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United States V-Shaped Recovery Unlikely Global QExit View GEF Archive

		The Global Economics Team

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Most important, however, we strongly believe that four factors make a V-shaped rebound unlikely: First, financial conditions will stay relatively restrictive.  Second, a still-large imbalance between housing supply and demand likely will remain a drag on home prices and housing activity into 2010.  Third, consumers have only begun a long process of deleveraging and repairing their balance sheets and saving positions, so spending growth should be subdued.  And finally, the breadth of the recession limits the cushion from any stronger sectors, including activity overseas. 

However, a sub-par recovery seems to be the consensus view, so it's important to look at upside risks.  In what follows, we examine the logic and recent evidence for our call, and then consider the circumstances that could potentially promote a more vigorous rebound. 

A strong case for a sub-par recovery.  The history of financial crises is on our side; because they result in deep and prolonged declines in asset values, such crises not only promote deep recessions, but typically the aftermath involves prolonged convalescence. 

More specifically, four factors underpin our case for a sub-par recovery.  First, financial conditions will stay relatively restrictive.  Losses are still rising at lenders, limiting risk appetite and balance sheet capacity, and thus restraining the availability and boosting the cost of credit.  A slow cleaning up of lenders' balance sheets will keep lending capacity low and the cost of using it comparatively high, and increased regulatory oversight will reinforce that restraint.  We think that such lingering restraint will affect all credit-sensitive areas of the economy, including housing, consumer durables, capital spending and working capital for businesses large and small.  As evidence, the National Federation of Independent Businesses just reported that, in April, credit was harder to obtain by small businesses than at any time in the past 29 years.  And while loan-to-value ratios at auto finance companies rose slightly in April - to 89% from 86% in January-February - required downpayments were still more than double what lenders wanted last year. 

Moreover, the lags between the change in financial conditions and the economy will prevent rapid progress.  To be sure, as Morgan Stanley interest rate strategist Laurence Mutkin argues, when more capital comes into the financial system, and securitization revives, competition will erode the high rates lenders are able to charge for the use of their balance sheets today.   In our view, however, that time may be far off, and both the scars from the crisis and the regulatory response to it probably will keep those costs permanently higher than pre-crisis norms. 

Second, the imbalance between supply and demand in housing is still significant and likely will remain a drag on home prices and housing activity into 2010.  The single-family vacancy rate in existing homes is double the 1.2% historical average through 2004.  Given the persistently tight financing backdrop, vacancies might undershoot that old 1.2% norm for a while to bring down the supply/demand imbalance quickly, especially as foreclosures rise again.  Consequently, prospective buyers need to start occupying roughly 750,000 single-family vacant homes before the housing market and home prices stabilize.  In turn, this implies that new and existing home sales must rise by roughly 20-25% from the current pace.  Likewise, in commercial real estate, vacancy rates and cap rates are rising and rents are falling. 

Third, consumers have only begun the process of deleveraging and repairing their balance sheets and saving positions, and we believe that the personal saving rate, currently at 4%, will rise to 7-10% in the next few years.  This process will mean slower growth in US demand.  Some argue that pent-up demand for vehicles and durables is strong following the recent retrenchment in sales.  We disagree.  It's true that to maintain the stock of vehicles on the road (245 million light vehicles) given normal scrappage would require about 13 million vehicles sold annually.  But with financing constrained, we think that consumers can endure 3-4 years of sales below those levels, since we spent the last 13 above them, especially with 15% more light vehicles on the road than licensed drivers.

Finally, the breadth of the recession limits the cushion from any stronger sectors.  For example, while growth appears to be improving in Asia, the global recession will limit US exports.  Unlike the experience since the crisis began nearly two years ago, in which net exports contributed more than a full percentage point on average to real US growth, we expect that the cyclical contribution to US growth from overseas activity will be flat to down over the next 18 months.

We think that the evidence for near-term economic weakness still dominates.  Home prices, pre-tax real incomes and profit margins are declining - by 18%, 0.3%, and 2 percentage points, respectively, over the past year.  Retailing is softening again, despite tax cuts that kicked in on April 1.  Pricing power is fading, notably for business semi-finished and capital goods, and especially as import prices for similar goods are falling.  High inventory-to-sales ratios suggest further production cuts: In March, we estimate that the real I/S ratio in manufacturing and trade rose back to 1.43 months, equaling the cycle high.  Finally, as more companies file for bankruptcy, we think they will liquidate stocks.  Big production cuts in autos will trim roughly one percentage point from GDP.  And, in contrast with the leveling off in initial claims for unemployment insurance, continuing jobless claims have risen sharply, to an all-time record and a 27-year high in relation to the workforce. 

Yet that evidence may not fully refute the bull case for a more vigorous recovery.  The bullish scenario relies primarily on turning the vicious circle of the ‘adverse feedback loop' between credit markets and the economy into a virtuous one.  The story is straightforward; indeed, it is simply the basic recovery story without the headwinds: Aggressive policy actions are breaking the cycle of losses leading to a deeper credit crunch, adverse economic outcomes and thus more losses.  Policy will get traction, first by eliminating systemic ‘tail' risk; for example, despite skepticism about how tough the ‘stress' tests for large bank holding companies were, the results reduced market uncertainty about the tail risk in the financial system.  The rally in financial stocks enabled several institutions to raise equity capital and debt without a government guarantee. 

In this optimistic scenario, improving financial conditions will thus increase the appetite for risk, reduce prospective credit losses, boost willingness to lend to creditworthy borrowers, and enable consumers and businesses to finance spending and working capital.  Improving financial conditions will also enable fiscal stimulus to get traction.  With the potential to satisfy pent-up demand built up during the recession, and inventory liquidation turning into accumulation, the time-honored cyclical dynamics of recovery can produce a strong, sustainable rebound.

If the logic for the rebound case is clear, what about supporting evidence?  There is some financial and economic evidence to support the rebound case.  First, financial conditions are becoming less restrictive.  Notably, funding and money market conditions have improved to pre-Lehman levels, hinting that concern about counterparty and liquidity risk has almost evaporated and that the pressures on bank balance sheets from ‘reintermediation' may be ebbing more quickly than we had expected.  Three-month LIBOR rates reached all-time lows last week, having declined for seven straight weeks, thanks to historically low policy rates and continued narrowing of LIBOR-OIS spreads - to 63bp.  Forward LIBOR-OIS spreads now discount a return to levels not seen since the credit crunch began, with December at 53bp.  And swap rates - a benchmark for bank loan pricing - may dip below Treasury yields soon.  Moreover, credit spreads have narrowed significantly; since April 1, investment grade spreads measured by the CDX index have tightened by roughly 50bp, to 157bp, while spreads in terms of the high yield index have narrowed by nearly 400bp to 1,150bp.  Surveys of credit availability - ranging from the Fed's Senior Loan Officer canvass, to the credit component of our own Business Conditions Index show important progress (see Business Conditions: Genuine Improvement or Mirage? May 15, 2009).  Some of the Fed's facilities, like the PDCF and the TSLF, are falling into disuse - a sure sign that money markets are healing.  And an improving economy would validate the new appetite for risk. 

There is also encouraging evidence that the intense declines in US output of the last two quarters are over: Although spending is weakening again, consumers are no longer retrenching aggressively.  Vehicle sales have stopped declining, and a ‘cash-for-clunkers' incentive may give them a modest boost.  Housing demand and big-ticket durable goods orders seem to be stabilizing, and business surveys are improving (e.g., our MSBCI rose above 50% in early May for the first time in two years).  Moreover, companies are aggressively liquidating inventories, I/S ratios have stopped rising, and jobless claims appear to have peaked.

Unfortunately, the evidence either supporting or refuting these two competing views is inconclusive.  And upcoming data, as always at inflection points, could be especially volatile and confusing.  For example, we cannot rule out a short-term inventory-led bounce in production if firms decide they have gone too far in destocking, only to give way to a relapse.  For investors, therefore, it makes sense to stay balanced and look for opportunities.  Risky assets, especially the higher-beta, lower-quality names and sectors, have discounted a good measure of the recovery story.  But our FX strategy team believes that reduced risk-aversion should weaken the dollar (see "Reflation Nations", FX Pulse, May 14, 2009).  And while our US equity strategy team has preferred US over global cyclical names, they believe that a weaker dollar makes global cyclicals attractive (see Last Man Standing: USD the Next Weak Link? May 15, 2009).  For their part, our credit strategists believe that it makes sense to move up the quality scale, as markets likely will be more hospitable to higher-quality borrowers (see Credit Basis Report: Some Pain, Much Gain, May 15, 2009).  Finally, we agree with our rates strategy team that significant increases in interest rates are eventually coming.  But the near-term possibility of disappointment in the progress of recovery and the lingering risk of another deflation scare should cap 10-year US Treasury yields near 3.25% for now (see US Interest Rate Strategist: A Tactical Opportunity to Enter Curve Flatteners, May 15, 2009).

Global
QExit
May 21, 2009

By Manoj Pradhan & Joachim Fels | London

Risky assets have rallied hard since early March. The S&P is now up nearly 35%, and credit and swap spreads have narrowed substantially. As we see it, an important driver behind this rally has been the excess liquidity that central banks have pumped into the system through rate cuts and quantitative easing (for a more elaborate discussion among the Morgan Stanley macro team about the causes behind the rally, see Gerard Minack, "The Debate Continues", Downunder Daily, May 20, 2009).  By pumping up money supply and asset prices, central banks have also helped to slow the pace of the global economic contraction. Thus, we have now entered the phase where massive policy action is finding traction, and we remain confident that the global economy will bottom out over the next couple of quarters.  With near-zero interest rates and quantitative easing (QE) playing a key role in the process, it is important to address the following two questions: (i) how long can we expect a continued boost from central banks, and (ii) when central banks decide to roll back rate cuts and unwind the considerable unconventional easing measures in play, what strategies will they employ?

Obviously, the shape of any recovery and the inflation outlook will be key in determining central banks' exit strategies from zero rates and QE.  We continue to believe that the global policy onslaught will return the global economy to positive growth in 2H09, with inflation risks returning further down the road. However, we caution investors against pricing in a rapid return to trend growth. The upward spike in the second derivative of growth (here defined simply as the change in the rate of growth) suggests that we are nearing a bottom for growth. However, the outlook for growth in and beyond 2010 remains weak as the second derivative quickly moves to zero. Our central case for the next few years is a combination of below-average growth with inflation slowly creeping upwards. Importantly, there will likely be a high level of uncertainty about the speed and strength of the global recovery. The tenuous nature of the recovery is likely to curb any desire to raise rates aggressively on the part of central banks. In fact, we expect monetary policy to remain expansionary for a significant period of time. And the subsequent unwinding of rate cuts and QE will probably take place in tranches, with pauses between each tranche.

How long before central banks start hiking/unwinding? Recently, the Fed, the BoC, the Riksbank, the RBNZ and the BoE have all given markets guidance to keep interest rates at current levels for a considerable period of time (see "A Different Unconventional Measure", The Global Monetary Analyst, April 29, 2009). Our global economics team has similar expectations. The first rate hike from most G10 central banks is expected in or after 2Q10, with the exception of the BoE, the SNB and the RBA (all of whom are expected to hike rates in 1Q10). 

For the EM giants, rate hikes will likely arrive around the same time, with India hiking first in 1Q10, followed by Russia in 2Q10, Brazil in 3Q10 and China on hold for the foreseeable future. As far as ‘active' QE is concerned (see "QE2", The Global Monetary Analyst, March 4, 2009, for a distinction between active and passive QE), central banks still have the majority of asset purchases ahead of them, and the risks are still that the size and scope of these programmes will be expanded. We believe that the assets purchased will stay on the books of the central bank for at least as long as rates are near zero, and in some case for much longer, as we explain below.

Rate hikes and active QE unwinds are most likely to occur contemporaneously. We think that the most likely outcome is for both to occur more or less simultaneously. Why? The most important aspect of both the interest rate hikes as well as the unwinding of QE is likely to be the signalling or communication aspect. Raising policy rates without starting to unwind QE would send confusing signals because QE was meant to amplify and complement the impact of near-zero interest rates. Thus, the more natural sequencing would be to start unwinding QE first and then raise policy rates at a later stage.  However, the problem with this approach is that medium and longer-dated yields would back up quite sharply and the yield curve could bear-steepen massively when central banks start to sell assets while keeping short rates near zero. Therefore, we deem it most likely that central banks for economies in which long-term rates are vital (e.g., the Fed and the ECB) would begin to unwind QE and start raising policy rates simultaneously. In the UK economy, however, lending is more closely tied to the front end. Unwinding QE before raising policy rates is therefore a more viable option for the BoE.

Policy rate cuts in this cycle have been less effective, given the money market dislocations that are still on the mend. Active QE purchases of housing-related assets and government bonds have allowed central banks to directly influence the most important part of the transmission mechanism - the longer-term rates and spreads that have a large impact on the cost of borrowing. Rates and spreads have by and large responded favourably to these purchases, making active QE the most effective policy tool in this unconventional cycle. However, at such long maturities and for risky assets, markets and central banks share pricing power with the result that the central bank's control over bond yields and spreads is far from perfect. Selling QE assets back to market is therefore fraught with risks because central banks are unwinding their most effective policy measure with less-than-perfect control. Raising policy rates and unwinding QE simultaneously would allow central banks to sell assets at a slower clip, which would mitigate some of these risks.

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