By Nouriel Roubini, Forbes.com
The global recession may end toward the end of 2009 – instead of sooner – but the global recovery in 2010 will be anemic and well below trend as households, firms and financial institutions are constrained in their ability to borrow, lend and spend.
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Meanwhile, a perfect storm of the following has inched a little closer on the radar of this cloudy global economic outlook: persistently large fiscal deficits and public debt accumulation; monetization of such deficits that will eventually increase expected inflation; rising government bond yields; soaring oil prices; weak profits; still-falling job figures; and stagnant growth. It’s a storm that could blow the recovering world economy back into a double-dip recession by late 2010 or 2011.
After rising sharply for three months, asset markets in the mature economies have paused and started a tentative correction in the last few weeks. Risk investors that had driven up prices have partially taken profits, and suddenly they are wary. They are right to be wary.
Before the recent correction started, there was a very sharp rise in asset prices, beginning around March 9. Equities rose, oil and energy prices rose, commodities rose. Credit spreads sharply contracted, indicating a surge of new confidence in the corporate sector. Long-term government interest rates shot up as ten-year Treasurys rose from 2% to 4% before retracing, suggesting that markets saw growth returning in the near future. The volatility of asset prices also fell, and that is always a sign of increasing confidence and lower risk-aversion.
Emerging market asset prices – equities, bonds and currencies – have, if anything, been more bullish. The broad indexes of the BRICs showed that, in early 2009, some investors again began to believe that these economies, starting with China, will recover and experience further rises in commodity prices.
In other words, markets, which only four months ago were pricing-in an L-shaped global near-depression and a near financial meltdown, were three weeks ago pricing-in a rapid V-shaped recovery toward potential growth. And there are some good reasons for part of this rally. At the beginning of the year gross domestic product (GDP) was falling at a rate that suggested that something close to economic depression really was looming, and there was a widespread sense that many of the world’s biggest financial institutions were effectively insolvent.
Today, both of those fears have been, for now, checked; the tail risk of an L-shaped near-depression is significantly lower. We have seen policy action by the U.S., Europe, Japan, China and many other economies that has been unprecedented, with interest rates reduced to near zero, with much bad debt ring-fenced (although not written off or worked out), with liquidity created by orthodox and unorthodox means and with final demand in many economies primed by central governments. The rate of output decline has shallowed dramatically, the “tail risk” of a chronic slump has been suppressed, and financial institutions are recording profitable quarters, at least on paper, as forbearance and public subsidies are, for now, hiding their mounting losses.
All this creates a moment when risk to a rally is to be expected. As tail risk is reduced, investors move back into equities, credit and commodities.
But better fundamentals are not the only drivers at work. Some proportion of the market upturn is the result of liquidity itself – and governments have raised a massive wall of liquidity, a wave that is now surging into asset markets. Take China: Most of the new credit that has been officially created has gone to state-owned enterprises that stockpiled raw materials and drove commodity prices higher.
Fear of the expected inflation that is likely to be caused by all this easy money is also a driver. When investors and companies see inflation coming, they seek an inflation hedge, and they reason that commodities today will be better than cash tomorrow.
Some argue that none of this matters. Who cares if credit spreads narrow, and asset prices – including equities – go up? After all, that is good for wealth and good for growth. But if it all happens too fast, too soon, the effect may be the opposite: Oil and energy prices rising too fast, too soon are a negative shock to oil-importing economies, and the rally in risky assets may deflate if weaker than expected economic and financial news reemerges. A new tipping point for the economy may be created.
The effect of that tipping point depends on how optimistic markets have become about the medium-term prospects and on how realistic that optimism is. Until recently, the level of optimism was not realistic. Markets were not just pricing-in a realistic calculation of the reduction in risk and a reduced risk of an L-shaped near-depression. They were pricing-in the expectation that the economies of the U.S. and Europe were close to returning to their potential growth levels, a V-shaped recovery. That is not realistic at all, as a weak, anemic U-shaped recovery is the most likely scenario for advanced economies.
For one thing, the recession is not about to end, with unemployment still rising and house prices still falling: The contraction has at least five months to run until year-end, and maybe a little longer. Second, the growth that will be achieved when the recession does end will be U-shaped, with weak growth, and it will stay weak for an extended period. Trend growth in the U.S. is around 3%, but with final demand so weak – as highly leveraged financial institutions restrain credit growth and as highly leveraged households and companies reduce their consumption and capital expenditure – growth of around 1% is more likely for 2010-11.
Most important, weak growth prepares the ground for a second leg down, back into recession-the “W-shaped” recession that may emerge in late 2010 or 2011 that markets seem to have forgotten about. If oil prices rise too fast because of the wall of liquidity and long-term government bond yields keep rising (because large fiscal deficits keep on being monetized, leading to a rise in expected inflation after a long bout of deflation) – all against a background of weak demand and continued consumer distress – markets and the broader economy will slide hand-in-hand down the next steep slope of recession.
Two factors are especially important in the shorter run. One is the employment-housing nexus. The other is financial industry distress.
Employment and housing are inextricably linked. Unemployment is growing – in the U.S. almost half a million people lost their jobs in June, and on top of that a larger number are having their disposable income cut by shorter hours, lower hourly wages or enforced furloughs and cuts in hours. The unemployment rate in the euro zone is equally weak – the figures are almost identical to the U.S.’ So income throughout the OECD is weak, which means consumption is weak, and no practical amount of temporary government tax rebates will change that – for example, most of last year’s $100 billion rebate in the U.S. was saved, not spent, and the same will be true this year.
This background of job losses and declining income guarantees that house prices will continue to fall to a cumulative decline of 40% to 45% from their peak; thus, another 13% to 18% fall in home prices is still ahead. Historically, house prices do not bottom out while unemployment is rising. Already this crisis will see over 8 million mortgage holders in the U.S. lose their jobs by year-end and be unable to service their mortgages.
Further declines in housing prices will in turn help generate a new round of financial industry distress. Investor sentiment toward large lenders has improved greatly in the last four months on the assumption that most of their housing- and consumption-related lending (two things that are impossible to disaggregate because they are often the same thing) has been accurately repriced. But it hasn’t. These loans have just been relabeled as “stress-tested,” but that is the equivalent of putting a bill in the filing cabinet instead of paying it. The toxic content has not been purged, not least because the stress tests were so feeble. The worst-case assumption of the U.S. stress tests were that unemployment could average 10.3% next year. The reality is clearly going to be worse as the unemployment rate is likely to peak around 11%.
Banks are going to go on filing bills instead of paying them for a couple of quarters more. Reality will sink in eventually, and the reality is that a higher level of bad-debt provision needs to be made for mortgages (whether subprime or prime), commercial real estate, personal loans, auto loans, credit cards and much more-but that may not happen until later this year or next year, when provisions for loan losses cannot be further postponed. And when that does happen it is very likely that the financial institutions of Europe will suffer most. European banks have built up higher leverage, with risky lending and massive exposure, especially to official and private borrowers in eastern Europe (lending that also has foreign-currency exposure, which, as the Asian financial crisis showed, is highly dangerous).
By that time it will also be clear that expectations of corporate earnings will have to be downgraded again. Today the market consensus is that next year’s profits will be around a third higher than this year’s. That view is based on another expectation – that growth will recover rapidly to trend levels and deflationary pressures will disappear. But these expectations are very likely to be disappointing: For the next year and a half, deflationary pressures will dominate in the mature economies as goods and labor markets remain very slack. Demand will be weak, most prices will be falling, and companies will therefore have little pricing power and their profit margins will remain squeezed. The expectation that in these conditions profits will rebound strongly is quite far-fetched.
A correction of the prices of risky assets – equities, credit and commodity prices – therefore seems inevitable and has already partially started in July. In the second half of 2009 the correction will be driven by worse macroeconomic performance than is currently expected. It will be driven by worse than expected shocks to financial institutions, with further writedowns of banking sector assets and greater than expected capital needs. And it will be driven by downside surprises on corporate profits when weak consumption will reemerge as the temporary effects of the tax rebates fizzle out over the summer.
The world economy can withstand such a correction without falling into an L-shaped near-depression. Near-depression would mean unemployment even higher than 11% and GDP growth negligible or negative for years. But while a near-depression will be avoided, the road ahead will be tough. Today, markets think that a strong recovery is just around the corner. There will be a recovery, but it will take another six months for all the indicators to start pointing in the right direction.
In the larger picture, it does not matter exactly when the turning point is reached: What matters is what kind of recovery we will see. An analysis of macro and financial fundamentals suggests that it will be weak for an extended period of time (what the wise folks at PIMCO call “the new normal”). And the risk that a weak recovery will relapse into a chronic stagnation, where inflation gradually takes over from deflation, is actually increasing, as the most likely scenario is that large fiscal deficits will keep on being monetized for quite a while and eventually lead to higher than expected inflation.
Emerging-market economies may fare better than advanced economies as – paradoxically – many of them have sounder macro and financial fundamentals. But the growth recovery of emerging markets will be constrained by the growth weakness in the G3 economies. Indeed, many emerging-market economies – starting with China – still significantly rely on net external demand as a major source of economic growth; the structural policy changes that will lead to lower savings, and greater private domestic demand (especially private consumption) will take many years to be implemented. Thus China and emerging-market economies cannot fully decouple from the fortunes-or misfortunes-of the advanced economies.
In conclusion, we are now closer than we were six months ago to the end of the worst financial crisis since the Great Depression and worst global recession in decades. But the road ahead will be very rough and bumpy: The recession in advanced economies will continue through year-end, the recovery will be very anemic and well below trend, the risks of a double-dip W-shaped recession are rising, and the growth recovery of emerging-market economies will be constrained by the weakness of advanced economies.
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