Introduction
At the start of 2011, there was significant optimism about global growth prospects in 2011/12. This was reflected in both economic forecasts and market pricing, especially developed market equities. In recent months, however, optimism about the outlook has deteriorated.
This slowdown has been fairly general across the global economy, although it was led by the developed economies, most notably the United States. This weakness in the US has accelerated in recent weeks, partly fuelled by the debt-ceiling debacle and subsequent downgrade of the US sovereign rating by Standard and Poor’s. The Euro-Area has been impacted by the renewed fiscal crisis - especially in Greece with growing concerns about Spain and Italy.
Japan is still feeling the effects of the 11 March earthquake which, besides the human tragedy, led to the closure of many electronic and vehicle production plants, a disruption to the supply of key motor and electronic components to factories around the world and a sharp fall-off in confidence levels within Japan. More positively, there is already evidence of a meaningful rebound in Japanese consumption indicators, while production levels have also improved. Japan is set to record improved growth rates in the second half of 2011, as manufacturing capacity is restored.
Growth in emerging economies has held up better than in developed markets, but has also moderated in recent months due to a tightening of monetary policy, especially in Emerging Asia.
Unexpected Shocks And Poor Fiscal Policy Have Damaged The Global Economic Recovery
The first half of 2011 delivered some unexpected shocks that have severely disrupted the pace of the global economic recovery. These unexpected events included a surge in political turmoil in North Africa and the Middle East that sent oil prices soaring; sharply higher global food prices aggravated by extreme weather conditions, a disastrous earthquake in Japan that led to a massive disruption of vehicles and electronic equipment production; and the re-emergence of financial tensions in the Euro-area. At the same time economic growth in China is being managed lower in order to quell inflation and control the pace of housing development.
In addition, recent poor fiscal policy management in the major economies has severely hindered the global recovery. While 2009 is seen as a year of fiscal and monetary policy success, 2011 will be seen as a year when policy, especially fiscal policy, began to hurt rather than help the fragile economic expansion. In particular, the US and Euro Area have experienced extreme political wrangling over the direction of fiscal policy which has damaged the pace of the recovery and done very little to resolve longer term issues of debt sustainability.
These unexpected shocks and poor fiscal policy have combined to undermine the strength of the global economic recovery. At the same time the outlook for monetary and fiscal policy has become complicated and uncertain across the globe. These events have led to extreme financial market volatility, especially in July and August 2011, as investors try to assess the seriousness and duration of the current "soft-patch" and the likelihood of a 'double-dip' recession.
While we are not yet forecasting a 'double-dip' recession, the incoming economic data has clearly been disappointing. Most developed economies are growing at 'stall-speed' - any further slowdown and these economies run the risk of returning to recession conditions.
United States Is Flirting With A Return To Recession Conditions
The economic recovery in the United States has become more inconsistent and somewhat uncertain in recent months. While the US is officially out of recession – having recorded eight consecutive quarters of positive growth - a range of key economic indicators have weakened in recent months, including the rate of growth in job creation.
US private consumption has been particularly soft, with overall consumption stagnant since February and sales of durable goods contracting since March. This is partly due to higher energy prices, which have eroded the consumer’s purchasing power. At the same time, investment expenditure is being curtailed by very sluggish demand for housing and commercial property. Investment in business equipment is one of the few positive areas, having grown at more than 9% over the past year. The recent weakness in consumption and investment indicators are in line with the sluggish improvement in the labour market. More positively, last week’s labour market report showed a moderate pickup in employment, with the private sector gaining 154 000 jobs in July. First-time (weekly) jobless claims have also edged lower over the last several weeks, suggesting that perhaps the labour market recovery is reaccelerating from a very slow pace in May and June. The same can be said for motor vehicle and retail sales.
The US economy is also facing a number of key structural economic challenges, most notably a weak housing market and high public sector debt. All of which has been aggravated by the Standard and Poor’s decision to downgrade the US's credit rating from AAA to AA+ on 5 August 2011.
The downgrade reflects S&P’s opinion that the fiscal consolidation plan that Congress and the Administration recently agreed (on 2 August 2011) falls short of what, in their view, would be necessary to stabilise the government's medium-term debt dynamics. S&P have argued that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than they envisioned.
Immediate market reaction to the downgrade was extremely negative. But the impact on the US economy and public debt sustainability might actually be fairly limited. Although the downgrade reflects the deterioration in the absolute quality of US debt; it is happening at a time when the fiscal outlook of virtually all major countries is also deteriorating. US bond yields actually fell substantially in response to S&P’s release, although this mainly reflected fears of economic weakness and a return to recession conditions.
In response to the downgrade and deteriorating economic data the US Federal Reserve took the unprecedented decision to announce that they are keeping interest rates extremely low to mid-2013. This makes it clear that the Federal Reserve is ready to take further actions to support the slowing recovery; although the remaining policy options are extremely limited. The main impact of the recent monetary policy announcement was to further lower already very low yields. At its next meeting on 20 September, the Federal Reserve may decide to ease policy further, possibly by increasing the average maturity of treasuries held on its balance sheet.
Euro-Area Fiscal Turmoil Has Been Poorly Managed
The Euro-area is facing a number of major economic, social and political challenges. At the heart of the problem, national debt levels are extremely high, while economic growth rates remain depressed, having not recovered from the Great Recession in 2008/2009.
Greece, Ireland and Portugal, have all received significant financial assistance from the European Central Bank and International Monetary Fund. Unfortunately, their financial difficulties have continued, especially within Greece, aggravated by the relatively slow response from European leaders to the debt turmoil.
In May 2010, Greece was granted a €110 billion ‘bail-out’ by the ECB/IMF. Since May 2010, most of these funds have been disbursed and used to finance both the fiscal deficit as well as the rolling-over of maturing debt.
Despite this bail-out Greece required additional financial assistance, and on 21 July the EU Summit agreed to make Europe’s financial support mechanism much more flexible and to provide greatly expanded financial support to Greece. This time the official financial assistance package totalled €109 billion, in addition to a gross private sector contribution of €54 billion (net €37 billion). European leaders also pledged to increase the flexibility of the EFSF. The specifics still need to be stipulated, but reforms will include providing financial support on a "precautionary" basis, granting loans to any Euro Area government to help with bank recapitalisation, and intervening in the secondary market for government bonds.
The details of the official bail-out package for Greece are as follows:
- The total official financing will amount to an estimated €109 billion
- The maturity of future EFSF loans to Greece will be lengthened to the maximum extent possible; from the current 7.5 years to a minimum of 15 years and up to 30 years with a grace period of 10 years. The maturities of existing Greek debt through the EFSF will also be extended substantially
- The EU will provide EFSF loans at lending rates equivalent to those of the Balance of Payments facility (currently approximately 3.5%), without going below the EFSF funding cost
- The EFSF lending rates and maturities agreed upon for Greece will be applied also for Portugal and Ireland.
The support package amounts to an extensive and generous restructuring of Greece’s debt aimed at stabilising the sovereign debt crisis in Greece, Ireland and Portugal, while at the same time trying to ensure that the crisis does not spread more fully to Italy and Spain. It will be interesting to see how the Credit Rating agencies respond to the debt restructuring, but at least there is no outright default. The EU has indicated that they are ready to support the banking sector in the Euro-area, if required.
Following the announcement of the new support package, Greece 2-year bond yield fell from over 40% to 26% within three days; however the yield has since risen to 33%.
Assuming the Greek government implements its adjustment and reform program in full and on time, Greek government debt should decline from 142% of GDP at the end of 2010 to 122% by the end of 2015 and 98% by the end of 2020. The government will need to work hard to convince markets that these assumptions are sensible, given the large shortfall of tax revenues during the first half of 2011.
Unfortunately, despite the EU’s comprehensive support package for Greece, Portugal and Ireland, the ongoing poor growth prospects in Spain and Italy accentuated concerns about the sustainability of their debt. The yield on Spanish and Italian bonds came under significant pressure in late July and early August, with the yield on Italy and Spain's 10-year government bond quickly rising to well over 6%. Crucially, the political timeframe required to implement the EFSF reforms agreed on 21 July (due to the need for parliamentary voting) meant that the ECB, once again, has had to try and calm the nervous European financial markets by buying Italian and Spanish government bonds in the secondary market. As a consequence both the Italian and Spanish 10-year bond yields have fallen to a more acceptable 5.0%. Hopefully, the ECB can continue to convince investors that it has a deep and strong enough commitment to reduce Spanish and Italian yields on a sustained basis, otherwise the financial crisis in Europe will move to a whole new level of turmoil and anxiety.
In addition to the problems in European bond markets, bank funding is also becoming increasingly problematic due to the progressive withdrawal of residents’ deposits, especially in Greece. This has to be offset by transfers between national central banks within the Euro-area, which then increases the financial systems’ imbalances between creditor and debtor countries.
Fortunately, Germany, which is the largest economy within the Euro-area, has performed particularly well. In Q1 2011 Germany’s GDP grew by amazing 6.1%q/q (annualised) reflecting broad-based growth. Confidence levels are high, the unemployment rate is 7%, which is the lowest level since the reunification employment data started in 1992, exports reached a record high recently, and there has been a surge in tax revenue resulting in a lower budget deficit and reduced bond issuance. On the negative side, inflation has been above 2% for five consecutive months and the most recent incoming data is pointing to a slowdown in economic activity (which is predictable and the consensus view given the high base in Q1 2011).
Conclusion
Given the recent disappointments in several key economic and financial indicators,most analysts have revised down their growth forecast for 2011 and 2012 to 1.8% and 2.6% from 2.5% and 2.9% respectively. And, on balance, most economists are not expecting a return to recession conditions in the US. In fact, on Bloomberg, only 1 out of the 79 analysts surveyed expect a negative economic performance in the US during Q3 2011, and none expect a negative performance in Q4 2011. There is a risk that the negative sentiment created by the debt ceiling debacle and credit rating downgrade could feed on itself and produce a more adverse outcome. Nonetheless, we still do not expect a double-dip recession in the US. Indeed, key economic data for July has shown some improvement including auto sales, retail sales, weekly jobless claims and non-farm payrolls.
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