2009 Might Well Surprise

The case has been building over the last month or so that we’re nearing the end of market and financial turmoil and if we can just hang on for a few more months we’ll hit a bottom and things will stabilise and even start looking better in the second half of 2009.

The global economy is now in a severe recession and in the short-term financial volatility will remain high and the economies of the world will have to struggle for several more months of forecast economic contraction.  In fact, economists at Danske Bank expect that the next three to six months will see the world’s economies continue to contract as the negative impact from the credit crisis continues to pounce.

Thus the months ahead will see a further deepening of the global housing slowdown, and a worsening backlash in emerging markets. The latter will exacerbate the current negative recession dynamics already in place.

But more and more we’re hearing from brokers and fund mangers that the market is starting to look attractive and is starting to offer increasing long-term value. Economists at Danske Bank number themselves among those of this opinion. That’s why the team has taken a good, hard look at this theory and have formulated two scenarios, both of which support this argument.

By mid-2009, Danske expects the majority of economies will return to positive growth rates and we will begin to see a slow recovery during the second half next year. However, this scenario assumes that the authorities succeed in unfreezing the credit markets. This will allow the positive effects from falling energy prices, monetary policy easing, and various fiscal stimuli to provide the benefits intended.

This is why the bank expects central banks to continue with their respective easing policies in the coming three to six months. At the same time, inflation is expected to fall dramatically as a result of the collapse in commodity prices and lower interest rates.  In some countries, the team expects a short period of headline deflation in H1 next year.

While Danske admits the recent drop in inflation has many spooked because of the possibility of a massive deflationary spiral, and the ingredients for such an outcome are undoubtedly present, the team thinks the risk of more permanent deflation is rather limited because of the aggressive measures taken by the authorities.

The team sees the Federal Reserve moving to a zero interest rate policy by January and expects the Fed will expand its quantitative measures. It expects the ECB will continue to cut aggressively to 1.5% by March next year, while the Bank of Japan will move ever closer to zero by easing to 0.1% by Q2 next year. Monetary policy in emerging markets will likely also be eased further as well.

What if all this doesn’t work?

There is the chance that despite aggressive policy measures to stem the tide, government initiatives may end up being ineffective, as the desired effects that bubble through will only do so imperceptibly. Money and credit markets might continue to struggle and this will leave no room for monetary policy stimulus to actually reach the real economy.

In this scenario, despite a boost to incomes from falling interest rates, fiscal stimulus and the collapse in energy prices, consumers and businesses will remain reluctant to spend. This outlook for an even more prolonged period of negative economic growth would see equity and housing markets plunge even further, putting additional pressure on spending, causing an ever worsening spiral.

Such a scenario would see the US, Europe and Japan all remain in recession through 2009, while emerging markets would continue to suffer as their raw material and manufactured exports would remain on a downward trend. Risk aversion towards those economies would remain high.

Good news, Danske has a contrasting scenario that it thinks is just as likely and that is for a much quicker recovery.

As most of the work has been done and most of the foundations laid, the financial crisis could be practically solved over the next three months. Confidence will start to build and fears of a longer lasting economic slowdown could prove unfounded as rate cutting and policy initiatives start to achieve their intended ends. The crisis will be contained and the economic impact beyond Q1 09 is limited. At least that’s what the team hopes.

If this is going to be the case, the team thinks we will see some stabilisation of markets in the beginning of 2009 and not long after there could be a limited return of optimism. There are a few stumbling blocks, but Danske thinks these could be overcome.

Admittedly, US consumers still face some significant headwinds from falling housing and financial wealth, while the threat of rising unemployment is also likely to keep a cap on consumer spending. But the team notes, as calm return to markets, consumers will realise they still have strong real income growth due to low oil prices. This would mean that in a relatively short space of time, slow growth would be replaced with trend growth.

At the same time, Europe gets a helping hand from emerging markets, as Danske sees a turn around in export market growth as a necessity for a resumption of sustainable economic growth. This pick up, coupled with increasingly effective economic policy measures, implies a resurgent German manufacturing sector could spark a very fast return to solid growth.

Consumer spending would be supported by low inflation and what are a still relatively healthy labour markets and so Euroland could be back on trend by early 2009.

While not an odds on outcome, it isn’t as far fetched as it sounds. The team notes the strength of the underlying growth potential in emerging markets has been vastly underestimated. Domestic investment expansion has been almost left untouched, and the above scenario would ensure exports are only marginally affected as growth in US and Europe pick back up. This means Asia remains comparatively strong and Eastern Europe could resume its fairly solid growth path.

If this were the case, global growth would only be contractionary for a short period and the central banks of the world could forget about easing policy and once again concentrate on tightening. Equities would rebound strongly on the prospect of a soft landing for the global economy, bond yields and commodities will rise and FX markets will return to interest rate differentials and carry trading to set the value of currencies.