Weekly Macro Comment Inflection Point Or Turning Point

25 May 2009

Weekly Macro Comment Han de Jong, Chief Economist

Inflection point or turning point? •

Improvement in some key areas

•

Confidence indicators continue to strengthen

•

S&P puts UK’s triple-A rating on negative watch

Last week was a light one in terms of macro data, and what

note that some progress is being made in all three areas,

was released did not show much direction either way for the

though not enough yet to claim victory. While I do not want to

global economy. I think this is typical around inflection points or

downplay the problems and the risks, the consensus is too

turning points in the economy. That, I suppose, is the key

negative in my opinion.

point: have we reached a turning point, or is this merely an inflection point? The difference between the two is this. An

1. The destruction of wealth must stop

inflection point is when the pace of growth—or contraction as is

There cannot be a sustainable recovery until the destruction of

the case now—lessens. In mathematical terms, it is when the

wealth stops and, ideally, reverses. Continued destruction of

second derivative of GDP changes direction, in this case: turns

wealth simply means that households and banks with

positive. A turning point is when economic growth changes

precarious balance sheets will sink deeper into trouble, which

direction, say from negative to positive. This would be the first

will require more adjustment on their part (more saving, less

derivative.

spending) to get back to a sustainable situation again.

It is safe to say that we have at least arrived at an inflection

US: NAHB, home-builders’ confidence

point. I think there is a better chance than the consensus is assuming that it will actually be the beginning of a turning point, though it is likely to take time for the economy to turn. What is causing this improvement in the economy? Economic policy and the inventory cycle. While the economic downturn has

been

savage,

the

policy

response

has

been

unprecedented. Interest rates have been cut to the bone, several central banks are buying a variety of securities directly in the market (currently being labelled quantitative easing), while budget deficits are not only allowed to go up but are rising rapidly as a result of active policy. It would be most surprising if all that action did not lead to an improvement in

index

80 70 60 50 40 30 20 10 0 2005

2006

2007

2008

2009

Source: Bloomberg

economic conditions. The question is how much of an improvement and how sustainable the improvement will be.

The key asset markets are the housing market and the equity

The inventory cycle is also critical. Companies have slashed

markets. It is clear that equity markets have rallied. That is

inventories in recent months. This simply cannot continue

helpful. Of course, the equity market can be volatile and the

forever. When the inventory cycle turns, demand increases

gains can easily be lost again. But so far, so good. Cycles in

and economic activity picks up. Bear in mind that different

the housing market are much less volatile than in the equity

industries and even different companies go through different

market and also tend to be significantly longer. The US

inventory cycles.

housing market started deteriorating in early 2006, with price changes (on a year-on-year basis) falling into negative territory

In the past, I have identified three areas where meaningful

in early 2007. Prices have effectively been falling for three

progress must be made before there is any hope of a

years. Construction activity continues to decline and is down

sustainable recovery. If positive developments in any of these

by 80% from its peak. But several recent indicators are

three are lacking, any recovery will be short lived. I will now

showing some improvement. The decline in house prices

discuss these three areas in detail but before I do so I would

seems to be moderating (second derivative only so far,

HAN DE JONG +31 (0)20 628 4201

ECONOMICS DEPARTMENT

25 May 2009 unfortunately), sentiment among builders as measured by the

Fed index both rose further in May, building on the

NAHB index has improved a little, and home sales are at least

improvement of recent months. In Germany, the ZEW index of

stabilising. Affordability has improved significantly and is now

confidence among analysts also rose in May, by much more

better than it has been for many years.

than expected. In Asia, the Bank of Japan raised its assessment of economic prospects.

2. The credit mechanism must be fixed An economy cannot function properly when credit arteries are

Eurozone PMI composite

blocked. There are essentially three credit channels: through the banks, through the financial markets and between companies. Following the demise of Lehman Brothers, all credit channels were abruptly blocked. Faced with this sudden lack of financing, companies were forced to be extremely careful with their liquidity: they stopped ordering supplies and started an aggressive policy of drawing down inventories. It was this sudden corporate liquidity crisis that triggered the dramatic turn in the inventory cycle. While this is rational behaviour for an individual company, it leads to calamitous chain effects. An unprecendented deep recession was the consequence. Companies cannot continue drawing down inventories forever, so this downturn was always bound to

index

60 55 50 45 40 35 2005

2006

2007

2008

2009

08

09

Source: Bloomberg

ease somewhat. If the working of the credit channels can be improved, a process of rebuilding some of these inventories is

US: Empire State

likely, lifting economic activity at least in the short term. The signs here are cautiously positive. Central banks have taken over some credit activities by buying various types of assets in the markets. And they have succeeded in restoring some liquidity in various markets, for example the mortgage

index

40 30 20 10

bond market in the US and the US commercial paper market.

0

In addition, by injecting liquidity generously into the financial

-10

system, the money markets are now in better shape. Risk

-20

spreads have fallen as a result. So financing through the

-30

markets has improved somewhat. Bank lending is still

-40

problematic, as bank capital remains scarce and the recession will mean more losses for banks and hence a further attack on

05

06

07

Source: Bloomberg

their capital in the period ahead. Nevertheless, according to the bank lending surveys carried out by key central banks every quarter, the pace at which banks are tightening lending criteria is easing. This is true for the US as well as the eurozone. That is encouraging. 3. The recession must stop The last area where we need to see improvement is economic activity itself. And clearly, a range of early indicators across all regions has improved. This is particularly true for early-cycle sectors and economies, and for economies where government stimulus has been the most decisive: Asia and in particular China. But business confidence indicators are improving everywhere. Last week saw the release of the preliminary PMIs for the eurozone. The manufacturing PMI (purchasing managers’ index, business confidence) rose from 36.8 in April to 40.5 in May. The services PMI rose from 41.1 to 43.9, its third consecutive monthly rise. In the US, the Empire State index of business confidence in New York State and the Philly HAN DE JONG +31 (0)20 628 4201

I believe that if there is enough of an improvement in all these three areas, a virtuous circle (or positive feedback loop if you prefer) could develop and that this could be the basis for a more sustainable recovery. Of course, given the degree of deleveraging that needs to take place, the recovery is unlikely to be particularly strong. And given the problems in the financial sector, even if there is some further improvement in the three areas mentioned above, a relapse is always possible. On balance, cautious optimism is warranted. S&P puts UK on negative watch; Bill Gross says US will follow S&P has lowered its medium-term outlook on the triple-A rating for UK sovereign debt from ‘stable’ to ‘negative’. This is, of course, not a formal downgrade, but it is a warning. The reason is that the UK’s debt-to-GDP ratio may approach 100% at some stage. The same happened to Japan around the turn

ECONOMICS DEPARTMENT

25 May 2009 of the century. Given where the debt level currently is, it all seems somewhat premature to me. Pimco’s Bill Gross was quick to say that the US would eventually also lose its triple-A rating. Such a warning coming from Gross is hardly surprising. He has argued the case for some time and has said that his bond portfolios are overweight credits against Treasuries. So Bill is not only providing a comment here, he is also talking his own book. US Treasury Secretary Timothy Geithner was quick to say that the Obama administration is aiming to restore balance in the public finances within a couple of years. That is all well and good, but we must not lose sight of the overall macro picture. The private sector needs to deleverage, which means it must run a financial surplus. Realistically, that means that the US government must run a deficit. When that might change depends more on the behaviour of the private sector than the government. The US government may be forced to run substantial deficits for longer than Geithner is assuming.

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HAN DE JONG +31 (0)20 628 4201

ECONOMICS DEPARTMENT