Arbuthnot Banking Group, “the on-going eurozone crisis continues to affect the rest of the world economy – both through the trade and the confidence channels. As there is little sign of any ‘final resolution’ to the crisis, the damaging effects will continue for the foreseeable future.”

Parry similarly says that the key economic story this year will continue to be about Europe – adjustments to resolve structural imbalances “that lie at the root of the eurozone’s problems.”

Financial markets are heavily focused on European political risks. In the context of elections and changing moods of electorates, “politics is messy and uncertain – it is not a financial model that you can plug numbers into,” says Morris.

The degree to which politics has mattered – the bailouts, the institutional arrangements - has made the crisis so challenging from the start, he says.

Yet as Marcussen puts it, “the sell-by-date of ‘muddle through’ is fast approaching - it could be one year, possibly three at most.”

Most would agree that the dominant economic dynamic for the world economy is not narrowly about Europe, however. It concerns the end of the credit cycle and deleveraging – how the developed world is paying down its debt – and the impact on demand and economic growth.

The key problem is that economic activity is no longer driven by the pattern of private credit extension or debt and consumption that built over previous decades.

As consumers cut back, and with less demand for goods and services, companies are more loath to hire and invest and also cut back.The problem is the impact on growth overall, and the most appropriate policy response. Many discuss the idea in relation to certain concepts – debt-deflation, a liquidity crisis, a ‘balance-sheet recession’. Although deleveraging is happening at different paces, in different sectors, across the world, it is being seen as a general problem.

A difficult issue is understanding the extent to which debt and deleveraging is causing a ‘downward spiral’ effect. Some argue this is indeed happening, but is arrested by governments’ ongoing fiscal and monetary stimulus.

Others would say however that ‘inflation expectations’ are holding up well around the world. Deflation, which can accelerate a downward spiral, is far from being at Great Depression levels. Also pointed to is the financial health of the corporate sector. With less debt compared with the 1930s, its balance sheet is healthier and can play a more stabilising role.

What is more clear perhaps is that, at the level of the world economy, the country that was the epicenter for debt-led consumption – the US - can no longer play the role of ‘consumer of last resort’, the engine of growth for the world economy as a whole.

“The US consumer, with European, especially UK, consumers, buoyed by easy credit, certainly kept the Chinese economy and the rest of the world motoring in the early-mid 2000s,” says Lea.

However we are seeing “an important transition at the moment,” says Turnill.

“The US consumer is stepping back. Over time, there is hope that the Chinese consumer picks up the baton from the US consumer. China is trying to go from a fixed-asset investment-led economy to a consumer-led economy.”

The transition will not be smooth, however, he says, creating volatility and lower growth.

Marcussen says that “we do not have any strong underlying dynamic in the world - and that is the issue. What we are asking Asia to do is to deliver a strong demand-side shock. But that does not happen overnight. It is a huge change - in recent decades it has only delivered supply-side shocks to the world.”

While China has been boosting investment, “the Chinese economy is not geared to creating demand for other parts of the world through stimulus,” says Varoufakis.

All that fiscal stimulus does is “increase the investment ratio of GDP to an astounding 70 per cent, pushing the consumption ratio of Chinese people to a ridiculous 25 per cent - a certain recipe for negative expectations of aggregate demand and growth.”

The trouble, says Varoufakis, is that “it is only the ‘profligate’ West that can generate the demand necessary to rebalance the global economy. China can simply not do it on its own.”

He says that “the West has lost its penchant for designing a globally sustainable macro-economy.”

Lea is also sceptical that China can be theglobal engine of growth in the near-term, as so much of its growth to date has been export-led.

“Further out,” she says, “it is hard to see the Chinese consumer replacing the US consumer as the driver of world growth - ever.”

In this context, she says “the West will have to recover.”

The problem of how best to recover is becoming the billion-dollar question, not just because of the new slowdown, but also because the developed world’s crisis is now in its sixth year.

Even this year, only Germany and the US among the largest developed economies had recovered output to previous pre-crisis peaks. At present huge resources are sitting idle, both capital and labour, unable to be utilised. That translates most obviously into high unemployment, but low growth keeps it high.

Varoufakis stresses some of the irrationality in the current world economy. A mountain of debt is being paid back from income and there are many banking losses, but what is less appreciated is a huge build up of “idle savings too scared to channel ‘themselves’ into productive investment”. This is the product of reduced demand and ongoing lack of confidence.

In the coming period, what may change is a shift to more proactive policy on growth, which could address the slowdown more directly. Whether this will happen at the international level is unclear. But already, there is growing skepticism about fiscal restraint or outright austerity.

Many feel that austerity in Europe is backfiring – ironically not just for the countries imposing it, but also for Germany which has seen its export markets shrink, and is now suffering a slowdown itself.

Austerity is increasingly seen as “self-defeating” – budget cuts harm the economy, which reduces tax revenues, and EU-imposed budget targets cannot be met.

In the UK context, some of the original arguments for fiscal constraint seem to have lost standing; the idea that fiscal contractions can be expansionary, the notion that fiscal spending ‘crowds out’ the private sector. The counterargument is that these might have been appropriate in the past, but not now, where economic and monetary conditions are very different.

However, the developed world seems to be limbo – more critical of austerity, more critical of the inadequacy of existing growth initiatives. For example, witness the widespread disdain shown towards the recent €120bn Growth Pact in Europe. But at the same time, it is not sure how to boost growth. There seems to be a lack of new ideas.

One key problem is a current narrowness in how the state and economy are conceptualised. There is a certain paralysis over what seems to be a classic ‘catch-22’ situation.

That is, for many advanced countries, is not easy to stop borrowing and run budget deficits – that harms the economy, deepens recessionary conditions and diminishes tax revenues. This is increasingly well-recognised in all the economic contexts – the US (i.e. the ‘fiscal cliff’ issue), the UK, Europe, and Japan.

At the same time, however, simply running up deficits and debts is not sustainable in a context where economies are stagnant or weakening. In this sense both advocates and critics of state spending have a point.

In trying to work out how to exit from this apparent ‘low-growth, high-debt’ trap, some economists argue that the only real viable option is to ‘grow out of the problem’ (see box).

The idea would be to more aggressively borrow to invest, create growth and new returns that could pay off debt over time, and wean economies off public debt and deficits. This would be in contrast to more passive state spending or tax cuts that serve to boost consumption or build infrastructure but fail to generate enough new wealth.

State institutions could be used more imaginatively for new investment. In practice that could mean much larger-scale investment in say industries around new technologies in energy, transport, manufacturing and so on. The case could be made to borrow from the likes of China who have an interest in seeing Western revival.

This kind of third way approach is not on the policy agenda at present, however. Many are still undecided about the extent of weakness in the economy and whether market forces can be relied on for regeneration.

What may boost the case for more proactive growth policy is a new realisation that the West faces long-standing, long-term problems as well. There is not just a short-term demand-side problem, but a longer-term ‘supply-side’ problem concerning poor investment, the creation of new wealth, and a lack of economic renewal more generally. This problem led the developed world to over-rely on paper money creation, not real wealth creation, and state borrowing and spending, over time.

It seems that developed economies have not been organised around a productive reinvestment of capital. This can be seen for both the corporate and bank lending channels. The corporate model in the West is not based around domestic growth, but cash-generation, as many have pointed out. Banks for some time have lent mainly for consumption, and for speculative purposes in real estate, but not for new industry.

States for their part have not properly invested – hence the poor state of US infrastructure, for example, negatively impacting productivity. Many economists and investors have noted this wider problem of a ‘misallocation of resources’. Others have talked about the flaws of the Western growth model – the twin process of deindustrialisation and financialisation. These are all issues that will need more attention and discussion.

The new problem post-2008, is that already historically-low levels of capital expenditure and economic growth are reinforced by further retrenchment owing to demand-side and confidence problems.

Yet overall, while the G20 countries rose to the challenge after the collapse of US investment bank Lehman Brothers in 2008, since then they have not been able to coordinate a global strategy for addressing the crisis, frustrating many.

A further slowdown in the world economy may concentrate the minds of policymakers.

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