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Is the crisis over?

At the G-20 summit in Pittsburgh, the global economic crisis was declared to be over. The unprecedented scale of the stimulus had saved the world from a bigger financial disaster. However the road to recovery is unlikely to be smooth, warns SG CIBs FX team, as the global economy faces significant headwinds even as the IMF raises its forecast for global economic growth in 2010 to above 3%. Persistent unemployment, further bank deleveraging, and the huge fiscal consolidation needed to recoup tax payer largesse are a big overhang, and growth is likely to be sub-par for an extended period of time. Martin Fluck reports.
SG CIBs central scenario is for mild, even decent economic growth in the US next year, with GDP growing 2.5%. It is still targeting 12,000 for the Dow next year, and Vincent Chaigneau, SG CIBs Head of FX & interest rate strategy, remains cautiously optimistic, but the risks are clearly to the downside. He thinks the worst is behind us for now in terms of economic growth, which started to rebound the second and third quarters. However, he points out that it is not only the rate of change of economic growth, but the level from which it starts that matters: Any growth now will be from a low level. Given the depth of the slump in output, there is now a huge output gap, and the signs are that the pace of the recovery is slowing down. Manufacturing has enjoyed a rebound in recent months as companies have started rebuilding some of the inventories they slashed, but leading indicators of manufacturing confidence are now flattening out and monthly gains in Japan are also decreasing. Home sales and durable orders in the US are sending the same message, says Chaigneau. It is for this reason that he questions the 25% earnings growth the equity markets have priced in. The standard deviation of polls of euro-dollar forecasts and IBES earnings, is very high. Without much visibility on earnings, and given the economic uncertainty, there are a wide range of views that dont seem to tally with the decline in equity market and FX volatility. The price the market is paying for protection is also hard to square with the overall health of the credit markets. With the VIX and other fear indices at 12-month lows, it is as if the market is assuming the system is as risk free as it was during 2003-2007 when maximum risk taking was rewarded and encouraged. Even hedge funds, the bane of banks last year, are now buying their shares, not shorting them. But a sustainable recovery depends on a revival in

Vincent Chaigneau

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consumer spending. Yet spending will be hard to sustain with unemployment rising in the developed world, and the shadow network of non-bank credit, that once provided credit to consumers, is likely to remain in stasis. This is a view that has led Albert Edwards, SG CIBs leading investment strategist to worry that the US economy will start to turn down in the first half of 2010. The recovery has so far been dependent on government support, but now the withdrawal of emergency schemes will keep consumer spending muted as the IMF is cautioning. Until now, unemployment benefits and redundancy packages have also masked the real impact of the credit crunch, but in many Western countries these will be expiring suddenly leading to greater social hardship.

In the US the talk is now of a stall-speed economy, where consumer spending will play a limited role in leading any recovery out of the worst recession since the 1930s.
spending in the US, and as these are normally correlated, this is very unusual, Chaigneau points out. Home sales have recovered in the US, but there are 7 million houses in the overhang or shadow inventory of delinquent loans that has grown inexorably in the tsunami of default and foreclosure, which suggests US housing might not be out of the woods yet. The mire housing is in is illustrated by the cure rate on delinquent loans: it was only 5% in the second quarter of 2009, compared to 66% in 2005. With new house sales stuck around 430,000 down 70% from their peak the worry is that the US housing market will stall again when an US$8,000 tax credit for first-time buyers will eventually expire. The rate of hiring in the US is still falling. But even if hours worked stabilises, SG CIB thinks real wages will probably decline, as consumer price inflation mechanically rises as a

result of base effect where inflation rises simply because the index is measured against a lower base. Real wages in the US up 4% as a result of the collapse in inflation have so far offset the decline in payrolls.

Europe still weak

There are similar concerns for the European consumer. German unemployment has not risen much yet, but it could rise strongly now - as in the rest of the eurozone as Kurzarbeit, a government subsidy scheme, that encourages companies to reduce the hours of their workers instead of firing them, runs out. This and Germanys car scrappage scheme have prevented mass layoffs during the deepest part of a sharp industrial downturn. But now Germanys car industry faces possibly the largest downturn it has ever suffered, according to the Center of Automotive Research, with sales falling by one million next year. Fiat's Sergio Marchionne has warned of "disaster" for Italy unless Rome renews its own car scrappage subsidies. Germanys exporters cannot live off China alone, and their other big customers, in America, Britain, Eastern Europe and Spain, will not be as free-spending as they once were. For now, the eurozones core countries are likely to do better than those on the periphery, but firms there will not carry idle workers forever. Competition is also hotting up as America and Britain hope to export their way out of trouble, with benign neglect towards

US recovery remains fragile

In the US the talk is now of a stall-speed economy, where consumer spending will play a limited role in leading any recovery out of the worst recession since the 1930s. Plunging home values and stock prices have fueled a record US$13.9 trillion loss in household wealth in the US since the middle of 2007. And given the truly shocking unemployment figures over half of 16-24 year olds are now unemployed it is not surprising that Americans are changing their behaviour and saving more, as can be seen in the fall in household debt. Theres a massive gap opening up between manufacturing PMI and consumer

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the dollar at the heart of Americas recovery strategy, just as a weak pound will help rebalance the UK economy.

After the bailout

Going forward, the biggest overall threat to economic growth is the end of the global stimulus. Government largesse on both sides of the Atlantic has to come to an end, as deficits reach political and financial limits. Chaigneau finds the fiscal trends extremely worrying, with G20 debt to GDP ratios rising from 80% to 100% when an ageing Europe already faces a demographic shock. This will remain a longer term headwind, keeping the growth of nominal GDP low. He thinks this could be 10 times more costly than financial crisis and increase this ratio by 200 points. So, while business and consumers have begun to retrench, government debt continues to rise. If governments do not start deleveraging soon, the markets could make the decision to do so for them, if they take fright and push up bond yields. The real deleveraging has not really started, Chaigneau says ominously. Meanwhile, money supply data is signaling that unless governments take action to accelerate lending there is a risk of a renewed downturn. Private credit is now contracting on both sides of the Atlantic at an alarming rate. US bank loans have been falling at an annual pace of almost 14% since early summer, for the first time since the 1930s. In Europe, where M3 money has been contracting at a 1% rate since

April, private loans have fallen by 111bn since January. The issuance of securities backed by consumer assets, such as car loans, may have come back from the dead in the US US$15 trillion of financing capacity has been taken out as banks have shrunk balancesheets but only thanks to a financing facility run by the Federal Reserve. The tripling of losses from syndicated loans to US$53 billion this year shows that there is a substantial mountain left to climb. In Europe, banks may need further recapitalization, given signs that the banking crisis is not necessarily over. High levels of unemployment, and muted economic activity are expected to push up loan losses, particularly in the UK and the euro zone. US banks have recognized about 60% of their expected losses, compared with 40% in both the euro area and the UK, according to the IMF. Accelerating corporate and commercial property defaults also threatened to slow the improvement in financial conditions, which could hinder the rebound. The need for banks to raise capital and shrink their balance sheets, is leading to the prospect of a renewed credit crunch over the next few months. Germanys Economic Ministry has drawn up plans for 250bn in state credit, knowing that the lifeblood of its economy, the smaller firms that make up the Mittelstand, will find it hard to roll over debts next year. To make matters worse, Europes banks are exposed to the economic situation in the Baltics and elsewhere in Eastern

Europe. As SG CIBs senior currency strategist Murat Toprak warns in this guide, Central and Eastern Europes ongoing banking crisis threatens to destabilise the markets once again. Swedish banks still facing huge losses on loans to the Baltic states, while Austrian banks are extremely exposed to emerging Europe, as are Germanys to a lesser degree. Questions are also being asked about the true health of banks in some European regions. In Spain, dauntingly high unemployment, which is approaching 20%, means an army of jobless will be reduced to 100 a week over the next year. Concerns about the losses its banking sector must absorb and whether it has owned up to the true state of its balance sheets are not surprisingly mounting. The interest rates at which banks lend to each other may have fallen to lower levels than those offered before the crisis, and the healthiest banks like Societe Generale may have thickened their buffers against loss by raising common equity and reducing exposure to high risk operations, but many banks may yet find themselves in difficulty. So, it really does seem too early to say that the financial sector is out of the woods, just as it is too early to conclude that a tentative global recovery will be self-sustaining. Investors and companies will need to keep their wits about them and prepare for changes in sentiment that may be as sudden as some of the currency realignments are likely to be over the next year.