Global economy – resilience, rebalancing and repression

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This post is a guest contribution by Joachim Fels of Morgan Stanley.

Investors have growing doubts about the sustainability of global economic recovery, fuelled by weaker US data over the first few months of this year, the surge in oil prices before the recent correction, and the tightening by central banks in many EM countries and the euro area in response to higher inflation. On the back of these doubts, government bonds have rallied and risky assets have wobbled.

We don’t share these doubts: Our big-picture view on growth remains unchanged from last month. We are constructive on economic growth; we think the global economy is quite resilient to the shocks we’ve seen; and we think that this recovery will be quite sustainable because of global rebalancing. Being constructive on growth does not mean we are blindly bullish. We don’t believe that global GDP will continue to grow at the 5% snapback pace we saw in 2010. Rather, we expect GDP to moderate to a little over 4% this year (4.2% to be precise) and we look for 4.6% next year. The important point is that we look for global growth to be above its long-term trend rate, which is 3.6% for the last 40 years.

Too young to die: Keep in mind that this global recovery is only two years old – it only started in the middle of 2009. On average, recoveries in the global economy have lasted a little more than six years. The shortest one over the past 40 years took place in the second half of the 1970s and lasted only four years. The longest one was in the 1980s and ended after eight years. Recoveries typically end when major imbalances in an economy have developed and become unsustainable – such as overinvestment in the late 1990s or overconsumption in the late 2000s – and when monetary policy becomes very tight. Neither is true now.

The global economy is relatively resilient: Despite the oil price shock, initial conditions are favourable because household and corporate balance sheets have improved since the financial crisis. Balance sheet clean-up and repair in the private sector has partly come at the expense of the public sector balance sheet, but that’s another story. Personal savings rates have increased in former bubble economies like the US and the UK, and corporate profit margins have widened to record highs. This implies that the capacity of both households and companies to absorb shocks from higher oil and commodity prices has increased.

Global monetary and fiscal conditions are still very expansionary: Most governments are shying away from tightening fiscal policy despite large deficits. The global real short-term interest rate is still negative and way below the growth rate of the economy, indicating very easy monetary policies. Long-term interest rates are also very low and have eased further recently. As for the monetary policy tightening in China and other EM countries, we think that much of this is not genuine tightening. For example, the many increases in banks’ required reserves imposed by the People’s Bank of China are largely aimed at neutralising the hot money inflows that pump up domestic liquidity. This is not a genuine tightening, but rather an attempt to make sure that liquidity doesn’t get even more abundant.

Moreover, while many central banks have been raising nominal interest rates, in most cases the increases in policy rates have lagged behind the increase in inflation. So, real rates have eased further in many cases. In short, monetary and fiscal conditions are still very easy around the world and should make the recovery quite resilient for now.

Global rebalancing is a powerful underlying trend: Global rebalancing means that the big consumers in the world economy are becoming savers, the big importers are becoming exporters, the big exporters are becoming importers and the big savers are becoming consumers. Global rebalancing requires new capital spending: the US export sector doesn’t have enough capacity and needs to expand – one reason why we have been seeing strong spending on equipment in the US. Conversely, China needs to direct more resources into the domestic economy. So, global capex is likely to be supported over the next several years, and companies have enough cash on their balance sheet to finance this spending. With the global imbalances that built up in the credit-fuelled boom of the 2000s diminishing and global capex being supported, this recovery look set to be more sustainable over time.

Global inflation is our bigger worry: While we are less worried about the growth outlook than most, we continue to worry more than the markets about further upside to inflation as what we’ve called the global ‘inflation merry-go-round’ keeps spinning. Core developed economies and emerging economies’ central banks are the drivers behind this merry-go-round. Super-expansionary monetary policy in the mature economies is imported by emerging economies through their US dollar soft or hard pegs. This has been pumping up EM growth and commodity prices and is fuelling EM wage and consumer price inflation. Having gained a toe-hold in EM, inflation is then exported into mature economies through more expensive goods exports. ‘Rationally inactive’ central banks in the mature economies accommodate this imported inflation, ultimately risking a domestic inflation take-off.

Financial repression at work: Normally, one would expect an ongoing, sustainable recovery and higher inflation to push bond yields significantly above their current low levels. Paradoxically, however, we think that bond yields will remain relatively low (though not as low as they presently are) despite resilient growth and upside inflation surprises. One reason is that the major central banks’ responses to higher inflation will be relatively muted, in our view, given concerns about high unemployment (as in the US) and peripheral sovereign and banking problems (as in the euro area). Thus, real short-term interest rates are likely to remain unusually low for quite some time. Another factor that is likely to put a lid on bond yields is financial repression. Economic history is replete with examples of how governments, though taxation and various forms of regulation, have strongly encouraged or forced private and institutional investors to keep buying government bonds at uneconomic prices at times of elevated inflation rates. In these episodes, low or even negative real interest rates helped governments to cope with high public debt levels. This time will be no different, in our view. Regulators are already (for the sake of financial stability) forcing banks, insurance companies and pension funds to increase their holdings of safe government bonds, thus creating a captive investor group. This, together with low short-term interest rates and higher inflation, is likely to promote a prolonged period of very low or even negative real interest rates that should help to make the high and rising public debt bearable for governments.

Source: Morgan Stanley, May 13, 2011.

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