As 2008 draws to a close, the global economy teeters on the knife-edge between recession and depression.
But today’s policymakers have learned the lesson of history: that such exceptional circumstances call for exceptional measures.
Central banks have slashed rates and injected liquidity on a grand scale. Governments have pledged more than $6 trillion (£4 trillion) to underpin the faltering financial sector and boost the real economy. And declarations resound of more changes to come. Regulators have joined the stage, promising fixes to ensure there can be no replay of 2008.
The immediate question is, “Will it all work?” The likely outcome is that the more benign scenario of global recession in 2009 will occur – as opposed to a vicious spiral of debt-deflation, replaying past depressions. The size and speed of the moves are plus points. In ordinary times, the measures adopted would boost global GDP growth by two to three percentage points in both 2009 and 2010. Moreover, the slide in oil prices from a peak of $145 a barrel to just over $40 has also brought a welcome respite for oil importers, easing the energy bills of households in Organisation for Economic Co-operation and Development countries by about one percentage point.
With these numbers in mind, the muted reaction of financial markets to policy stimuli to date seems odd.
Markets are not irrational, however, and there is a risk the measures taken may fail. The battle today is one of confidence: if households and business managers choose to save their gains rather than spend or invest, the odds of success are reduced.
Nevertheless, in this battle, policymakers have the upper hand. Central banks do not have balance sheet constraints like ordinary commercial banks. And governments can do much more than they have so far, if necessary – all the more because central banks stand ready to monetise debt in the war against deflation.
We see global economic growth of just over 2% in 2009, well below the 3% line that marks the border between a slowdown and recession.
As the year advances, signs of gradual improvement are set to emerge and, heading into 2010, growth should be out of recession territory, albeit still below trend potential. Indeed, the necessary deleveraging process will continue to act as a drag on growth in both 2009 and 2010, preventing any fast-track recovery.
To win the war against deflation, however, there are two battles that will be lost along the way.
Promising to fight deflation is tantamount to promising inflation – so in an ideal world, once recovery sets in, policymakers will tighten up the reins. Yet reining in policy too quickly could risk plunging the real economies back into recession. Faced with this choice, policymakers will most likely choose to risk inflation.
From a structural point of view, the era of ultra-cheap inputs has come to an end. Top of this list is commodities. While the cyclical slowdown has taken some of the tightness out of commodity markets, it is worth recalling that, at just over $40, oil is still well above the $22 average that prevailed from the 1980s until globalisation kicked off at the beginning of this decade.
With the structural growth story of emerging markets intact, commodity prices are set to remain at higher levels for any given point in the cycle. And the cost of labour in emerging economies, while still cheap, is ticking up.
Second, the comeback for fiscal policy also marks a return for big government. Again, there is a case to be made for a quick reversal once recovery starts, but we remain sceptical.For the overall economy, greater intervention will inevitably entail some crowding out of the private sector. Add to that a tighter regulatory environment reducing the scope for leverage, and the stage is set for a higher cost of capital.
These points will have significant implications for asset classes across the board. On government bonds, dynamics in recent years have been predominantly driven by monetary policy. As fiscal policy takes on a greater role, the long-forgotten theme of sovereign spreads is set to reappear.
With tighter regulation and a higher cost of capital, return on leverage investments will be lower, all else being equal. Consequently, while equities have the scope to enjoy a re-rating from depressed levels, the top-line drivers from profit and the leverage multiple are unlikely to boost returns in the near term. Corporate bond holders therefore seem better placed than equity holders in this environment.
Finally, the consequence of the points raised is greater volatility for both inflation and real economic growth. With that comes greater market volatility. As we look ahead to 2009, there is no turning back the clocks.