Looking ahead
February 2009
We have certainly experienced a roller coaster ride in global
markets over the last year. What started out as a sub-prime
mortgage crisis in the US has rapidly snowballed into full economic
slowdown on a global scale. Looking ahead, we believe there are
three steps which the key Western economies must travel down during
the current economic contraction. By calibrating where we are on
the journey, it becomes clear how much further we still have to
travel before we can reasonably expect a recovery.
Step 1 - Property prices continue to fall
and the rate of household savings continues to rise, consumer
demand dissolves as individuals focus exclusively on
essentials.
Step 2 - As consumer demand deteriorates,
and with the banking sector unable and unwilling to lend, corporate
profits follow suit.
Step 3 - Rising unemployment becomes
inevitable creating renewed impetus to the global slowdown by
contracting consumer spending still further.
Referring to step 1, the continued fall in
property prices has been, and continues to be, covered extensively
by the media, however, the impact of a rising household savings
rate is less well covered. In previous financial crises, the
household savings rate has always moved more than the policymakers’
original expectations due to the fear factor taking centre stage
among consumers. The typical pattern is for an additional increase
in savings driven by fears over job security and the ability to
service household debt. During the three months ending September
2008 (latest data available), the debt held by US households fell
for the first time since the government started keeping records 50
years ago. In the last three months of 2008, the US personal
savings rate rose to its highest level in six years. Some
commentators argue the savings rate may rise to 8-10% over the next
couple of years and this will create a persistent drag on
consumption, and run the risk of significantly prolonging the
period of recovery. On step 1 therefore, we believe there is still
some way to go and the general consensus is that property prices
are only expected to bottom, in both the UK and US, at some point
in mid 2010. In the UK, no real property recession has lasted less
than five years in duration and many consider that the UK house
price falls of 10.2% in 2008 will be followed by further double
digit falls in 2009.
The flow of credit from the banking sector
is a fundamental factor to step 2 and one which is still some way
from being resolved. Despite the huge injection of public money to
recapitalise banks and the improvement seen in wholesale markets,
the availability of credit remains very tight. The deteriorating
economic environment has raised the level of bad and doubtful debts
on bank balance sheets and this fall in asset quality has led to
increased provisioning and less capital being available to lend.
Additionally, distressed credit market prices have led to further
write downs, which have also absorbed a significant portion of the
fresh capital injections. This lack of capital to lend, coupled
with an unwillingness to lend (because of the large banks’
uncertainty as to the scale of undiscovered problems), is choking
the corporate sector of credit and remains a significant risk to
economic recovery.
In the US, the Federal Reserve has
introduced a number of initiatives to improve the liquidity of
commercial banks in a drive to make credit more easily accessible.
In the UK, the Monetary Policy Committee has expressed its concerns
at the tightening of the availability of credit to both the
household and corporate sectors, and has recognised that action
needs to be taken to arrest this worsening position. The situation
is made more difficult with the adoption of a zero interest rate
policy in the US and sharply falling rates in the UK and Europe.
The revenue of banks is significantly constrained by the reduced
level of margin income they are able to secure. Stronger banks –
with an appetite to lend – will only emerge from this crisis once
they are profitable, with increased cash flow supporting the
recapitalisation process. Before then, more government support
should be expected for the banking sector as the current halfway
house is exactly that.
Finally, referring to step 3, the
devastating impact of unemployment has become a reality for a
growing number of people, not just in the Western economies but
across the developing world too. Pockets of social unrest in Russia
and China have been reported, as collapsing overseas export markets
have resulted in factory closures and a rising jobless rate.
Unemployment globally has much further to run.
This bleak landscape, coupled with our view
that the unprecedented level of public debt accumulating is simply
stoking economic difficulties for the next generation, makes us
very cautious for the year ahead. Quite simply, the US and UK
governments, in particular, can’t afford all these measures and
they risk creating further economic dislocation.
The opinions in this article are those held
by the authors at the time of publication.