18th October 2010
On the face of it, the scale and seriousness of problems the global economy is experiencing suggests prospects are very gloomy. But it is not so cut and dried, as Keith Wade, chief economist at Schroders, is keen point out.
Even now, in the midst of various crises buffeting the world economy, retrenchment by the corporate sector looks to have run its course and Wade is expecting its next move to be increased capital expenditure and return to hiring. Indeed some evidence for that is already there: capex in the US has been rising at double digit rates for the last three quarters while the UK had a good second quarter on those measures. More globally, capital goods orders have been picking up, quite noticeably so in the US, Germany and Japan.
Wade concedes, however, that the employment picture is not looking so promising though it is showing signs of improvement. "Even in the US we have gone from quite aggressive job shedding to the private sector beginning to recruit. Having said that, there is no doubt the private sector needs further strengthening for that to continue and accelerate."
With unemployment in the US and eurozone standing at around 10%, and in the UK at 7.7%, job creation in the private sector is clearly a must; especially in the UK and eurozone which are facing massive tightening in public expenditure.
The markets are very focused on the unemployment picture, not least because high levels of jobless can be a big drag on government finances. "My big concern is that the recovery we are expecting does require improvement in corporate spending, which feeds into employment, which in turn benefits household budgets. We badly need consumer spending to hold up and that does rely heavily on household income and, of course, consumer confidence."
For the UK, markets have taken to heart the new government's tough stance on public expenditure, especially as indicated in the incoming coalition's emergency budget. "Markets certainly rallied on the back of that budget, with ratings agencies reiterating their triple A ratings for the UK. So quite a lot of pricing in has taken place in relation to the promised tightening," says Wade.
The big concern for Wade is the scale of the tightening being proposed the Chancellor, George Osborne: "Even if it's over four to five years, it amounts to 8% of GDP per annum, that is a big, big tightening of fiscal policy."
Indeed the tightening being proposed by Osborne is bigger than the 6% of GDP squeeze notched up in the wake of Britain's ejection from the ERM in 1992 and which lasted into the first term of the New Labour government. That particular period of tightening, however, was far less onerous as it occurred against a backdrop of a thriving economy. "This time, relatively, it is going to be much more difficult and painful. That is why if unemployment continues to increase it will become a major problem for the economy and markets," says Wade.
The QE conundrum
To ease or not to ease is another major issue facing policymakers on both sides of the pond. It certainly looks like the US is for another bout of quantitative easing (QE) but then, in technical terms, the US Federal Reserve can make the case for more QE, with core inflation very low, standing just below 1%. Indeed a survey of economists by Bloomberg found most believe that as things stand, US inflation will fall short of the Fed's long term goal reveals.
With UK inflation remaining stubbornly above the 2% target and currently standing at 3.1%, it is much more difficult at the moment for the Bank of England to justify another round of easing. But Wade and his team have very recently upped their probability of some form of additional QE in the UK, sometime in the first half of next year, to 40%.
The belief at Schroders is that during the first quarter of 2011 the economy will begin to look weak, and retailers in particular will see demand fall substantially. Under this scenario, the weakening of the economy and attendant impact on inflation could form the basis of a justification by the BoE for more QE, with the run to the May inflation report a possibility in terms of its timing.
Wade adds: "Our central view remains negative on chances of more QE in the UK but the probability has increased because of the changing circumstances and metrics."
Question marks over China
Casting his eye more globally, Wade homes in on the break out of currency wars and China's reluctance to revalue the yuan as a major problem. "We do need progress with China on this – it would help a lot, as would revaluation of currencies generally in some of the stronger Asian and emerging countries that are running up big trade surpluses."
Wade recalls a recent conversation with an economist from China who thought Beijing would undertake some revaluation ahead of the G20 meeting but only on the scale of 2-3%. Certainly a revaluation on that scale will do little to mollify criticism of China currency policy, particularly from Washington which is becoming increasingly angry and threatening over Beijing's stance.
The row over the yuan could spill over into moves by the US towards protectionism, as considered in this Wall Street Journal report. Wade points out, however, that threats of the US ‘going nuclear' with protectionism against China if there is no meaningful movement by Beijing on revaluation are pretty much being driven by the Democrats. If the Democrats do badly in the mid-term elections, as looks likely, they will have difficulty passing through protectionist legislation as the Republicans are far less supportive of such moves.
Another major concern for Wade is expectations as to what QE can achieve: "People get too optimistic about the benefits of QE for the economy as opposed to its impact on markets. As we know from the first programme in the UK, it does very little for the real economy, hardly any gets through to households, and it ends up being a big disappointment."
Emerging asset bubbles a worry
Indeed he fears that more QE round the world might actually create asset bubbles in emerging markets. He explains: " What QE tends to do is push down yield, encourages more people to search for risk, which in turn means increasing demand for high yields, all sorts of assets. Inevitably, a fair chunk will go to emerging markets investments and that could create bubbles in certain areas. It would be quite exciting for a while but as we know bubbles eventually burst and cause even more problems."
At present, Schroders central view on the global economy is that troubled economies somehow "muddle through". Wade says: "If we get half way decent growth rates or stronger, that would help support equities and growth assets but of course it would mean a revision of rate policy as currently they are very low. The justification would be there then for withdrawing stimulus. All that could have quite major ramifications for bonds in particular."