15 June 2009
Weekly Macro Comment
Han de Jong, Chief Economist
The problem of Serving all Masters
• Global economy at a cross road
• Data still consistent with our cautiously optimistic view
• Further rise in bond yields is a potential danger to the recovery
My team and I provide services to all parts of our organisation. are the beginning of a recovery; others say they are just
When everything is plain sailing, we do not really notice any weeds. So, we have come to a crossroad.
difference in the responses from the various audiences. Under
current circumstances, the differences are screaming at us in The optimistic case
the face. Having been on the pessimistic side of the debate for According to the optimistic argument, the severity of the
a long time (we were early when, in October 2007, we started downturn late last year and early this year was driven by an
forecasting a recession in 2008), we moved to the more aggressive process of inventory liquidation. Faced with frozen
positive side two months ago. Many of our colleagues involved credit markets and paralysed banks, companies had no option
in providing investment advice to clients love us for it. But our but to sit on their liquidity. Even the inter-company credit
colleagues in Risk Management are not quite so happy. This channel tightened up. The way companies save liquidity is by
difference is understandable. Financial markets are forward running down inventories. This process has been brutal. But
looking and if you want to beat the market you have to be even the positive side is that inventory liquidation cannot last
more forward looking. That means that you must have the forever. In early-cyclical sectors, the inventory cycle has
courage to take more risk before others are prepared to do so started to turn. This should lead to an improvement in
and well before it is clear to everybody that things will actually economic conditions. Policy stimulus is bound to have a
improve on a sustained basis. If, on the other hand, you work positive impact on economic conditions as well. This process
in Risk Management, you must err on the side of caution - it is has probably already started, but will become more
your job, in fact, your duty to do so. Hopefully, by clearly pronounced in the months ahead. The turn in the inventory
underpinning and constantly challenging our own view, while at cycle and the effects of policy stimulus will reinforce each
the same time identifying the risks, we can provide a other. At the same time we are witnessing an improvement in
satisfactory service to all. financial market conditions. Credit spreads are coming down
and liquidity is improving here and there. This means that the
What are the facts? availability of credit is improving. Finally, some asset markets
The facts are that the global economy has hit the worst crisis that got hammered in the downturn are starting to show more
since the 1930s following the implosion of a range of bubbles. positive signs. The recovery in equities is very clear. But
It is also a fact that the ‘system’ had got excessively leveraged housing markets that have been badly hit are also showing
and that a process of deleveraging was inevitable. It is also a some signs of stabilisation, particularly in the UK.
fact that the response of policymakers is unprecedented.
Budget deficits are rising rapidly, interest rates have been The combination of these positive developments constitutes
slashed and central banks are engaging in quantitative easing. the core of the optimistic argument. This combination is
This combination of unprecedented problems and an currently slowing down the vicious circle and will hopefully lead
unprecedented policy response makes the situation to a more virtuous circle in the months ahead.
fascinating, but also very unpredictable.
The pessimistic case
As far as economic data is concerned, it is a fact that the data According to the pessimistic argument, the improvement
deteriorated at an incredible pace following the collapse of caused by a turn in the inventory cycle is purely temporary.
Lehman Brothers, although a recession had started earlier in Efforts by policymakers are futile as they simply lead to
most countries and the recession had started to deepen shortly unsustainable budget deficits. That is OK for a brief period, but
before Lehman’s demise. It is also a fact that economic data soon enough governments must stop their expansionary
has become less dire during the last two or three months, often policies as they are in danger of bankrupting themselves.
referred to as green shoots. Some argue that the green shoots Some in the pessimistic camp also question the effectiveness
HAN DE JONG +31 (0)20 628 4201 ECONOMICS DEPARTMENT
15 June 2009
of many policy measures. It is true that the Chinese unemployment. Nevertheless, if you can ill afford to suffer
policymakers are very active, but the pessimists argue that meaningful losses, this is certainly not the time to increase risk
there is little evidence that this amounts to much more than in any significant way.
stockpiling raw materials. In this view, the rise of commodity
prices and the rise of the Baltic Dry index, which measures The W-case, or double-dip scenario
shipping costs, are the result of China importing more Some pessimists argue that we may experience a bit of a
commodities at low prices in order to replenish inventories. recovery, but that it will be unsustainable. They see a recovery
now as the result of aggressive policy actions and believe that
Baltic Dry Index policymakers will step back at some point, triggering an even
Index more damaging recession, perhaps in 2011 or 2012. I do not
have a particularly strong view on this. It is possible, though
12000
not part of my most likely scenario. The truth is that such a
10000 second recession is still so far away that the question whether
8000 or not it will happen does not drive decisions yet.
6000
What does recent data say?
4000 We are satisfied that recent data supports our view: an
2000 improvement in economic conditions and in financial markets
and some improvement in key asset markets.
0
2005 2006 2007 2008 2009
The improvement is mostly visible in Asia and the US and less
Source: Bloomberg so in the eurozone. This is no surprise. The eurozone lagged
going into the downturn, and it will certainly also lag coming
The core of the pessimistic argument is that the process of out. In addition, the policy response in Europe is less
deleveraging has much further to run and that anything more aggressive than in the US.
than a very brief improvement in economic conditions cannot
occur until much more deleveraging is completed. US retail sales were a tad better in May than expected, rising
0.5% mom, while the numbers for April were revised upwards.
Where do we stand? Higher petrol prices boosted retail sales figures, but there was
As indicated above, we have been cautiously optimistic for also an underlying improvement. The pace at which the US
several months, with the emphasis on cautiously. We believe labour market is deteriorating is clearly easing. Initial jobless
the positive developments that are occurring will reinforce each claims fell to 601,000 is the most recent week. Consumer
other. Of course, the global economy and financial system will confidence edged higher in May, according to the preliminary
need to go through a further process of deleveraging, which is reading of the index of the University of Michigan. Finally, the
negative for economic growth. But we do not believe that US April trade balance data showed a small widening of the
growth can only resume once the deleveraging process has deficit, but the details of the report suggest an improvement is
been completed. As long as deleveraging is gradual and under way in real terms.
orderly, a sustainable recovery is possible, albeit that very
strong growth is unsustainable. US: Initial jobless claims
x 1,000
The risks, however, are significant. For some time, we have 700
argued that investors should gradually add risk to their 650
portfolios, and in the advice to clients, several steps have been 600
made in this process. The uncertainties are too big to be very 550
aggressive, though. In the end, it all depends on your ability to 500
tolerate risk. There is no doubt that we are still going to see a 450
lot of bad news in the months ahead, particularly in economies 400
350
that have lagged the cycle, such as the eurozone and
300
specifically the Netherlands. Defaults and bankruptcies will
250
continue to rise for some time; unemployment will continue to
Jul-07 Jan-08 Jul-08 Jan-09
grow and housing markets will generally come under increased
pressure. Bear in mind that these are generally lagging Source: Bloomberg
indicators. They are painful, but a forecast for the economy
should not be based on the recent trend in defaults or
HAN DE JONG +31 (0)20 628 4201 ECONOMICS DEPARTMENT
15 June 2009
China saw mixed data last week. The trade figures were borrowing costs. Either bond yields must come down from
disappointing, with import growth and export growth both falling current elevated levels or the ‘green shoots’ are seriously
further into negative territory in May after having shown an under threat.
improvement in recent months. But retail sales growth picked
up from 14.8% yoy to 15.2%, while industrial production growth
improved from 7.3% yoy to 8.9%.
China: Export and import growth
% yoy
80
60
40
20
0
-20
-40
04 05 06 07 08 09
Export Import
Source: Bloomberg
Data in the eurozone were disappointing. Industrial production
fell more than expected in April and German April trade data
also disappointed. This confirms that the eurozone is lagging
the cycle.
What are the biggest risks in the near term?
The improvement in economic conditions is vulnerable and still
in a state of infancy. Two developments in particular worry me.
First, the rise in oil and other commodity prices has been so
sharp that it is going to push up headline inflation numbers
before too long. Higher petrol prices are already working as a
tax on consumers. We reckon that US inflation can be back at
least to the 2% level (from negative currently) by year end if oil
prices stay at USD 70. This is not good news. It erodes
purchasing power from battered consumers.
The second development that contains big risks is the rise of
borrowing costs along the yield curve. Early this year, the yield
on 10-year US government paper fell almost to 2.0%. It then
rose towards 3%. But when the Fed announced its quant
easing strategy, yields collapsed back to 2.5% instantly.
However, since then yields have been on a rising trend,
approaching 4.0% recently. This has led to a rise in mortgage
rates, which in turn has reduced activity in the mortgage
market. I think that the economy simply cannot cope with rising
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HAN DE JONG +31 (0)20 628 4201 ECONOMICS DEPARTMENT
