Deep waters

Leading economies are in recession and the International Monetary Fund\'s forecast is that the global slowdown will be worse than expected. Abigail Montrose traces the course of the worldwide slump and assesses the prospects for recovery.

Global markets and econoGmies have had a tumultuous time over the past three months. The period started with a continued crisis of confidence in the banking system, which reached maximum intensity in September and prompted the authorities to take dramatic action to stabilise the financial system and avoid complete disaster.

Equity markets suffered huge falls as a result of a massive unwinding of risk appetite and fears of recession took hold. Economic data confirmed that the world’s main economies were going into recession. This prompted a bigger and more dramatic policy response from the authorities than expected: interest rates were slashed and fiscal measures introduced worldwide.

Commodity prices have dropped sharply, while house prices continue to collapse in America, Britain and parts of continental Europe.

As global markets and economies have gone from one crisis to another, so the authorities have taken ever greater steps to get control. An era of big government has arrived.

September saw a continued crisis of confidence in the banking system. After the American government rescuedFannie Mae and Freddie Mac, the mortgage guarantee agencies, it then allowed Lehman Brothers to collapse, making it the first large bank to collapse since the start of the crisis.

Meanwhile, Merrill Lynch, an American investment bank, agreed to be taken over by Bank of America for $50 billion (GBP 34 billion) and the Federal Reserve unveiled an $85 billion package to rescue American International Group, the country’s biggest insurance company.

The bad news continued. On September 25, Washington Mutual, a giant mortgage lender, was closed by the regulators and sold to JPMorgan Chase. Four days later Wachovia, the fourth-largest American bank, was bought by rival Citigroup in a rescue deal backed by the authorities.

The crisis had spread to Britain and continental Europe. On September 17 it was announced that Britain’s biggest mortgage lender, HBOS, was to be taken over by Lloyds TSB and 12 days later a fellow mortgage lender, Bradford & Bingley, was nationalised. In October, Royal Bank of Scotland (RBS) and Lloyds TSB were part-nationalised.

On the Continent, Fortis, a banking and insurance giant, was partly nationalised to ensure its survival. The Icelandic government stepped in to rescue two of its largest banks, Glitnir and Landsbanki. Dexia, a European bank, was bailed out by three European governments and the German government announced a GBP 50 billion (GBP42 billion) plan to save one of its biggest banks, Hypo Real Estate.

Confidence was at a record low. The banks no longer trusted each other to lend even on a short-term basis and they did not trust each other’s balance sheets. Lending was freezing up. As investors reeled at the scale of the banking system’s plight, several European governments stepped in to calm nerves by increasing guarantees – in some cases offering blanket guarantees – on deposits.

These moves were essential to restore calm, in the view of Charles Dumas, the chief economist at Lombard Street Research. “The Europeans went on to recapitalise the banks but the most important thing they did was to guarantee liabilities, so then banks didn’t mind depositing because liabilities were guaranteed by the government,” he says.

The Americans were first into the crisis and tried to be first to lead the way out. By September it was clear that unless something was done the distrust among banks would lead to a breakdown of the payment system. Henry Paulson, the American Treasury secretary, hastily put together a $700 billion rescue plan, the Troubled Assets Relief Program (Tarp) to buy up the bad debt or toxic assets from America’s ailing banks. Initially rejected by Congress, it was passed in amended form at the beginning of October and helped to calm nerves in highly volatile stockmarkets.

Britain then came up with its own rescue plan. Unlike Tarp, it sought to recapitalise the banks rather than simply address the liquidity problem.

“This was a more direct and efficient way of dealing with the problem,” says Marino Valensise, chief investment officer at Barings. “A few weeks later the US used some of its rescue plan money to follow suit and recapitalise the banks. For the first time the UK led the way.”

Britain’s rescue plan involved injecting billions of pounds in capital and guaranteeing loans in the hope that lending would resume. The total package of GBP387 billion consisted of GBP250 billion bank debt guarantee, GBP100 billion of Bank of England short-term loans and a Treasury injection of GBP37 billion which was pumped into RBS, Lloyds TSB and HBOS.

“By recapitalising the banks you are telling banks to write down their debts as they see fit and you know they have the capital to absorb this,” says Tom Elliott, global strategist at JP Morgan.

The British plan has been seen as the way forward and has prompted America to abandon plans to use Tarp money to buy up the banks’ toxic assets and to use the fund instead to buy shares in the banks.

Continental Europe took its lead from Britain, announcing its own rescue plans. “We have now walked away from the global banking crisis, thanks to recapitalisation,” says Elliott.

“We say global but we mean the US, UK, Germany and Switzerland when talking about global recapitalisation. But there’s an awful lot of the world that has not had to recapitalise its banks, such as Japan, Spain, Chile. Outside of Eastern Europe, most emerging markets have not needed to recapitalise.”

World stockmarkets have been highly volatile, with the credit crisis and the fear of recession undermining confidence. There has been a sharp increase in risk aversion and a flight to quality that has left many markets, particularly emerging markets, nursing heavy losses.

After a brief rally in August when the price of oil fell below $100 a barrel – it is about half this figure – September brought a fall in global stockmarkets as interbank lending began to freeze and banks started to fail. In October, shares dropped sharply, first on Congress’s rejection of the Tarp and then on wave after wave of poor economic data.

Hedge fund activity also played a large part in October’s slump, says Dumas. By the end of September the worst of the banking sector crisis was over, but central banks and governments were pouring money into banks. So suddenly the banks could take bad assets and discount them and ask hedge funds for proper collateral for the loans they had given them.

This forced hedge funds to liquidate assets, while at the same time many hedge fund investors gave notice to redeem.

“By October the scene had shifted to tremendous hedge fund liquidation, and pension funds with similar commitments liquidated. This caused the slump in stockmarkets,” says Dumas.

The hedge funds had been long on commodity futures, which they were selling, prompting a crash in the prices of oil and other commodities such as metals. They bought in yen, causing the currency’s value to rise.

Meanwhile, pension funds sold large non-Japan Asian equityholdings, causing the Asian markets to plunge. Many positions had been funded in dollars, so when the pension funds sold these they were paid in dollars, which forced the American currency up in value against the euro. The euro fell about 30% against the yen between July and October because of this, in an “extraordinary bilateral move” says Dumas.

Since then there has been a bit of a rebound on markets, although poor American consumer price figures in November sent global markets lower and October’s lows are expected to be tested again in the coming months.

Now the main concern is recession. Britain, Germany, Italy and Japan are all considered to be in recession, and America and Spain are expected to follow shortly.

That the world’s leading economies should simultaneously be in recession is a frightening situation, and one that has prompted dramatic responses from national governments, which are intervening more than they have done for years.

The first line of attack has been monetary. In October, America cut its base lending rate by half a point to 1%. In the same month the European Central Bank (ECB) cut its rate by a similar amount to 3.75%, following this with a further cut to 3.25% in November. In Britain the Bank of England slashed interest rates by one and a half points to 3% – their lowest level since 1955.

Few doubt that rates will go lower. Richard Batty, a global investment strategist at Standard Life Investments, says he would not be surprised to see the Federal Reserve eventually cut its rate to 0%, the Bank of England to 2% or even less and the ECB to 1%.

“The issue is not the price of credit but the availability of credit,” says Batty. “Increased availability is the harder thing to do because we are going through a deleveraging process so you might as well make the price of credit as cheap as possible to aid the process of provisioning credit.”

The next phase of attack is fiscal, with governments daily announcing tax cuts and rescue packages.

In America, the leading economic indicators have been poor for some time. September’s payroll figures showed unemployment rising from 6.1% to 6.5%. Retail sales fell 1.2% in September, the biggest monthly drop in three years, while consumer prices slid 1% during October, which is the biggest fall in 61 years. This reinforced fears of a rapid slowdown and sent world markets tumbling on November 19, when the figures were announced, with Wall Street falling 5% to its lowest level in five years.

“We really don’t know the depth and duration of this downturn and a lot will depend on what happens to unemployment,” says Elliott at JP Morgan. “Around 70% of the US economy is consumer spending, so if unemployment continues to rise it will be bad news for high street spending, with deleveraging increasing in pace.”

America, like many other countries, will look to spend its way out of recession. Valensise at Barings expects the American deficit to go much higher. “We could see an 8% to 9% fiscal deficit in the US which is very high,” he says.

But Julian Chillingworth, the chief investment officer at Rathbone Unit Trust Management, can see some signs of hope. “We need to establish the bottom in terms of economic growth. That’s probably going to trough out mid-2009 in the US. Improvement in the property market is also needed and will take a while. And then there will be a gradual recovery and that will be true across Europe and the UK as well,” he says.

But Chillingworth says the problems in Britain are more profound because consumers are much more overborrowed than Europe. He does not see the British economy recovering until the end of next year or early 2010.

Sterling has also been a big loser. It has shed more than a quarter of its value against the dollar since July and is below $1.50 for the first time since 2002. The pound is also at its weakest level against the euro since the European currency was launched in 1999. The Bank of England expects the economy to shrink by 2% over the next year. House prices are still falling; manufacturing output fell 0.8% in September – the seventh fall in succession, and much worse than expected. Unemployment is at an 11-year high and many companies have announced redundancies.

The Bank of England’s heavy cut in interest rates shows it is not afraid to take dramatic action to help the economy. But monetary measures alone are unlikely to be enough and the government has now proposed tax cuts to increase spending.

Elliott says: “What happens on the high street will be very important. If we have a weak Christmas, then in the new year a lot of retailers will start shedding staff. Then the banks will have a second round of problems: they will see defaults on auto loans, mortgages and credit cards.”

Deflation could also become a problem. Britain’s inflation fell in October from a 16-year high. The Consumer Prices Index fell from 5.2% in September to 4.5% in October, while the Retail Prices Index, which includes housing, fell from 5% to 4.2%. The Bank of England has said inflation could fall below its target of 2% next year to 1%.

This is likely to prompt a cut in interest rates, says David Kern, the chief economist at the British Chambers of Commerce, who acknowledges the risk of deflation. “Deflation would have appalling consequences for British business and for the economy as a whole, so it is imperative the government and the Bank’s monetary policy committee take forceful action,” he says.

The eurozone has officially entered recession, with the economy shrinking 0.2% in the third quarter. German and Italian GDP saw the greatest falls, but one bright spot is France, whose economy showed a surprising expansion.

The downturn in Europe has been stronger than expected and more bad news is anticipated. As the eurozone countries are hampered by rules that say they should not have a budget deficit that exceeds 3% of GDP their options for buying their way out of recession are limited, Valensise says.

The downturn in the Asian economies, which were a big export destination for European goods, has been a big factor in Europe’s fortunes.

Batty says: “Europe is an export-exposed economy, so it will be an export-exposed stockmarket. The economy is more cyclical than the US and will probably feel the down draught more severely.”

In Germany, orders for goods fell 8% between August and September with those from outside Europe down 11.4% and domestic orders down 4.3%.

But, in a recent note, Lombard Street Research said it expected Germany’s recession to be shallow and short-lived. “It does not face the domestic debt problems that plague the Anglo-Saxon economies,” the note says. “Several years of tight fiscal policy have left the government with plenty of room for manoeuvre to boost state spending and cut taxes, with GBP 50 billion of stimulus (2% of GDP) already in the pipeline (largely tax cuts and incentives for business). Moreover, German business remains ultra-competitive relative to its European neighbours after several years of restructuring and falling labour costs.” Several other European countries are considering tax cuts and spending packages, including France and Italy.

While America, Britain and continental Europe find themselves in similar situations, it has been a different story for Japan. Although in recession, with growth hit by the global economic slowdown, it is expected to be one of the first economies to recover. The reason for this is that its weakness is not home grown but rooted in America. Japanese banks have not lent unwisely, consumer debt is not an issue with the current account in surplus, and there is no inflation. Also its fiscal deficit is just 1.4% of GDP this year.

The Japanese stockmarket has taken a battering in recent months and the strong yen has made the country’s exports less attractive. But Julian Jessop, the chief international economist at Capital Economics, says that Japan is in relatively good health and should recover quickly.

“Japan has been hit by the global inflation shock but none of the other problems,” he says. “The financial sector and household finances are in good shape. So it should be one of the first major economies to recover as global inflation shocks fade. Domestic demand should hold up well but obviously it will still be hit by the global downturn like everyone else.”

Equity markets in emerging countries have been hit hard by risk aversion. But many of the economies still look fairly healthy, particularly in Asia, which do not have the same problems as America and Europe. China and India are still posting good growth rates, albeit lower than in recent years.

China has announced a massive investment plan to boost its slowing economy. It has cut interest rates twice and said there will be cuts in company tax to support its economy.

Eastern Europe and Latin America are likely to find the going tougher, according to Jessop. “They have big financial and economic imbalances that will cause problems in years to come.”

Latin America has been under pressure because of hedge fund selling and because its economies are commodity based. However, Chillingworth points out: “If commodity prices pick up, this will help these economies and a pick-up in Chinese growth could do this.

“But Eastern Europe has lots of problems because of overborrowing. There is also the Hungarian situation, which has seen Hungarians buying houses using Swiss franc mortgages. This has been disasterous because of exchange rates. There are also balance sheet issues for Eastern Europe.”

With recession now the main concern, economists in America and Europe will be watching unemployment figures to measure the depth and severity of the economic slowdown. On the markets, analysts will be adjusting forecasts for corporate earnings, which have fallen back and need to be revised downwards. But as stockmarkets usually anticipate any pick-up in the economic climate roughly six months ahead of time we might well see a gradual recovery in markets in 2009, although there is still the potential for disappointment if the incoming data worsens.

Jessop sums up: “It’s an uncertain period. On the one hand you’ve got the economic data, which clearly shows the economies are heading into recession. On the other hand policymakers seem to be pulling out all the stops to make sure that recession is as short and shallow as possible. Exactly which way those two forces will play out is unclear.”

The International Monetary Fund view

Prospects for world growth have deteriorated and countries need to stimulate their economies as we encounter a worse than expected global slowdown, according to the International Monetary Fund (IMF).

In its latest forecast the organisation sharply revised its projections for world
growth downwards, warning that it is expected to slow to 3.75% in 2008, compared with 5% in 2007, and to 2% in 2009, with the downturn led by the advanced economies.

“The prospects for global growth have deteriorated over the past month, as financial sector deleveraging has continued and producer and consumer confidence has fallen,” the IMF said in its updated World Economic Outlook, published on November 6.

World output is expected to expand by 2.2% in 2009, which is down threequarters of a percentage point of GDP on projections in October. Output in advanced economies over 2009 is forecast to fall for the first time since the second world war. In emerging economies the picture is not so bad, but growth will still slow to 5%.

Olivier Blanchard, the IMF’s chief economist, says that these projections are based on countries’ current policies and called for further monetary and fiscal action to improve the outlook.

“We think that global fiscal expansion is very much needed at this point. If it comes, then the forecast we have will be on the pessimistic side,” he says.

International Monetary Fund forecasts:
Shows November 2008 IMF forecasts for GDP growth (%) in selected countries and regions.

Source: IMF The International Monetary Fund view