Over the past three months the outlook for global economic activity has significantly worsened. But at the same time the upside risks to inflation have largely dissipated and the prospects for lower official interests have improved [written before global rate cuts]. The key developments were the sharp fall back in oil and other commodity prices from their early-July peaks and, less happily, the re-emergence of serious strains in financial markets.
The fall back in commodity prices is good news for the economic outlook. The final surge in commodities in the first half of this year was speculatively-driven and as such represented a negative shock to the global economy, undermining growth while at the sametime pushing up inflation. The un-winding that has seen the oil price fall back from $140 per barrel down to $90-95 and the price of grain and several important metals drop by 20-35% should be welcomed. Consumers’ real incomes and spending should receive a boost in most countries while non-oil profits should also benefit. And central banks can be more relaxed about cutting official interest rates.
Unfortunately, financial developments are weighing heavily on economic activity. The crisis of financial confidence is affecting the real economy, despite the efforts of monetary authorities to make huge amounts of liquidity available. Market interest rates have risen sharply and corporate bond yield spreads have widened to new peaks (see graph); and the availability of credit to non-financial borrowers has tightened markedly.
In short, the credit crunch has intensified and the risk of recession has increased. But there is also a separate but related issue. Globally, banks are short of capital as a result of losses and write-offs, and because of the collapse of the shadow banking system that previously allowed banks to earn fees while keeping the assets off balance sheet.
Moreover, with yield spreads increasing dramatically, banks are no longer able to raise significant amounts of tier-two capital by issuing perpetual and other subordinated debt. The most likely outlook is that bank capital will be rebuilt slowly using strategies such as cuts in dividend payout ratios and restraint on the expansion of loan books. Until the process is complete, credit availability will stay tight by the standards of recent years. This does not rule out a global economic upturn in 2010, but it does make it unlikely that an upturn on that time-scale will be a strong one.
As a result, the outlook for the next two to three years is significantly weaker than looked likely three months ago, as illustrated in the table. Next year is set to be a year of very weak activity, with GDP growth of about 0.8% for the main advanced countries. This would be the weakest since 1991, and risks are weighted to the downside with an outright fall by no means impossible. Although we project some recovery in 2010, it is likely to be a fairly muted one.
The weakness is widely spread. In America, the housing market is showing some signs of stabilising but the outlook for consumer spending and business investment is poor against the background of sharply reduced household wealth and tight credit availability. Economic activity in the eurozone has turned down, with painful retrenchment in overstretched areas such as Spain and caution in relatively sound areas such as Germany.
In Britain, the weak housing marketwill further depress residential investment; squeezed real incomes and reduced household wealth will curb consumer spending; and the credit crunch and deteriorating corporate liquidity will weigh on business investment. On the face of things, Japan has emerged relatively unscathed from the banking crisis. However, Japan’s robust economic growth over the period 2004 to 2007 was driven primarily by exports. It is struggling in the face of a sharp slowdown in the advanced countries, and a steady deceleration of demand from China and other emerging Asian countries.
The balance of risks to inflation is more favourable, given the drop in energy prices and indications that food price inflation is peaking out in most countries. Moreover, a significant margin of spare capacity is likely to emerge in the advanced countries, which should restrain wage costs and put some downward pressure on underlying inflation rates.
There is scope for official interest rates to fall by 100 to 125 basis points in Britain and the eurozone, to 4% and 3% respectively, over the next year or so. In America the question is whether the Federal Funds rate is maintained at 2% for a sustained period or whether it is cut further. In Japan, an increase from 0.5% looks unlikely before late 2009 at the earliest.
RICHARD DINgWALL-SMITH Chief economist, Scottish Widows Investment Partnershipnigel Thomas Fund Manager