The World Economic Recovery: Navigating between the Positives and Pitfalls

Thierry APOTEKER
The global economy is currently in very uncertain times. Equity and commodity markets are pricing for a V-shaped recovery, but bond markets are pricing for a mild, low recovery with no inflation. These rifts must, at one point, give way to the reality which is either one of three scenarios. Key risks and opportunities must be forecast for the next cyclical phase.

Most of what will be presented is supported by very strong quantitative development even though the details of the models and data mining techniques will not be discussed, though much information on these quantitative methods is available on TAC's website.

There is a need to understand what the key risks are in the next phase. The question is whether the recovery will be V-shaped or a "double dip" with a fall-back into recession and low growth. Also, the revived concept of decoupling between developed and emerging markets will be assessed. There does not seem to be a risk for a double-dip recovery, rather taking the shape of a hockey stick, with a short collapse and a long, slow recovery. As for decoupling, emerging markets are not able to move independently from what is happening in the industrialized world, though some regions have gained more autonomy in economic growth.

Regarding a global economic outlook, from a look at the quarterly growth rates of the U.S., the UK, and the Eurozone over the last three years, it is apparent that the recession is extraordinarily intense and dramatic being the worst shock to the Eurozone since World War II. Almost all of these three areas have returned to neutral in the second quarter of 2009, and forecasts predict that the third quarter will see growth in all industrialized areas.

The figures for the U.S. are very likely to be surprisingly high due to the significant effects of the "cash for clunkers" automobile program. This alone may add 1% to the GDP growth of the U.S. However, this growth spike cannot be extrapolated for the future as the program is a one-off measure.

Despite the fact that the recession started with the subprime mortgage crisis in the U.S., the U.S. has proved more resilient than the other industrialized areas. The core of the financial difficulties was in the U.S., but the most important impacts of the financial crisis are in the industrialized world outside the U.S. This must be kept in mind in the midst of talk of the immediate demise of the dollar and U.S. leadership. Even in very poor and tense circumstances, the U.S. economy has an incredible adaptability, flexibility and reactivity that allows is to be more resistant and come out of the crisis earlier and stronger than other economies.

Regarding why neither the V-shaped nor double-dip recovery forecasts are accurate, employment and new orders, cyclical indicators for the U.S. economy hold two simple messages. First, the trough in terms of leading indicators was reached around the end of 2008 and early 2009. This is where orders started to pick up and employment surveys started to increase. Orders have progressively and quite rapidly improved since the end of 2008, and crossed the line between expansion and contraction in June 2009. The same can be seen in employment with a significant improvement from 650,000 jobs lost each month to 250,000 jobs lost between March and July 2009. These clearly show that the worst is over and that there will be positive industrial production and stabilization in the job market.

A second issue which is critical is that while the spike in orders is related to the cash for clunkers program, the stabilization in the employment survey implies that the U.S. will not be creating new jobs any time soon. The pace of job destruction is slowing down, but this will not cross into net job creation in the near future. As long as there is no job creation, a V-shaped recovery is very unlikely due to the lack of a sharp increase in consumer spending. The drop in consumer spending is a direct result of disposable income drying up due to increasing unemployment.

Comparing the previous figures with their counterparts in the Eurozone brings to light how much more flexible and reactive the U.S. economy is compared to those in the Eurozone. The troughs of these indicators have passed, implying that the worst is over. However, the recovery in the Eurozone will be much more tepid and gradual than in the U.S. The shapes of the leading indicators' graphs in the Eurozone are much flatter than those in the U.S., especially the graph for new orders, which reached its low point as late as June 2009. Again, this means that the Eurozone will exit the recovery later with more weaknesses and with less speed than the U.S.

A significant part of the recovery is related to huge fiscal stimuli in all industrialized countries. Looking at public deficit as a percentage of GDP figures from the U.S., the Eurozone and Japan, it can be seen that there was a move amongst the three from rates of between 0% and 2% in 2007 to between 6% and 12% in 2009. This reveals an unprecedented policy reaction in terms of fiscal support for demand. This is strong enough to avoid a double-dip, and policy will remain significantly proactive into 2010.

The U.S. consumer confidence index gives a mixed message. Consumer confidence in the U.S. began its decline long before the crisis began in July 2007, with the first declines in real estate prices and the first problems in the subprime market. The trough was in January and February 2009. Since then, consumer confidence over three different surveys shows stabilization rather than a steep increase which would support the notion of there being a V-shaped recovery.

The most important thing to keep in mind is that not only will the recovery be tepid, but also the medium-term prospects for growth have been seriously dented by the crisis. The exit from the recovery will not be a return to business as usual due to the fact that the weight of public debt on future fiscal policies will lead to all industrialized countries implementing tightening in budgetary policies with tax increases and spending declines.

When you look at public debts, which are all huge and increasing, Japan is a special case as it is the only country where the gross debt, which is exceptionally huge at close to 200% of GDP in 2008, is around twice the Net debt as the Japanese public sector has a lot of assets both domestic and foreign. This huge difference between gross and net debt figures is specific to Japan and in terms of future constraints on growth related to public debt, there is not a very big difference between Japan and the rest of the industrialized world.

The second constraint on medium-term growth is financing consumption. Up to 2007, the growth in personal consumption in the U.S. was fed by a massive increase in household debt. The increase in personal debt started to slow down, and this was followed by a slowdown in consumption. Starting in the third quarter of 2008, debt began to contract, which was immediately followed by a contraction in household consumption. The medium-term question is whether it will be feasible for households to go back to this kind of debt increase to support consumption. The answer is no because households have to repair their own balance sheets and banks will be subjected to much tighter regulatory standards for credit distribution to households. It is therefore unlikely that the U.S. will not be able to return to 3-3.5% growth rates by 2011, with uncertainty also present for 2012.

Regarding world trade, the current crisis is far more intensive than the crisis following the burst of the internet bubble. International trade came to a standstill at that time, whereas now it is contracting by more than 10% in terms of volume. The recovery from this drop is rather mild as the IMF is forecasting a 2.5% increase in the volume of trade in 2010. Given what was previously discussed about the U.S.'s medium-term growth prospects, it is highly unlikely that growth in the volume of world trade will return to rates of 8-10% per year as seen between 2004 and 2007. This has strong consequences for emerging markets.

One area of serious concern is inflation rates. There is today excess productive capacity, slack in the production cycle and the output gap is high, and this situation feeds a benign neglect on inflationary pressures. And it is striking to see that in such a favorable environment, there are already inflationary signs. The consumer price index increased from July to August 2009 by 1.5%. Also, the worst decline in prices in the U.S. in decades was seen immediately after the Lehman shock and this creates a "base effect" which soon will technically provide bad figures on year/year inflation rates; expect deteriorating figures at the end of the year.

Despite the excess capacity that comes with the stabilization period, both the consumer and producer price indices have been increasing with great volatility, but the average of the last three months is an increase 0.4-0.5% per month. If the situation remains at this level or increases, the annual rate of inflation will be far higher than the 2% which is considered to be within the comfort zone. The question is how one of the price indices can be increasing at 0.5% per month while so much excess capacity is present. This does not mean to say that inflation will hit 5%, but that benign neglect of this issue is not warranted.

If market operators and policymakers are too complacent regarding inflationary risks, what this means for monetary policy must be assessed. The question is when the Federal Reserve Bank will tighten its monetary policy. The Fed will face this issue in the coming quarters and I believe that very soon the Fed will start this tightening by removing the unconventional quantitative easing that it has injected into the economy. The pace of the quantitative easing was so rapid and so large that nobody knows what the effect on markets, yield curves, long-term interest rates, and other factors will be when the easing is scaled back. Most probably there will be a steepening of the yield curve.

Regarding the movement of the dollar, under the aforementioned scenario, it is unlikely that the European Central Bank will tighten its monetary policy before the Fed. Our model shows that the dollar should not go over 1.50 euros, but will be accompanied by huge volatility due to uncertainties on monetary policies and the consequences of these monetary policies. The dollar is predicted to fluctuate in-between a 1,50 to 1,40 range until the end of 2010.

Moving on to the developing world we never "bought the fad" about decoupling. As developing countries still account for slightly more than 30% of global GDP, if the other 70% of the world's economy is in recession, one cannot expect the developing countries to be unstuck. Developing countries send around one-third of their exports to other developing countries (and some part of it is only supply-chain trade), with the other two-thirds going to the industrialized world. It is therefore naive to think that the developing world can quickly compensate by increasing trade amongst themselves.

A look at the graphs of GDP growth for the developed world and the developing world, which are parallels, clearly shows that decoupling does not exist. However, when looking at the same figures for developing Asian countries, a partial decoupling can be seen. This is directly related to the ability of China and India to implement rebalancing towards domestic demand. It is also striking to see that developing Asia built a solid trade with the Middle East Countries. In the medium term there will certainly be more growth linked to domestic demand and trade will show further regional integration.

To assess which countries are better placed to recover quickly from the on-going crisis, we looked at the changes in exports (latest figures compared to the worst ones recorded at the beginning of the year) and measured the "domestic demand momentum." Countries like Russia, Indonesia, and South Africa have seen a significant reacceleration in exports, mostly linked to the rise in Commodities' prices, but neutral or negative domestic momentum. These countries are getting out but are still highly vulnerable to anything that happens in the international trade environment. Countries like Thailand, Romania, Hungary and Poland will have a more difficult time exiting the crisis as they show neither an acceleration in international trade, nor strong domestic demand. On the other hand, China and India are not being pulled by the international trade recovery, but their strong domestic demand, mostly generated by public spending in infrastructures, which is pulling them out of the crisis. Korea is clearly the "star" as both engines of growth are strong.

Regarding regional integration, developing Asia appears to be the only region where things are moving to help it become more or less dependent of the "global" economy.

The key vulnerabilities of the developing world that are measured in the models of ours include liquidity and exchange rate risks, banking system and cyclical risks, and political risks versus economic and financial risks. Results can be summarized into a country risk premium that our customers add to their own domestic cost of capital and use as a benchmark, a hurdle rate, a comparative rate of return for budget allocations. In terms of exchange risk, many Eastern European countries and Turkey remain high-risk, with Thailand as the lowest-risk country. In Russia, the stabilization of the ruble leaves it still vulnerable to any decline in oil prices.

As for China, we do not believe that China's currency is undervalued. It is a very controversial issue, very sensitive politically and it would be needed to be explained in detail. The majority of Chinese exports come from productive factories in coastal regions, owned partially or totally by foreigners, who brought technology. For those the currency might be undervalued. However, in that region, a substantial portion of exports still come from public factories, with low efficiency and large labor forces for whom the currency is not undervalued. To illustrate this, the fast appraisal of the renmibi in the last period had no impact on the U.S. trade-deficit with China. What must be kept in mind is that in the 1997 Asian financial crisis, part of the crisis resulted from the competitive depreciation of currencies that took place three years before that in Turkey, China and Mexico. Currently, the Turkish, Mexican, and other currencies are depreciating significantly thus creating negative competitive pressure on the Chinese currency. Because of this, the Chinese are not going to start an appreciating trend against the dollar until they see that their exports have recovered significantly.

Looking at the political versus economic and financial risks measures, some countries with low political risk have high economic risk, like Hungary, which compensates for its high economic risk with its low political risk. On the other hand, countries like Argentina, China, and Thailand have low economic risk, but high political risk.

The country risk premium, taken from the aforementioned measures, show that Poland, Malaysia, Korea, the Czech Republic, and Thailand are among countries with low overall risk premium. (For example, this means that, in the case of Malaysia with a score of around 200 basis points, when investing, one must look for a return on their operation that is 2% higher than the return they expect in their home country in order to cover risk.)

Regional integration in Asia is a long-term process for which the current crisis has only served as an accelerator. This will require huge strategic changes in terms of products, marketing and finance when exporting to or dealing with Asia. Smaller countries or those with limited policy space will remain vulnerable to exchange rate pressures and will register an increase in corporate difficulties in the short term. Many Eastern European countries are still the most risky and require extreme short-term caution. The Middle East is progressively coming out of difficulties but financial tensions and debt negotiations are still likely. Latin America apart from Mexico and most of Africa remain highly dependent on commodity prices, and there is a higher likelihood of volatility in these regions. Finally, more than ever, differentiation remains the key word for developing countries.

Thierry DA
What Thierry Apoteker Consultant (TAC) measures is only exchange risk, growth risk and cross-border demand and it does so on three time horizons: one, three, and five years. This is important to keep in mind because these ratings do not say that one country is better than another one. When we warn on risks or give poor ratings, it is exclusively in relation with such focused risks. For example it is not totally clear what rating agencies are rating (normally: sovereign default) and at which horizon. Therefore it is nearly impossible to MANAGE risks with such ratings.

A few years ago we were giving better ratings to Egypt than Hungary, shocking many of our customers (Hungary being a member of the EU etc.). The reason was not because Egypt is a "better" country, but rather that at the time the risks of exchange rate depreciation in Hungary were much greater than in Egypt. (Please Note that "exchange risk competitiveness" is measured by looking at the ten major exports of a country and the currencies of the country's ten major competitors in each of these exports.

Q: Regarding the U.S. inflation rate, I do not see any macroeconomic possibility for demand-pull inflation. Do you think that there is any possibility of import-led inflation?

Regarding the renminbi, do you think that Japan is not a competitor to China, given the rise of the yen?

Thierry APOTEKER
On the inflation question, I am not from the monetary school of economists, but Milton Friedman expressed a very simple truth: inflation is fundamentally a monetary phenomenon. If a huge amount of liquidity is being created in a country, it must be going somewhere. During crises, like now, it is parked in safe assets, like government bonds, which today are highly overpriced. When the recovery comes and the job market stabilizes, this liquidity that is parked in safe assets will be moved into either other assets or goods.

This said, inflation cannot be demand-led in the sense that demand will be so strong as to create tension on productive capacity. As soon as demand recovers, firms are considering whether they can increase prices, which is currently being created by the depreciation of the dollar. Pricing power and monetary and exchange rate elements are moving in the direction of higher inflation.

Looking at the differential in interest rates between the inflation index of five-year bonds in the U.S. and fixed-rate five-year bonds, the differences came to zero in January and February 2009, meaning that at that time, financial markets were expecting inflation rates of zero. This suggests that financial markets have since moved from an expectation of zero to 2% in the medium term. A trigger for higher inflation could be further depreciation of the dollar or a cost-push factor through commodity prices, though there is an upward trend in the medium to long term for commodity prices.

If one holds that there is no inflationary risk, then a bubble must be present, as the liquidity must go somewhere. There may be bubbles in the equity, bond, and commodities markets, which would be present if there is no inflationary risk.

On the question of the renminbi, at the margin there are always industries in which there is competition between emerging and developed economies. For example, some textile manufacturers in the developed world might complain to their national governments about competition from China. However, products like automobiles in the developing world cannot yet compete with those in the developed world. While there might be some industries where there is such "marginal" competition, by and large, the sheer difference in cost per unit, labor costs and productivity per unit results in more product segmentation than competition. Worries over Chinese competition are more real for Korea as its middle-range products will soon be under competition from China.

There is no doubt that all industrialized countries have constant pressure to improve quality, technology, refinement and segmentation of goods because the overall development process is pushing them to the higher end. This is also pushing developing countries to move up the ladder.

Q: In mentioning Japan's 200% national deficit, you mentioned that there were large assets in Japan. Could you please give us your estimate for the net national debt of Japan?

Related to that, even though Fed Chairman Ben Bernanke said that zero percent interest rates will not last forever, in Japan they have lasted since 1995.

Thierry APOTEKER
The Bank of Japan's interest rate remains at zero with a low level of success. This should be an example that the U.S. should not follow. The way Japan tried to get out of the real estate bubble and what is called the Lost Decade where there was low economic growth accompanied by stimulative economic policies that did not work. The bottom line is that the U.S. will not use this example as the way to move forward.

Among the differences in the U.S. and Japanese case include demographics, with the U.S. being by far the most dynamic country in the industrialized world in terms of demographics. Second and more important, is a comparison of the results of the U.S. banking sector two quarters after the crisis and Japanese banks five years after the crisis. The U.S. banks shifted problems to their friends in Europe and Japan, and in the last quarter of 2008 the amount of losses U.S. banks took on their balance sheets was huge.

The U.S. banking industry acted in the opposite way to how the Japanese banking industry did and to how the European banking system is acting now. These banks hid the problem and expected that time would remove it. In the low-growth environment of Japan in the 1990s and Europe in the years to come, the problem is not eliminated by delaying it; it only becomes a long-term problem. The U.S. frontloaded the losses to the maximum extent, which led to huge differences in how monetary policy is carried out between the U.S. and Japan.

Regarding Japan's debt, the gross debt, according to IMF figure for 2010, is around 225% of GDP, whereas the net debt is around 110% of GDP. This means that the IMF is expecting Japan's public sector to have assets over the private sector which are in the order of 100% of GDP

Q: How can the interest rate, set by the Bank of Japan rather than the market, be maintained for 14 years, and how is this expected to help Japan's economic problems?

Thierry APOTEKER
There are many Japanese economists who would be much better suited than me to comment on the long-term zero interest rate in Japan. All central banks do fix their leading rates, which is the rate at which banks refinance themselves when they need liquidity from the central bank, and this is not peculiar to Japan. The question is whether there is a lot of liquidity outside the central bank or not. If not, the central bank must be the source of liquidity and the role of the leading rate in this regard.