Recession will be u-shaped, not v-shaped
Source: BI-ME , Author: BI-ME staff
Posted: Mon February 25, 2008 12:00 am

INTERNATIONAL. In its latest monthly Global Focus, Standard Chartered predicts there will be no sharp upturn in the current US recession and it will have a global impact. The rest of world may be better insulated, but not decoupled, and as risk aversion mounts, countries with current account deficits will see their currencies under pressure.

The big story that is set to continue to unfold over coming months, and indeed years, is how the balance of global economic and financial power is shifting, from West to East. But three issues currently stand out. First, how severe will be the present economic and financial downturn in the US? Second, to what extent are emerging economies insulated from events in the US? And third, to what extent is the present surge in energy and food prices leading to an inflation problem?

Exports from the Middle East and Asia to other destinations could ultimately re-couple with those to the US, Standard Chartered said. Having the right mix of export products helps, but will not halt the downtrend. Everything ultimately boils down to domestic Asian and Middle East demand, which for now is still solid.

One example has already been seen in the first two months of this year, with a number of sovereign wealth funds providing sufficient capital that, for now, has prevented a consolidation of the US financial sector. This big story has many different facets to it, including the commodity boom, emerging new trade corridors, a huge infrastructure boom across emerging regions, the sheer scale and pace of change in the GCC, in China and the catch up potential in India.

First, regarding the US downturn. Domestic demand in the US has almost ground to a halt, and in turn import growth has slowed sharply. With the weak dollar giving a temporary boost to US exports, a significant improvement in net trade and a sharp fall in the current account deficit may allow GDP growth in the US to not only be revised up for the last quarter, but to stay positive in this quarter. Yet, do not be deceived. The domestic economy is weak and, Standard Chartiered said it regards the US economy as in full recession. This does not mean that everything in the US is bad, and indeed, and perhaps not surprisingly, there have been recent stories of the strong position of many US businesses.

The last US recession, in 2001, saw a mild 'V-shaped' recession, led by the corporate sector. That in turn triggered many large US firms to restore their balance sheets and position themselves to benefit from Asia's growth.

In contrast, this downturn seems more likely to be a longer, 'U-shaped' recession, led by the consumer. The recent collapse in the University of Michigan's consumer confidence measure, to a 16-year low, highlights how challenging the present environment is for people: the housing market is weak, the jobs market may be turning down, credit conditions are tighter, and there is increased uncertainty about the stock market and, in turn, about people's pensions. In such a climate even US firms that are in good shape will be reluctant to invest at home. The weakness overhanging US consumers also focuses attention on whether more bad news is to come out of the financial sector. This adds to the note of caution about the US outlook, certainly for this year, and also for the first half of 2009.

But the underlying strength of many large US firms is also prompting some debate as to whether the US will be able to rebound in 2009, helped by the aggressive policy stimulus taking place? The combination of fiscal easing, a weaker dollar and, in our view the prospect of the Fed funds target rate falling to 1% by third quarter 2008 will provide a powerful stimulus. In addition, the ongoing steepening of the two to ten year Treasury curve will help banks recapitalise. And some might argue a new US president may also provide a new boost, allowing those with the money, to feel positive enough to spend, especially if by then it is seen that the rest of the world has held up well, despite a US downturn, providing additional reasons for the US to bounce back. Indeed, in this scenario, the US might also receive a boost during this year from developments in the rest of the world.

Although not the mainstream view, such an upbeat assessment has some features to merit it and should not be dismissed out of hand. For now, however, the risks to the economy still appear to the downside, particularly as there may yet be more bad news to come out of a financial sector not helped by ratings downgrades.

No decoupling, only insulation

This leads on to the second big issue, that of insulation. Decoupling has been one of the buzz words of the last year. In some respects we have been an early advocate of decoupling. Last year Standard Chartered had one of the most downbeat views of the US, but was upbeat about Asia. But really decoupling is best thought of as a longer-term trend; a further sign of that shift in the global economy. This year, for instance, not only is Standard Chartered pessimistic about the US but also it has a below consensus view on the outlook for Asia, where we expect slower and steadier rates of growth. The way we captured this at the end of last year was that, "there is decoupling but the business cycle still
exists".

However, many observers talk about decoupling in terms of the rest of the world's ability to withstand any impact from the US. Instead, the term that is probably more appropriate to use is insulation. That is, a US
recession, or a sharp US downturn, will have a global impact - because the US is the world's biggest
economy, but the rest of the world is better able to cope - it is better insulated. Policymakers - like good
house owners - can add to their insulation, in this case by fiscal pump priming (tax cuts, or higher spending) or through monetary easing (lower interest rates or intervening to keep currencies competitive).

The issue then is which countries are insulated and by how much? Exports from Asia to the US have been weakening for over a year, particularly those exposed to the downturn in the electronics sector. In contrast, non-US demand has held up well, so far. This divergence in Asian export performance between exports to the US and elsewhere is likely to moderate during the year, as US weakness spreads. With this in mind we will all keep a close eye on the small, open economies across Asia such as Malaysia and Singapore that are most exposed to any downturn in global trade. In these two cases, the governments have been very visibly building up their trade and investment links with the GCC in the past 12 months.

Perhaps conscious of this, the Singapore authorities have just unveiled an annual budget aimed at being pro-business and positive for the financial sector. Although there were many features, it was noteworthy that a series of micro-measures when added together provided a credible overall framework that should boost the economy, with for instance, wealth management benefiting from the removal of estate duty with immediate effect, Islamic financing benefiting from a 5% tax concession for Sharia-compliant activities, plus other measures such as a commitment to increase research spending in coming years. Elsewhere across Asia, policymakers appear intent on providing similar pro-growth stimuli.

The economy where sentiment has turned down recently is India. Although India is still a relatively closed
economy, with exports to the US particularly low, it is via financial links that the economy is being hit as the stock market corrects in response to events in the US and rising inflation and previously tightening monetary policy at home. Moreover, political inertia may now start to grip policymakers ahead of next year's elections. This leaves the Rupee vulnerable, notwithstanding many longer-term positives. In fact, as global risk aversion mounts, many countries with current account deficits may see their currencies come under pressure. This is particularly a concern for Eastern European countries, but it also has led to the Turkish Lira and the South African Rand suffering, and as is often the case when the market mood shifts, poor news that may previously have been taken in its stride now leaves the currency vulnerable, in this case power shortages in South Africa.

In the last two years, Africa attracted much attention as Middle East and other investors looked for 'frontier markets' in which to invest. Already this year there have been sufficient signs of the risks associated with such frontier economies. Kenya's problems have continued, but at least the latest news suggests some sort of agreement has been reached, but full details have yet to be unveiled. Whilst Kenya's troubles have attracted much coverage, it is South Africa that warrants market focus. The economy is slowing, the currency is weakening as global risk sentiment shifts, and political uncertainty has risen. The power crisis is compounding problems and is likely to contribute to a much weaker first quarter growth.

Domestic demand matters

The third current focus is inflation. Here, there are so many different factors at play that it is important not to lose sight of how the shift in the global balance of power is having a profound impact on international competition.

More production appears to be moving to the East and Middle East, and the trade-off here is that winners are those firms able to lock into lower costs, whilst the losers are Western workers who find it unable to compete with lower costs, and possibly more productive workers in countries such as China. This shift is also having a profound impact on inflation, in recent years leading to intense competition, contributing to disinflationary pressures.

In recent years the world has witnessed a global boom without significant inflation. A number of factors contributed to such low inflation including the fact that when this boom began there was much spare capacity in the world economy and since then there has been intense competition from economies such as China. Although there has been low overall inflation, recent years have seen inflation in some sectors, particularly in some asset prices, with real estate and equity markets in many parts of the world enjoying strong rises. This liquidity driven inflation was concentrated on certain sectors. In recent months, a tightening of liquidity conditions has led to a correction in many real estate and equity markets. Instead, now, inflation pressures are seen in areas linked to food and energy prices.

A year ago, financial markets around the world were discounting so much good news that equities, bonds, derivatives and commodities were all expecting a good outcome. Of course, it wasn't possible for them all to be right: what we were seeing was the consequence of ample liquidity, and asset price inflation. As we reached the end of last year, decoupling was evident in the markets with equities holding up whilst the credit markets collapsed.

This year has seen equities correct. But the most interesting markets at the moment are probably the commodity markets, which continue to provide evidence of decoupling or insulation. But the reality is there are significant variations across commodity markets, although one unifying theme is tighter supply conditions. Supply concerns have led to a recovery in freight and base or industrial metals, following their previous sizeable fall as US demand weakened through 2007.

Oil prices have stayed stubbornly high, both because of strong non-US demand and also because of OPEC's tight control of supply. Uncertainty over the dollar, despite its recent firmer tone, and worries about the financial sector continue to keep precious metals prices high. But the real action has been on agricultural prices, again here, heavily influenced by supply. The combination of high energy and food prices continues to feed discussion about inflation. The data, as before, varies considerably around the globe. Yet, after years of relatively low inflation it is giving central banks more to think about. We continue to keep a close eye on inflation trends, given persistently high energy and food prices. More vigilance has to be focussed on those economies with strong domestic demand, and/or those with price subsidies, where the full impact of rising costs has been disguised.

As a result, markets and policy makers appear more sensitive to poor inflation news, and if anything appear to be on inflation-alert. The inflation outlook, however, varies considerably, heavily influenced by domestic demand pressures. For instance, in the US, although the steeper yield curve reflects rising inflation expectations, the sluggish outlook for consumption suggests the pressure of higher costs is more likely to be borne by profit margins, not overall inflation.

In contrast, economies in the Arabian Gulf, China and India face still strong domestic demand and overheating pressures. In China, for instance, where food is around two-fifths of the consumer price index, the combination of strong demand for food from wealthier consumers and supply constraints has already pushed inflation to 7.1% year on year in January 2008 and it looks set to head higher, forcing further domestic policy tightening and allowing greater acceptance of the case for a stronger Yuan. Rising inflation is already set to be an issue in Malaysia's forthcoming election and will certainly figure as an issue in India's polls next year, the latter likely to contribute to further intervention by the authorities there to prevent the full impact of inflation feeding through.

As worrying as this rise in food and energy prices is, it is important not to overlook the continued intense global competition that is likely to continue to suppress the prices of large ticket manufacturing goods. As a result, when one looks at inflation there is a strong need to analyse this from a local perspective, as conditions vary considerably from country to country.

One region where inflation is rising fast is the Middle East, not helped by the link to the dollar that has led to continued cuts in interest rates across the region although there is a domestic need for higher, not lower, rates. Although the latest news shows no immediate desire to change currency policy, Standard Chartered and others continue to factor in a GCC revaluation later this year.

One currency that looks set to appreciate is the Chinese Yuan and, once again, this was the only currency mentioned in the recent G7 communiqué which welcomed China's decision to increase the flexibility of its currency, and encouraged accelerated appreciation of its effective exchange rate. This implicitly draws attention to the Yuan Renminbi's weakness versus the Euro. As usual, the communiqué said they will continue to monitor foreign exchange markets closely and cooperate as appropriate. The trouble is, it is probably not the currency markets that the G7 needs to watch in coming weeks, but the continued damage to come in the financial sector.

 

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