World Economy Continues to Defy the Pessimists

PERSPECTIVES: The recovery phase tends to be one of the longer phases of the cycle and this time should prove no different

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Against a backdrop of continuing concerns about rising government budget deficits, tougher financial regulation and the return of protectionism, global economic activity continues to come in stronger than expected. Indicators of global activity such as the regular Purchasing Managers Indices (PMI), or the less conventional copper price are buoyant.

Emerging Economies Are Booming Again, But Europe is Lagging
Estimates for US GDP growth in the first quarter are now running at 4% (q/q annualised) following a revival in consumer spending and continued expansion in the industrial sector. Capital spending in the business sector is also growing, having picked up at the end of last year and, along with the better tone to consumption, indicates that the recovery is broadening beyond the inventory cycle.

In Japan, growth forecasts are also being revised up as business confidence rises and across Asia generally, growth is surprising on the upside as trade revives. Singapore achieved remarkable quarterly GDP growth of 32% annualised in the first quarter and China beat expectations by growing at 11.9% y/y in the first three months of 2010 with exports rising 29% y/y. Elsewhere, in the emerging markets activity in Brazil and India remains robust.

The only area not to share in the general upgrade to activity is the Eurozone where the labour market and consumer spending remain sluggish. Part of this may relate to poor weather which depressed activity at the start of the year. Fiscal tightening has also moved up the agenda as a result of the situation in Greece. Similar concerns are keeping UK forecasts on hold as investors focus on the general election. Whoever wins it is clear that the UK will be facing several years of tightening fiscal policy.

Stronger profits, the rally in financial markets, ongoing resilience in the emerging world and policy stimulus have all played a part in the recovery

We would identify four areas of support for the recovery:

1. The first would be the benefit of the strong recovery in corporate profits. The macro numbers have improved as US firms have started to deploy their cash flow by raising capex and beginning to recruit again. Although this has been accompanied by a rise in unemployment as firms cut costs, the fact that it was delivering strong productivity and profits gains indicated that the pace of cost cutting would moderate and eventually cease. Importantly, unemployment is a lagging indicator whilst profits lead economic activity.

2. Second, is the stabilisation and recovery in financial markets. Although some see this as misplaced (a “distrusted rally”), the revival has increased household wealth and allowed companies access to capital. From a macro perspective, this helps both consumer and corporate spending.

3. The ongoing strength of the emerging world has also played a part with the Asian and LatAm economies rapidly regaining the output lost in the downturn and proving able to withstand the drop in global trade.

4. Fourth, underlying all these factors has been the continued level of policy stimulus, with both fiscal and monetary policy providing significant support.

Recessions and Recoveries Compared
The key feature of recessions caused by a financial crisis is that they tend to be deeper and longer than conventional recessions. This largely reflects the impairment of the policy transmission mechanism as banks restrict credit whilst they focus on rebuilding their balance sheets. Meanwhile, a fall in asset prices prompts a similar period of balance sheet repair in the household sector. Consequently, recovery is slower than in conventional cycles as monetary policy fails to stimulate expenditure.

Whilst downturns caused by financial crisis are worse than the conventional, those which are synchronised tend to be the worst of all with a period of 14 quarters needed to regain the previous level of GDP. Given the global nature of the recent crisis most commentators expected this to be the path followed by the world economy.

Looking at the current performance of the US economy we can see that it experienced a recession which was as deep as past recessions caused by financial crises, although not as bad as a synchronised crisis. The upturn which began in Q3 last year has been better than history would suggest with the economy about six months ahead of the average experience for a recession caused by financial crisis. By contrast, the Eurozone is following a move typical path for an economy recovering from a financial crisis.

Of course, the average may not be the best benchmark to judge performance as it includes a range of different economies in terms of size and structure. Nonetheless, the performance of the US is testimony to its flexibility and rapid response to the crisis.

Reserve Currency Status has Helped the US
No doubt the better performance by the US also reflects the status of the US dollar as the world’s reserve currency. Unlike most currencies of countries in financial crisis, the USD did not collapse. After initially weakening in 2007 and early 2008, the USD firmed as the crisis deepened with investors seeing the US as a safe haven. Despite doubts about the willingness of China and others to maintain close links with the USD, they have continued to fund the US and the currency has held firm. This contrasts with the experience of others in financial crisis who have suffered capital flight and a sharp rise in interest rates, deepening the recession and hampering recovery.

Significant Challenges Remain in Withdrawing Policy Support
Whilst there are good reasons why the US has beaten expectations, we should not be complacent. Policy stimulus has played a big role in the recovery. Monetary policy is likely to stay loose for some time. However, questions are already being asked about the sustainability of government borrowing with the result that fiscal stimulus will be reigned back and reversed in coming years. China is already moving to slow loan growth and has raised reserve requirements. Meanwhile, the private sector in the US, UK and parts of Europe is likely to de-leverage further to restore balance sheets and there has been no pick up in credit growth to support the recovery so far. It could well be that the pessimists are right, but just too early on the timing.

Into the Recovery Phase
Despite the better tone to growth, inflation remains well behaved in the advanced economies. There has been a pick-up in headline CPI inflation as a result of the rise in energy prices, but core inflation (CPI excluding food and energy) remains subdued. In the US, core inflation has been broadly flat over the past five months, bringing the annual rate down to 1.2%, its lowest level since 2003. For the G7, core inflation is at its lowest level for six years.

Economic ‘Sweet Spot’ as We Move Into the Recovery Phase
The combination of rising growth and falling inflation is a characteristic of this stage of the cycle. The presence of a large output gap means that there is little pressure on resources as firms can easily raise output and will look to increase volumes rather than prices. The result is that we experience the “sweet spot” in the cycle as output and profits rise while inflation remains subdued.

In our asset allocation framework we describe this as the recovery phase, which on our definition began in April after nearly two years in recession. The recovery phase tends to be one of the longer phases of the cycle and given that we are starting with a record amount of spare capacity, this time should prove no different.

Recovery Will Bring Higher Interest Rates
A key feature of the recovery phase is that monetary policy begins to tighten. As the recovery takes hold and unemployment begins to fall, policymakers look to remove the very loose policy settings put in place during the recession. On average, interest rates rise after 10 months of recovery and thereafter gradually increase.

And a Flatter Yield Curve
Rising policy rates result in gradual upward pressure on bond yields and consequently the yield curve can be expected to flatten. At present the gap between 10- and 2-year yields is close to a record wide and we would look for this to narrow as the recovery takes hold.

Move into Recovery Phase Signals Shift Into Real Assets
No two cycles are identical and we would be careful to simply extrapolate from one to the next. For example, interest rates could well remain lower for longer in this cycle. Nonetheless, on a cyclical basis the trend is clear and so from an asset allocation perspective, this would suggest moving away from government bonds as yields can be expected to rise. Instead, investors should focus on real assets which benefit from the increase in activity. Our analysis finds that equities and property perform well during this phase. Rising interest rates are not an obstacle to the performance of risk assets when driven by an improving economy, where growth is improving and inflation is well behaved. It does mean though that equities are unlikely to re-rate and instead their performance tends to be driven by rising earnings. The main adjustment to asset allocation strategy as a result of the move from recession to recovery is to reduce exposure to government and credit bonds (primarily Investment Grade) which are hit by rising yields, and increase weightings in equity and property.

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