Credit Crunch Fallout…..UK Remains More Exposed than Most
November 29, 2007
By David Miles | London
The UK looks more like the US than any other European economy (maybe more like the US than any other economy, period). It has:
- An exceptionally low household savings rate – not far from zero if you exclude savings done by companies on behalf of households when they pump more cash into corporate pension schemes.
- A very high stock of mortgage debt (80% of GDP) and a housing market that has turned a corner so that house prices are just starting to fall across most of the country.
- A government running a fairly large fiscal deficit despite several years of economic growth at or above trend.
- A large current account deficit on the balance of payments.
- An economy with a large financial sector.
It is because of all this that we have taken a fairly pessimistic view on the growth prospects for the UK for some time. The UK slowdown we see as imminent is not so much driven (that is caused) by the sharply slowing US economy; rather it is that the many similarities between the UK and US economies mean that the UK is likely to follow a trajectory that shares common features with the US. Our central forecast now is for UK growth to be a bit under 2% next year and for there to be only a rather anaemic increase in growth in 2009, which we forecast will also see sub-trend growth. The scope for growth to be weaker than our central forecast is significant; and we do not see a whole lot of prospects for growth to turn out substantially above our central estimate. So, risks to near-term growth are disproportionately to the downside. This view is now (as of last week) shared by the Bank of England. In terms of the specifics of the fallout from re-pricing of credit, we laid out the story in a recent piece on household and corporate balance sheets (Companies ands Households in a Tougher Credit Environment, Melanie Baker and David Miles, November 8, 2007). The key conclusions in terms of consumer and company spending of the re-pricing of credit seen so far were these: * Cost of funds has risen: The (nominal) cost of corporate capital has risen only about 15bp since the start of 2007. For households, the rise in the cost of consuming (relative to borrowing less or saving) is much greater and is up some 70bp. This probably has some way still to go. But this is a story not just about cost – for some households there is now no secured (mortgage) debt available at any price. * Impact on consumption and investment: Our best guess is that these increases in the cost of funds could knock up to 1.4% off consumption, all else equal. This is one of the factors behind our forecast for much slower real spending growth (1.6%) next year compared with the average for recent years. For corporate investment, the impact is likely to be much smaller. * Income gearing ratios stretched: Both corporate and household gearing ratios look stretched on some measures, particularly income gearing. But, in aggregate, both corporates and households have built up substantial cash piles, keeping aggregate capital gearing ratios contained. * Disaggregated data give further cause for worry: There is much evidence to suggest that assets are concentrated in different households to liabilities. Aggregate data therefore underestimate the vulnerability of the household sector. * Weaker consumption and investment ahead: We expect slower growth in 2008, but expect business investment growth to undergo a milder slowdown than consumption and to regain its footing faster. Further risks to credit availability… Credit conditions could tighten further if the major UK banks find their ability to expand balance sheets seriously curtailed. According to Bank of England calculations, simply bringing back off-balance sheet liabilities onto bank balance sheets will not in itself generate huge problems. Its estimate is that UK bank capital ratios will only fall marginally if the great majority of off-balance sheet lending is brought back. …but the situation will be more severe if substantial losses come at the same time.The figures from the Bank of England above suggest that the Tier 1 capital of major UK banks is around £155 billion. Barclays recently announced a write-down of £1.3 billion too. We can assume that there are more to come. If the total write-downs of capital came to – say – £10 billion, this would take the capital ratio down from 7.6% (which assumes we get a substantial stock of lending back on balance sheets) to around 7%. That is not trivial. But as the Bank of England and FSA have noted, UK banks have been very profitable in recent years and they at least start from a position with decent Tier 1 capital. So, while we see more risks to UK consumer and corporate spending on the downside of our (fairly pessimistic) forecast than on the upside, we don’t believe that a situation in which banks just have to stop new net lending is very likely. But the availability of credit to some borrowers who until recently had been able to access credit cheaply – most obviously households with patchy credit history or less-than-convincing evidence of income – will be very sharply curtailed. We think that this will have a significant impact on the housing market, driving transactions and the level of house prices down in 2008. If that process becomes self-reinforcing, it could mean that our profile for household spending turns out to be too optimistic, and this is the main downside risk to our growth forecast. Oil prices The UK is fortunate that as a major oil producer it is – at least in aggregate – significantly sheltered from the hit to national wealth that has been substantial for major oil importers. But the UK is no longer self-sufficient in oil and is a (small) net importer. Furthermore, some of the gain from much higher oil prices flows to overseas holders of the companies that pump the oil from the North Seas. But petroleum revenue and corporation tax levied by the UK government still mean that a large part of the gain from higher oil prices stays within the UK. In addition, UK taxes on petrol are exceptionally high and are not a fixed proportion of the production cost of oil. This insulates consumers from the cost of living impact of a given percentage change in crude oil prices. Nonetheless, we think that higher oil prices is the single most important factor in temporarily taking UK inflation from its current level (very close to the 2% target level on CPI) to just under 2.5% in 1Q08. But because this is temporary, the Bank of England will feel able to cut rates over the next month or so, even though inflation may be a bit above target. This is a key factor in limiting the scale of the UK slowdown.
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Manufacturing Employment – No Boom, Limited Bust?
November 29, 2007
By Luis Arcentales | United States
With fears of a recession in the US mounting, Mexican assets have taken a pounding in November: the Bolsa is again hovering near its August lows while local rates have surged past their August peaks; meanwhile, the peso traded near the 11.0 threshold last week. Indeed, while some markets such as Brazil’s have held quite well despite renewed turbulence in the US, the slump in Mexican asset prices appears to signal that just as during the last major US downturn in 2001, Mexico is bound to quickly follow its northern neighbor into a period of subpar growth. But just as Mexico’s export dynamic today is less US-centric, employment in manufacturing – where the link with the US is the strongest – is playing a less important role in driving total employment. Recently, we documented how exports to non-US trading partners are growing at multiples of the pace of US-bound shipments while, at the same time, Mexican exports have continued to gain share in the US imports market, thus softening the hit from slowing US demand (see “Mexico: A Decoupling of Sorts”, GEF, October 23, 2007). Meanwhile, in contrast with 2000 – the year before both Mexico and the US dipped into recession for the last time – when manufacturing jobs made a disproportionate contribution to total employment growth, in the past couple of years Mexico has only experienced a modest expansion in manufacturing employment. The upshot: if external demand dries up, Mexico’s economy could be more resilient as the adjustment to employment in Mexico’s export-oriented manufacturing complex could prove less severe than in the past. No boom, limited bust?
In the run-up to the last recession of 2001, manufacturing activity and employment in Mexico were booming. Formal manufacturing jobs peaked at over 4.5 million in October 2000, expanding over the preceding four years at an average pace of over 27,000 new jobs per month. As recession hit and the ascension of China as a manufacturing powerhouse intensified, Mexico shed jobs at a monthly pace in excess of 22,000 positions over the ensuing 39 months before staging a mild recovery. Since then, jobs have recovered at less than 40% of the pace experienced in the last major upturn that ended in late 2000. Indeed, formal employment in manufacturing has only recovered about half the jobs lost in the past 2000 slump. Importantly, the improvement in manufacturing jobs has not been accompanied by an increase in unit labor costs, as was the case in late 2000 and into 2001. Manufacturing jobs have played only a minor role in overall employment growth in the current cycle. So far this year, manufacturing has accounted for just 13% of formal jobs, only a fraction of the 30% share in 2000. By contrast, construction added as many jobs as manufacturing so far this year, even though it represents about a third of manufacturing in terms of value added. And construction is likely to remain one of the brightest spots in the Mexican economy. On the housing front, improved credit affordability, combined with significant pent-up demand, suggests that Mexico’s mortgage credit expansion can carry on largely independent of the US credit cycle. Moreover, the turmoil in markets for asset-backed securities and the slowdown in remittances are unlikely to dent Mexico’s secular homebuilding and mortgage lending stories (see “Mexico: What Credit Crunch?” GEF, September 26, 2007). Moreover, courtesy of the additional funds from the fiscal reform approved last September, Mexico’s 2008 public investment program will be the most ambitious in two decades – the approved amount of total investment promoted by the public sector will jump 25% (real) in 2008 to 5% of GDP. Overall, authorities expect that public works will add 0.2 percentage points to GDP growth next year. A word on employment quality
Behind the headlines of good growth in formal employment and relatively low rates of unemployment, we have been critical of Mexico’s inability to create good quality jobs (see also “Mexico: Jobless No More?” GEF, May 2, 2006). In the first year after Mexico’s Statistical Institute (INEGI) released its comprehensive quarterly employment survey – which dates back to 2005 under a new methodology – we found that its details provided little room for encouragement. The recently released survey for 3Q07 suggests that the tide on the labor quality front might be beginning to turn. Arguably, the changes have been modest at best but at least an increasing number of metrics of employment quality are either pointing in the right direction or remain stable. On the positive side, in the 12 months ending September 2007, Mexico generated 313,000 new jobs, which represented a modest net expansion of 34,000 positions once growth in the economically active population is factored in. Moreover, the share of wage-earning workers (65.4%) rose in the third quarter compared to 2006 at the expense of both self-employment and non-remunerated positions. Looking at 3Q data for each of the past three years, underemployment dipped below 7% of total employment for the first time in 2007 while informality remained fairly steady at 26.9% of workers. INEGI’s measure of workers in ‘critical conditions’ – which includes those forced to work less than 15 hours per week, those working 35 hours but making less than one minimum wage, among other groups – dipped to 11.2% of the employed population, the lowest level for a third quarter on record (INEGI has been able to reconstruct this indicator back to 2000). But discouragingly, the government gained further ground, accounting for 5.0% of total employment, up from 4.7% in 3Q06. Bottom line
Given the strong links between the two economies, the ability of Mexico to insulate itself from the US business cycle is limited. But several factors – from the decoupling on the export front to the credit cycle, favorable prospects for infrastructure and housing investment and less reliance on manufacturing jobs as a growth factor – point to a more resilient economy than in the run-up to the last slump in 2001. A more important buffer against a downturn in US activity could come from further progress on the reform front. Victories on the public pensions and fiscal fronts show that Mexico is capable of breaking from its own past of gridlock and raising the possibility of further reform progress, with positive implications for competitiveness and employment growth.
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Risk of Recession Receding?
November 29, 2007
By Carlos Caceres | London, Eric Chaney | London
The risk of a manufacturing recession signaled by business surveys last month has receded: the rebound in production indicators in most euro area countries was stronger than we had expected. Our Compass models this month suggests that the euro area economy may prove to be more resilient than we previously thought. Nevertheless, strong macroeconomic headwinds still lie ahead: high oil prices, a strong euro – which would certainly have an adverse effect on capital expenditure – and the impact of more restrictive financial conditions that emanated after this year’s financial turmoil. Overall, we believe that these headwinds will continue to have a negative but incremental effect on the real economy. Current production bounced back this month, effectively offsetting the October fall. Germany’s current production, which was responsible for the dive in the aggregated production indicator for the euro area last month, exhibited a momentous increase this time. In fact, production also picked up in France, the Netherlands and Belgium; Italy was the clear outlier, as current production declined slightly. Nevertheless, it is worth noting that current production has followed a downward trend since it peaked in April and could decline further in the coming months. Despite a somewhat descending path followed since April, when it recorded an all-time high, demand remains fairly stable and robust: it is still one standard deviation above trend. In addition, company managers’ assessment on inventories exhibited a move back towards the ‘insufficient region’. Nevertheless, it is now much closer to normality than it was a few months ago. Production plans for the next three months remained unchanged in November. Companies are taking on board the slowdown in demand, but also the fact that the slowdown has been orderly. This situation could change in the future, as companies are likely to believe that the current macroeconomic headwinds will have a negative effect on demand. After a sharp but brief drop below the deceleration line, our Surprise Gap Index moved back into the neutral zone. It is still unclear whether the ‘risk of recession’ signal sent by our Compass model last month was a false alarm, or a preamble to a series of rather negative readings in the near future. However, it is fair to say that the rebound we witnessed this month was stronger than we previously expected. In any case, we still see risks to production as being skewed on the downside. It seems that the ‘orderly slowdown’ scenario that we have been advocating since the summer (Euroland Business Cycle Watch: Towards an Orderly Slowdown, July 27, 2007) keeps materialising. Our GDP indicator is predicting growth at 0.47%Q (or a 1.9% annualised rate) for the current quarter (4Q07). In addition, it is predicting a marginal deceleration next quarter, leaving growth at 0.40%Q (1.6% annualised). It thus seems that output growth could remain relatively stable in the near future. However, another correction – like that observed in October – remains plausible, given the recent rise in the euro and in oil prices, and a possible further tightening of the current credit conditions. Yet, in our view, the euro area economy is proving to be resilient, thus rendering a hard landing unlikely. Our Compass models have been suggesting – on balance – that the euro area economy is cooling, orderly and incrementally. In the short term, the ECB is likely to stick to its tightening bias, especially with inflation knocking at the door throughout the euro area. However, a bigger-than-expected economic downturn – deflationary in nature – combined with a strengthening euro could convince the ECB to reconsider its current monetary policy stance.
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