Three Questions for the ‘Last Four’ and the ‘Big Five’
May 15, 2008
By Manoj Pradhan & Joachim Fels | London
How long and how deep will the current US recession be? How does the Fed’s monetary policy response compare to previous comparable episodes, and what has typically happened to inflation during such periods? While history never repeats itself, it often rhymes. That’s why we examine not only the past four US recessions (1975, 1981, 1990 and 2001) but also five big bank-centred financial crises that occurred in other countries during the past 30 years (Spain 1977, Norway 1987, Finland 1991, Sweden 1991 and Japan 1992) to help answer the questions above. We find some striking empirical similarities between the average US recession and the average of the five major banking and financial crises, but also some important differences. Whether this US recession will be more akin to the last few on its shores or to the Big Five foreign crises holds the key for risky asset prices. In either case, there is likely to be more pain ahead across the board.
The Big Five and the Last Four. Our selection of the five big foreign banking and financial crises is based on the analysis in a recent paper by Reinhart and Rogoff (see Carmen Reinhart and Kenneth Rogoff’s Is the 2007 Sub-Prime Financial Crisis so Different? An International Historical Comparison, NBER Working Paper 13761, January 2008). Their Big Five crises are all protracted large-scale financial crises that were associated with major declines in economic performance for an extended period in the respective countries. All of them left deep marks, with the Japanese ‘lost decade’ being the worst of the five. Our rationale for using the Big Five as a benchmark for comparison in addition to the past four US recessions is that, like the current US crisis, the Big Five financial crises were all preceded by a significant run-up in house prices, followed by a significant decline. Reinhart and Rogoff also show that the run-up in US house prices prior to the current recession was even larger than in the average Big Five crisis. The average recession during the Big Five crises lasted two years, while the Last Four US recessions on average lasted only about half that time. The typical Big Five recession was much deeper than the average US recession. Credit growth followed the pattern of the economic slowdown. Moreover, the typical Big Five recession was accompanied by a five-year slowdown in credit growth, with a trough three years after the onset of the crisis. US recessions typically tended to have this trough about a year-and-a-half earlier. With the Big Five recessions taking place after a banking/financial crisis, a lower willingness to lend and the desire to contract balance sheets were probably similar to conditions evident today. The weaker demand for funds in a slowing economy and a contraction in the supply of funds from lenders probably accounts for the nearly three years of reduction in credit growth after the onset of the crisis. US recessions that were not preceded or accompanied by financial crises have been more benign. Credit growth troughed nearly six quarters earlier at 2.5%, rather than the complete stop witnessed by the Big Five. This time around, inflation may break with history… The peak in inflation typically occurred soon after the onset of the recession. In the case of the Big Five, disinflation continued well into the recovery of the economy and financial markets. By contrast, in the Last Four US recessions, inflation typically troughed in year two after the onset of recession and then moved higher again. Effectively, monetary authorities were correct in the past to watch closely for the onset of recession as a reliable leading indicator for inflation. Once this was evident, the path for policy action was clear-cut and monetary countermeasures were launched until the economy turned around. We argue below that assuming inflation will follow growth lower may not work today. …and so may bond yields. Bond yields have followed the path of inflation in these episodes, echoing the long-term relationship that exists between the two. While the co-movement of bond yields and inflation is clear, it was the path of inflation rather than growth that was the driver of bond yields. Growth in the Big Five recovered about two years after the onset of the crisis, while the recession-induced slowdown in the US ended about a year earlier. However, bond yields clearly shared their trough with inflation, rising in the US as inflation rebounded and continuing lower along with inflation in the Big Five. This has strong implications for the current episode. If inflation remains sticky and is further stoked by monetary easing, as we suspect will be the case, a sell-off in bonds is the most likely outcome. Our strategy team is positioned for such a move with bear-steepening and breakeven-widening trades (see Global Perspectives: Flows vs. Fundamentals, May 2, 2008). Equities exhibited a different pattern. Equities, however, show the opposite pattern. Share prices started their recovery well before the recovery in growth in the Big Five or in the US. Surprisingly, the equity market recovery in the Big Five occurred even sooner than in US recessions. Presumably, with the financial turmoil preceding the economic downturn, equity prices were hammered down very early in the cycle and recovered earlier too. Policy action was commensurate with the length and depth of the problem. The policy response to the Big Five slowdowns has naturally been stronger than the Fed’s average response to recessions in the US. Given the severity of these banking crises and the ensuing economic slowdown, it is no surprise that borrowing rates were pushed lower for nearly two years until the trough in growth was apparent. Similarly, narrow money growth is suggestive of a large expansionary push from the monetary authorities. Regardless of the nature of the recession, the impetus from central banks’ policy easing has been clearly visible – narrow money grew 8% over two years in US recessions and by nearly 15% over a year for the Big Five. How long will the Fed keep the easing measures in place? Importantly, the Fed has been much more aggressive than the precedents in history, starting from a lower level of the fed funds rate and cutting much faster than before. Narrow money growth clearly marked its trough in the middle of last year, and is now on the rise. However, the critical test for the Fed is likely to be the test of duration – how long does it allow these expansionary measures to remain in place? Our US team expects the first hike from the Fed to occur in 2Q09; this will mean its easing campaign will have lasted seven quarters – roughly in line with the average response of the Fed in the past. The backdrop for this one is a lower level of rates and, notably, a less hospitable inflationary environment. Enough to prevent a deep recession, but easing will push up inflation and bond yields. It is noteworthy that most of the crises and recession (with the exception of Spain in 1977 and the US in 1975) happened during the benign disinflationary phase of globalisation. Back then, policymakers were able to abandon their worries about inflation and focus solely on getting the real economy back on track. With globalisation now an accomplice rather than a moderating influence on inflationary forces, the behaviour of inflation today is likely to be different from these other episodes of economic pain. In our previous work, we have argued that globalisation may have turned inflationary, while lower trend productivity and a flatter Phillips curve at home are all threats to US inflation (Joachim Fels and Manoj Pradhan’s The Global Monetary Analyst: A New Inflation Regime, March 5, 2008). Policymakers face the unenviable task of reviving a flagging economy while keeping the inflation genie bottled. We believe that the Fed’s focus on keeping the financial crisis from sending the economy down the path of the Big Five will succeed, but lower rates and surging money growth will spill over into inflation. Bond yields are likely to follow inflation higher. (For the charts that accompany this piece, please see The Global Monetary Analyst, May 14.)
Important Disclosure Information at the end of this Forum
Germany: A Re-emerging Economy?
May 15, 2008
By Elga Bartsch | London
Raising Our 2008 GDP Growth Forecast… On the back of a head-start that the German economy likely had moving into 2008, we are raising our full-year GDP estimate from 1.7% to 1.9%. The upgrade puts Germany even more firmly above our euro area average growth forecast of 1.5%. The upward revision reflects a stronger-than-expected re-acceleration in activity during the first quarter. Incoming monthly indicators suggest that our previous estimate of 0.4%Q in non-annualised terms was too conservative; instead, a print as high as 0.7%Q seems more likely. A flash estimate for 1Q GDP will be released later this week. It will be followed by a full report later this month. At the same time, the most recent data points underscore that Germany – like the rest of the euro area – is heading for a very noticeable slowdown over the summer. Looking for merely 0.2%Q quarterly GDP growth in the current and coming quarters, we have probably taken on board most of the near-term downside risks though. Beyond the summer, we continue to be concerned about the longer-term downside risks stemming from the lagged impact of the financial market turmoil, the stronger currency, the higher commodity prices and the slower growth overseas on economic activity. If anything, we therefore see the risk to our 2009 forecast of 1.5% as being tilted to the downside. …on the Back of a Strong First Quarter Incoming data hint at a strong expansion in the industrial sector between January and March on the back of well-filled order books, rather robust business confidence and relative resilient consumer sentiment. In addition, construction activity has likely benefited from the unusually mild winter weather, which allowed many construction companies to continue with their outdoor works, and a rebound in both order demand and building permits in public infrastructure and corporate structures. Services growth will probably have been supported by recovering distributive trade and relatively steady growth in public services. Meanwhile, financial services, including real estate and business services, will likely have seen a marked slowdown. In terms of the demand components, strong retail sales – which show a quarterly rate of expansion of 0.9%Q on the broad measure including cars – suggest that consumer spending has recovered smartly after its 0.8%Q drop at the end of last year. Investment spending growth is likely to have moderated as spending on machinery and equipment has been hit by new depreciation rules that kicked in in January. Despite considerable headwinds, merchandise export growth has staged a modest recovery in 1Q. At the same time, however, imports of merchandise goods have rebounded very smartly after a sharp outright contraction recorded in 4Q. Net exports will therefore probably have provided less of a boost to overall GDP growth. A New Engine to Pull the EMU Train? Back in January, we argued that Germany would likely become a locomotive to what would be a slow euro area train (see Germany Economics: Pulling a Slow Train? January 3, 2008). Our main thesis was and still is that there will be a fundamental shift in Europe’s economic landscape. This shift is caused by the headwinds hitting the debt-driven, asset-based, consumer- and construction-led peripheral economies that have become over-reliant on credit in financing their spending habits. Core countries such as Germany, by contrast, are likely to prove relatively resilient. Many of the headwinds created by the current financial market turmoil – cooling housing markets, the private sector debt overhang and, potentially, even an outright credit crunch – are likely to be felt less in Germany. In addition, the long-term benefits of the heavy corporate restructuring and relentless wage moderation of the last several years are still coming through in terms of robust job, wage and investment growth. Hence, morale among corporates and consumers is holding up better in Germany and other core countries than in the euro area as a whole and, certainly, is showing much more resilience than the periphery. Redefining the Growth Landscape in Europe Thinking about these relative developments within different euro area economies, it makes sense to draw a stylised map of the economic landscape in Europe, which has two dimensions: GDP growth and inflation. Mapping the individual countries relative to the euro area, we can then distinguish four different cases: superstars (strong growth, low inflation), inflationary growth (strong growth, high inflation – labelled ‘getting richer, but…’), losing out (low growth, high inflation), and shrinking fit (low growth, low inflation). Typically, countries would move anti-clockwise through this stylised diagram. After spending an extended period of time in the ‘shrinking fit’ quadrant thanks to a combination of below-average growth and inflation, Germany has now likely moved into the ‘superstar’ region – at least if we discount the temporary spike in inflation on the back of last year’s VAT hike. The structural reforms that allowed Germany to regain cost competitiveness are well documented (see, for instance, Restructuring in a G3 Perspective, July 21, 2006). The sharp rise in Germany’s trade balance surplus since the start of the decade and the stellar performance on global goods markets are testament to the progress made (see Excelling at Exports, February 19, 2007). However, the marked rise in the current account surplus also highlights a dark side: as domestic income growth has outpaced advances in domestic spending, Germany has started to export capital at a significant scale. The next stage of Germany’s economic turnaround story should also see capital being put to work within the country, we think. Looking Closely at the Current Account … Formally, the current account is determined by the balance between exports and imports of goods and services (plus current transfers and factor incomes). Fundamentally, the current account reflects the savings and investment imbalances in an economy. Thanks to the book-keeping logic of the national accounts, the two will add up to the same number. It is the savings and investment imbalance that is probably more meaningful in analysing the current account. Essentially, a country that spends more than it earns on international goods, services and factor markets – i.e., runs a current account deficit – will need to import capital from abroad to fund part of the spending. A country that invests more than it saves has to attract foreign capital to cover the gap. … and its Drivers by Economic Sector The overall savings and investment balance can be broken down into individual balances for the government, the household and the corporate sector. Germany, which has been running a current account surplus for most of its post-war history, saw its current account sliding into the red after unification. This was due mainly to a deficit in the corporate sector and, to a lesser extent, a government budget deficit. The noticeable improvement of the German current account position in recent years has been driven by shrinking deficits in the corporate sector and government sector. The marked improvement in corporate savings – i.e., retained earnings – has also been reflected in record corporate profits, strong balance sheets and less bank lending. In addition, German consumers stopped lowering their savings rate. In our view, 2007 will likely mark the peak in the current account surplus. We now expect robust domestic demand, driven by a recovery in consumer spending and still solid investment spending, to weigh on the current account surplus. Bigger Current Account Balances Everywhere It’s not just the German current account balance that has been on the rise in recent years. Owing to rising capital mobility globally, especially within the monetary union, current account balances have been on the rise across EMU. With a significant repricing of the costs of funding globally, countries with a large current account surplus are likely to be less exposed to the global financial market turmoil than those with a deficit (for a broader discussion, see Currency Economics: The Dollar Smile and the Fall Lines of Dominos, April 3, 2008). Within EMU, a potential currency adjustment for the deficit countries, of course, is no longer possible. Yet, the potential drying up of foreign funding of a current account deficit could be very relevant to the macro outlook. By the same token, Germany’s current account surplus should act as a cushion as global funding pressures are on the rise.
Important Disclosure Information at the end of this Forum
Disclosure Statement
The information and opinions in Morgan Stanley research were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley Dean Witter C.T.V.M. S.A. and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley"). As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates.
Global Research
Conflict Management Policy
Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.
Important Disclosures
Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.
With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.
To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.
Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, Morgan Stanley Research and any access to it is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and FirstRand Investment Holdings Limited, which is wholly owned by FirstRand Limited.
Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.
The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.
|
