Weekly Macro Comment The Problem Of Serving All Masters

15 June 2009

Weekly Macro Comment Han de Jong, Chief Economist

The problem of Serving all Masters •

Global economy at a cross road

•

Data still consistent with our cautiously optimistic view

•

Further rise in bond yields is a potential danger to the recovery

My team and I provide services to all parts of our organisation.

are the beginning of a recovery; others say they are just

When everything is plain sailing, we do not really notice any

weeds. So, we have come to a crossroad.

difference in the responses from the various audiences. Under current circumstances, the differences are screaming at us in

The optimistic case

the face. Having been on the pessimistic side of the debate for

According to the optimistic argument, the severity of the

a long time (we were early when, in October 2007, we started

downturn late last year and early this year was driven by an

forecasting a recession in 2008), we moved to the more

aggressive process of inventory liquidation. Faced with frozen

positive side two months ago. Many of our colleagues involved

credit markets and paralysed banks, companies had no option

in providing investment advice to clients love us for it. But our

but to sit on their liquidity. Even the inter-company credit

colleagues in Risk Management are not quite so happy. This

channel tightened up. The way companies save liquidity is by

difference is understandable. Financial markets are forward

running down inventories. This process has been brutal. But

looking and if you want to beat the market you have to be even

the positive side is that inventory liquidation cannot last

more forward looking. That means that you must have the

forever. In early-cyclical sectors, the inventory cycle has

courage to take more risk before others are prepared to do so

started to turn. This should lead to an improvement in

and well before it is clear to everybody that things will actually

economic conditions. Policy stimulus is bound to have a

improve on a sustained basis. If, on the other hand, you work

positive impact on economic conditions as well. This process

in Risk Management, you must err on the side of caution - it is

has

your job, in fact, your duty to do so. Hopefully, by clearly

pronounced in the months ahead. The turn in the inventory

underpinning and constantly challenging our own view, while at

cycle and the effects of policy stimulus will reinforce each

the same time identifying the risks, we can provide a

other. At the same time we are witnessing an improvement in

satisfactory service to all.

financial market conditions. Credit spreads are coming down

probably

already

started,

but

will

become

more

and liquidity is improving here and there. This means that the What are the facts?

availability of credit is improving. Finally, some asset markets

The facts are that the global economy has hit the worst crisis

that got hammered in the downturn are starting to show more

since the 1930s following the implosion of a range of bubbles.

positive signs. The recovery in equities is very clear. But

It is also a fact that the ‘system’ had got excessively leveraged

housing markets that have been badly hit are also showing

and that a process of deleveraging was inevitable. It is also a

some signs of stabilisation, particularly in the UK.

fact that the response of policymakers is unprecedented. Budget deficits are rising rapidly, interest rates have been

The combination of these positive developments constitutes

slashed and central banks are engaging in quantitative easing.

the core of the optimistic argument. This combination is

This

currently slowing down the vicious circle and will hopefully lead

combination

unprecedented

of

policy

unprecedented response

problems

makes

the

and

an

situation

to a more virtuous circle in the months ahead.

fascinating, but also very unpredictable. The pessimistic case As far as economic data is concerned, it is a fact that the data

According to the pessimistic argument, the improvement

deteriorated at an incredible pace following the collapse of

caused by a turn in the inventory cycle is purely temporary.

Lehman Brothers, although a recession had started earlier in

Efforts by policymakers are futile as they simply lead to

most countries and the recession had started to deepen shortly

unsustainable budget deficits. That is OK for a brief period, but

before Lehman’s demise. It is also a fact that economic data

soon enough governments must stop their expansionary

has become less dire during the last two or three months, often

policies as they are in danger of bankrupting themselves.

referred to as green shoots. Some argue that the green shoots

Some in the pessimistic camp also question the effectiveness

HAN DE JONG +31 (0)20 628 4201

ECONOMICS DEPARTMENT

15 June 2009 of many policy measures. It is true that the Chinese

unemployment. Nevertheless, if you can ill afford to suffer

policymakers are very active, but the pessimists argue that

meaningful losses, this is certainly not the time to increase risk

there is little evidence that this amounts to much more than

in any significant way.

stockpiling raw materials. In this view, the rise of commodity prices and the rise of the Baltic Dry index, which measures

The W-case, or double-dip scenario

shipping costs, are the result of China importing more

Some pessimists argue that we may experience a bit of a

commodities at low prices in order to replenish inventories.

recovery, but that it will be unsustainable. They see a recovery now as the result of aggressive policy actions and believe that

Baltic Dry Index

policymakers will step back at some point, triggering an even more damaging recession, perhaps in 2011 or 2012. I do not

Index

have a particularly strong view on this. It is possible, though

12000

not part of my most likely scenario. The truth is that such a

10000

second recession is still so far away that the question whether or not it will happen does not drive decisions yet.

8000 6000

What does recent data say?

4000

We are satisfied that recent data supports our view: an

2000

improvement in economic conditions and in financial markets and some improvement in key asset markets.

0 2005

2006

2007

2008

2009

Source: Bloomberg

The improvement is mostly visible in Asia and the US and less so in the eurozone. This is no surprise. The eurozone lagged going into the downturn, and it will certainly also lag coming

The core of the pessimistic argument is that the process of

out. In addition, the policy response in Europe is less

deleveraging has much further to run and that anything more

aggressive than in the US.

than a very brief improvement in economic conditions cannot occur until much more deleveraging is completed.

US retail sales were a tad better in May than expected, rising 0.5% mom, while the numbers for April were revised upwards.

Where do we stand?

Higher petrol prices boosted retail sales figures, but there was

As indicated above, we have been cautiously optimistic for

also an underlying improvement. The pace at which the US

several months, with the emphasis on cautiously. We believe

labour market is deteriorating is clearly easing. Initial jobless

the positive developments that are occurring will reinforce each

claims fell to 601,000 is the most recent week. Consumer

other. Of course, the global economy and financial system will

confidence edged higher in May, according to the preliminary

need to go through a further process of deleveraging, which is

reading of the index of the University of Michigan. Finally, the

negative for economic growth. But we do not believe that

US April trade balance data showed a small widening of the

growth can only resume once the deleveraging process has

deficit, but the details of the report suggest an improvement is

been completed. As long as deleveraging is gradual and

under way in real terms.

orderly, a sustainable recovery is possible, albeit that very strong growth is unsustainable.

US: Initial jobless claims x 1,000

The risks, however, are significant. For some time, we have

700

argued that investors should gradually add risk to their

650 600

portfolios, and in the advice to clients, several steps have been made in this process. The uncertainties are too big to be very aggressive, though. In the end, it all depends on your ability to tolerate risk. There is no doubt that we are still going to see a lot of bad news in the months ahead, particularly in economies that have lagged the cycle, such as the eurozone and specifically the Netherlands. Defaults and bankruptcies will continue to rise for some time; unemployment will continue to grow and housing markets will generally come under increased pressure. Bear in mind that these are generally lagging

550 500 450 400 350 300 250 Jul-07

Jan-08

Jul-08

Jan-09

Source: Bloomberg

indicators. They are painful, but a forecast for the economy should not be based on the recent trend in defaults or HAN DE JONG +31 (0)20 628 4201

ECONOMICS DEPARTMENT

15 June 2009 China saw mixed data last week. The trade figures were

borrowing costs. Either bond yields must come down from

disappointing, with import growth and export growth both falling

current elevated levels or the ‘green shoots’ are seriously

further into negative territory in May after having shown an

under threat.

improvement in recent months. But retail sales growth picked up from 14.8% yoy to 15.2%, while industrial production growth improved from 7.3% yoy to 8.9%.

China: Export and import growth % yoy

80 60 40 20 0 -20 -40 04

05

06 Export

07

08

09

Import

Source: Bloomberg

Data in the eurozone were disappointing. Industrial production fell more than expected in April and German April trade data also disappointed. This confirms that the eurozone is lagging the cycle. What are the biggest risks in the near term? The improvement in economic conditions is vulnerable and still in a state of infancy. Two developments in particular worry me. First, the rise in oil and other commodity prices has been so sharp that it is going to push up headline inflation numbers before too long. Higher petrol prices are already working as a tax on consumers. We reckon that US inflation can be back at least to the 2% level (from negative currently) by year end if oil prices stay at USD 70. This is not good news. It erodes purchasing power from battered consumers. The second development that contains big risks is the rise of borrowing costs along the yield curve. Early this year, the yield on 10-year US government paper fell almost to 2.0%. It then rose towards 3%. But when the Fed announced its quant easing strategy, yields collapsed back to 2.5% instantly. However, since then yields have been on a rising trend, approaching 4.0% recently. This has led to a rise in mortgage rates, which in turn has reduced activity in the mortgage market. I think that the economy simply cannot cope with rising Important information The views and opinions expressed above may be subject to change at any given time. Individuals are advised to seek professional guidance prior to making any investments. This material is provided to you for information purposes only and should not be construed as an advice nor as an invitation or offer to buy or sell securities or other financial instruments. Before investing in any product of ABN AMRO Bank N.V., you should obtain information on various financial and other risks and any possible restrictions that you and your investments activities may encounter under applicable laws and regulations. If, after reading the brochure, you consider investing in this product, you are advised to discuss such an investment with your relationship manager or personal advisor and check whether this product –considering the risks involved- is appropriate within your investment activities. The value of your investments may fluctuate. Past performance is no guarantee for future returns. ABN AMRO Bank N.V. has taken all reasonable care to ensure that the information contained in this document is correct but does not accept liability for any misprints. ABN AMRO Bank N.V. reserves the right to make amendments to this material.

HAN DE JONG +31 (0)20 628 4201

ECONOMICS DEPARTMENT