Australia | Nov 25 2009
By Greg Peel
Since stock markets began to factor in a turnaround in global economic fortunes from March this year, there has been an obsession with alphabet soup. The stock market is a leading economic indicator, and from March to now it has roughly traced out a “V” bounce in the US and elsewhere. It thus follows that the global economy should bounce from its GFC depths in a sharp “V”, meaning a rapid return to normal GDP growth.
Even as the stock market began bouncing, protagonists were locked in a debate whether the following economic bounce would trace out a “V”, a “W” (meaning double-dip recession), an “L” (meaning a flat line of zero growth a la Japan’s lost decades), or a “U” (meaning a more gradual turnaround).
Just to confuse the issue, another favourite was the “reverse square root sign”, in which the economy initially bounces like a “V” but only gets some way back before flat-lining like an “L”.
Last night the first revision of the third quarter GDP was released, which took the number down quite substantially from an initial 3.5% estimate to a 2.8% first revision (one more revision to come). The last quarter of positive US GDP growth was the second of 2008, being 1.5%. The next four quarters were all negative, at 2.7%, 5.4%, 6.4% and 0.7% respectively. The third quarter 2009 represents the first post-GFC positive quarter, but already that has been revised down. Current consensus has the fourth quarter looking at only 2.4% growth.
Not much of a “V” then really, despite a stock market which has recovered 50% of its losses. We might still be heading for a “W”, a reverse square root sign, over even an “L” with a bit of license. Or we might simply be in part of a wider “U”, in which recovery is evident but slow and sluggish.
Nouriel Roubini of Roubini Global Economics (RGE) was a stern voice of bearishness in the lead up to the bursting of the debt bubble, constantly warning as the decade unfolded that a bursting of the debt bubble was inevitable. It cost his followers a few years of super-positive returns, but clearly Roubini was ahead of the game. He thus went from being dismissed as a pesky uber-bear to being lauded as an oracle.
Roubini dismisses all letters of the alphabet other than an extended “U”. He sees a slow recovery out of global recession rather than the “V” bounce suggested by stock markets, and this week offered ten reasons why. He also notes that the third quarter US result was heavily fiscally stimulated, which may only result in growth potential in the future being “stolen” and stashed in the third quarter ’09.
(1) It is noted often enough that the US consumer represents 70% of US GDP, and given the size of the US economy this translates into about 16% of global GDP. The importance of the US consumer cannot be overstated. The top 20% of US earners account for 50% of all income and 50% of all consumption. They are also the households which respond positively to a rise in stock prices.
The “V” bounce bulls believe the “V” bounce which has occurred in the stock market will feed back into a “V” bounce in consumption as wealth is returned via stocks. But Roubini notes stocks are still 30% below their 2007 peak and in inflation-adjusted terms still 20% below where they were all the way back in 1999. The return of wealth is thus not particularly substantial, and positive wealth effects from stock markets take longer than a year to materialise if history is any guide.
This suggests the stock market “V” is not enough in itself to assure a 2010 economic “V”.
(2) And then we need look at the other 80% of the population which represents the other 50% of income and consumption. This group is not much affected by stock markets, rather it is far more affected by house values. RGE is still forecasting an ultimate 40% drop in house prices from their peak, implying up to a 10% drop in prices still yet to come. Throw in high unemployment, which RGE sees peaking at 10.8% in the second half of 2010, along with the big reduction in hours worked which effectively equates to another three million jobs lost, and you have few reasons for half of US consumers to revert straight back to “normal” spending patterns.
It is more likely they will be cautious and thrifty in 2010.
(3) Most economic recessions are earnings-driven but this one has been balance sheet-driven. The financial crisis has been caused by over-leverage and the accumulation of too much debt, notes Roubini. History shows recessions following financial crises of this nature tend to last longer and lead to weaker recovery.
It won’t be different this time, Roubini suggests. Households have stopped increasing debt but they haven’t exactly been reducing it quickly either. But there has been a massive re-leveraging in the public sector to compensate for what the private sector has lost. In order to pay for this releveraging out of the private sector eventually (to not do so would be to simply increase the deficit forever) it is inevitable that taxes will be raised and the tax base widened.
In the meantime, while the public sector pumps out massive amounts of debt it is crowding out private sector attempts at the corporate level to get back in the game. And as households quietly reduce their debt to income ratios, together the private sector will not compensate for public sector debt.
(4) Capacity utilisation across the globe has improved but remains at a very low 70% in both the US and EU. An economy grows by creating new capacity but it cannot grow at all while almost a third of capacity is laying idle. Excess capacity in both regions and in China can turn into deflationary pressure, Roubini notes, “down the line”.
(5) The global banking system has been severely damaged. Already over 200 small banks have failed in the US and there’s another 400 on the watch-list. The big US banks have reported most of their losses but many European banks still have a long way to go. Roubini suggests global credit losses will peak at around US$3 trillion and we’re only half way there.
In the meantime, the “shadow” banking system (non-bank lenders, special investment vehicles and “conduits”) has been blown away, with over three hundred shadow banks out of business. Securitisation is all but dead despite ongoing attempts by the Fed to support and reignite the market.
Roubini suggests this means less credit growth which would otherwise flow to corporates and households, further crimping their capacity to consume.
(6) It has already been noted that house prices have further to fall. The commercial real estate cycle is lagging behind residential, Roubini suggests, and losses will materialise in the sector and act as a drag for several years.
(7) Fiscal and monetary stimulus across the globe is “backstopping” the financial system and preventing recession becoming depression. That’s all well and good, but how do you get out of it?
The risk of pulling support too early is that the economy is not yet actually breathing on its own, and could fade straight back to recession (the “W”). But keeping support going for too long means massive deficits incurred to support rapid recovery (“V”) will ultimately lead to runaway inflation. Even before such inflation makes its presence known, a stimulus-fuelled bubble-and-bust cycle could well occur.
On that basis Roubini sees both the “V” and the “W” as dangerous. Careful consideration of government and central bank exit strategies will be required and the margin of error is great.
(8) The developed world not only has to fight all of the above to get back to normal growth, it is now looking at lower potential growth. Roubini suggests potential growth in the EU and Japan stood at 2% before the crisis, but has now likely been shattered. Until these governments launch “aggressive” structural reforms, potential growth will not return and actual growth will remain anaemic.
(9) Consumer “retrenchment” by previously overspending countries (Roubini singles out the US, UK, Spain, Ireland, emerging Europe, Australia and New Zealand) as they move to reduce debt to income ratios, could be compensated by savings growth elsewhere. But real wage growth in the saving countries (Germany, Japan) will lag and there is little incentive to increase savings anyway.
There will not be a balance. The over-spenders are pulling back from spending but the over-savers are not increasing their demand to match.
(10) A lot of weight has been put on the shoulders of China and other emerging markets as global economic saviours. RGE is actually even more bullish about these economies (the ones entering the GFC with current account surpluses at least) than the market. But there’s one small problem.
Today Chinese GDP is US$4 trillion and US GDP is US$14 trillion. Together the US, Germany and Japan represent US$40 trillion Get the picture? It’s a long road to hoe.
Three hundered million Americans consume US$10 trillion while 1.3 billion Chinese consume US$1 trillion and a billion Indians consume US$600 million. Chinese and Indian consumption together equates to about a sixth of US consumption. It’s a big stretch to ask China and India to increase consumption quickly enough in the short term to compensate for that lost in the US. Then expand that equation to the rest of the world.
To conclude, RGE sees US GDP growth in 2010 as a sluggish 1.5-1.8%. The Fed has long been warning economic recovery will be sluggish too, but its current 2010 forecast is 2-4% growth. Not even the Fed would call this a “V”. Roubini is calling a stretched-out “U”. The stock market, on the other hand, is still saying “V”.
But at least Roubini is still seeing a “recovery†no matter what the alphabet soup throws up.
[Note: FNArena editor Rudi Filapek-Vandyck presented a lengthy discussion on alphabets in April this year which is in line with Roubini’s thinking and still relevant today. A DVD of “Which Way Forward” is available free for new subscribers or it can be purchased here
