Share market performance was pretty crappy during June thanks to growing fears about a double-dip and worries over government balance sheets and spending. Is another downturn on the cards? That’s certainly what falling government bond rates seem to be suggesting, and it is a potential scenario we pay attention to. However, we think we are more likely to see a slowing in growth rather than an outright collapse a view we lay out in more detail in this article.
In other words, what we are seeing is more likely a growth scare. With share markets back at their year-to-date lows, we certainly think some of that optimism has fallen away as the indicators on the real economy have faltered, and that equity markets are now priced for a slower growth scenario. While the Chinese currency decision will have little impact on developed markets, we do see it as good news for China and having benefits for the rest of the region.
Hold tight for the double-dip?
The range of scenarios for US growth in the next few years is wide.
- V-shaped (4-5%pa growth)
- Normal (2-3%)
- Muddle-through or "new normal" (0-2%)
- The feared double-dip recession
We see normal (2-3%) as the most likely result, and economic forecasts are now heavily clustered in that range. But market commentators tend to gravitate to the extremes. Their talking points dominate lot of the financial discussion and analysis, and investors have to sort through this to make decisions on how much weight to give to each issue. Of course the commentaries simply reflect why markets are noisy or volatile. Folate this noise, or volatility, has been far greater than one would expect coming out of recession. There is a genuine contest on here between the conventional V-shaped recovery that easy monetary policy and big spending by governments has always guaranteed over the last 30 years, and the notion that maybe, just maybe, that easy way to exit recessions won’t work this time.
So over much of 2009 and the first part of 2010, the V-shapers were in ascendancy, with a huge rally in equity markets that seem validated by a massive bounce in forward indicators of manufacturing activity. But in the last few months the V-shapers have yielded the floor to the double-dippers, who expect growth to slow substantially or even enter another leg of recession. There are three broad arguments for their view.
- Macroeconomic indicators are weakening. The equity rally has stalled, and forward indicators of activity are down from their peaks. Unemployment remains persistently high, consumer confidence is dreadful, and the US housing market (the trigger for the crisis) is not recovering.
- The European crisis could go global. The transmission mechanism would either be a sharp European growth slowdown or a second financial crisis arising from bank problems. Interbank lending rates have been increasing steadily, as they did during the global financial crisis.
- Austerity from governments could derail the recovery. In response to the European sovereign debt crisis, governments are announcing spending cuts, savage ones in some cases. It is unclear if they really need to cut spending most government bond yields (ie the cost of borrowing) are moving lower, not higher. But everyone is afraid of being the next Greece.
What to make of it all?
First, the historical evidence is not on the double-dippers’ side. Sharp recessions are more likely to be followed by sharp recoveries than weak recoveries. And actual double-dip recessions are extremely rare. This outcome is not that surprising; once activity has been depressed, marginal businesses have been wiped out, and governments have ramped up their spending, risk-takers in the private sector and those whose balance sheets aren’t destroyed by debt start to take advantage of very low borrowing costs, and then all factors point skyward.
The short-term macroeconomic models suggest little chance of recession. The fall-off in forward looking indicators (eg manufacturing indices) has simply not been that extreme, which was not the case leading into the credit crisis. At that stage, the downturn in the housing market and the negatively sloped yield curve (tight monetary policy) both hinted at the recession to come.
Finally, there is some evidence of a "normal”, demand-driven recovery underway. US retail spending has grown strongly over the last year, and Americans who have jobs are working more hours (normally precursor to increased employment), boosting their incomes. Employment is growing, albeit not enough to keep up with population growth or to dent unemployment rates.
A dissenting argument is that credit crises are exceptions to the normal run of things and produce particularly anaemic recoveries. They disrupt the monetary policy channel, stopping central banks from pumping up the economy with easy money. They also produce a large increase in government debt the result of borrowing to bail out banks. This debt has to be repaid eventually through austerity measures (higher taxes and lower spending), undermining the recovery. Furthermore, it is still unclear how much deleveraging needs to take place in the post-credit crisis world, and what impact that will have on growth.
So how afraid of austerity should we be?
John Keynes is the economist credited with the idea that policies of big government spending were a way to end the 1930s depression. The traditional Keynesian view is that government borrowing to spend more has strong impact on demand and growth, especially when the economy is depressed to begin with. In this view, it is crazy to shut off that demand at such an early stage of a recovery.
But the actual impact is much debated. Some believe that government spending simply crowds out the private sector (as government borrowing keeps interest rates up and discourages private-sector spenders who would otherwise borrow to finance them spend), and that business investment and consumer spending will pick up on its own as the government cuts back. Others believe that the impact on confidence from a government plunging into debt outweighs the stimulus effect. Even in a case where a government cuts back on spending, the central bank still has the final say on stimulus; it can provide more monetary support (lower interest rates or print money) to counteract the government’s belt-tightening.
And all this assumes that austerity goes ahead. But a lot of it is posturing governments want to appease financial markets now, but delay pain until later. A lot of the deficit reduction that has been announced would have occurred regardless, as the economy and tax revenues recovered.
So what kind of recovery are we talking about?
So you can see there is an argument for every angle! The truth is we don’t know until it happens. The data disappointments of the last few months have removed the V-shape from contention (for now). But broadly, the data is still consistent with a normal recovery, and the promise of austerity to come does not change that conclusion.
What’s going yuan?
China has been under international pressure for some time to allow the yuan to appreciate. The American government, in particular, views the fixed yuan as unfair support for Chinese exporters. There is also a concern that it contributes to global imbalances. China needs to send money offshore to keep the yuan steady, making global debt cheap, and contributing to greater leverage. But the economic evidence that Chinese currency policy is having a major impact on the global economy or US manufacturing industries is unconvincing.
Nevertheless, the decision to allow some appreciation is a good signal both that the Chinese administration is open to more market-based policies, and that they believe the Chinese recovery is robust enough to withstand a higher exchange rate. And economically, it is good for the world, as a higher currency should put the brakes on an overheating China by transferring some of that excess demand to China’s trading partners (through the net export channel). That effect will be most prominent in the wider Asian region, including Australia and New Zealand. In the long run, a stronger yuan should also produce a stronger currency for Australia and New Zealand (measured against the US dollar or the euro).
China allowed the yuan to appreciate by 7%pa in the three years prior to the global financial crisis. So resumption of that policy has been on the cards for a while. But the conservative Chinese administration will not allow a dramatic appreciation expect around 5%pa. Changes in the real exchange rate (the important variable) will be faster, as Chinese inflation outpaces the low inflation rates in the developed world.