May 12, 2008
- A popular new economic term that has hit the financial media is “decoupling”, which suggest that non-US economies are unaffected by the US economy (that their growth correlation has “decoupled”). This concept is myth. The US economy is too large not to affect the global economy. As such, to fully discuss the global economy we must first comment on the US economy.
- Due to the significant amount of leverage in the US economy, measuring growth versus contraction in the economy is an important distinction.
- Modest US GDP growth in the last two quarters, combined with the risk contraction this quarter, will negatively affect the global economy but will not push us into a global recession (not in 2008 anyhow).
- Europe’s economy is very connected to the US economy. As US’ GDP rebounds in the second half of the year, so too will Europe’s GDP.
- Asia’s economy is very connected to the European economy. As Europe’s economy rebounds in the second half of the year, it will assist in Asia’s resurgence to double digit GDP growth.
- Latin America is very connected to the Asian economy. As Asia’s economy again moves toward double-digit growth it will drag up Latin America’s GDP.
Somewhere down the road, this current business cycle that we are muddling through may “officially” be called a recession by a small group of independent folks calling themselves the National Bureau of Economic Research. Somehow along the way these guys have pulled the claim-to-fame of being the unofficial arbiters of calling an official recession.
In regards to the NBER calling it an “official” recession or not, one astute observer I was watching on televisions exclaimed “Why? Because one-year after the fact this group of guys who nobody knows says so?” I thought that he made a good point because the NBER considers (but sets no official measurements) of things other than just GDP growth, like employment, income, and final sales. The NBER, unlike many other people, don’t rely on the standard definition of two subsequent quarters of negative GDP growth (I suppose that if they did then they would render themselves completely useless).
So the NBER may eventually call this a recession without the aggregate US economy ever actually contracting. But due to an enormous amount of leverage in the economy, the distinction of growth versus contraction is an important one. Due to leverage, when “losses” occur in the economy a little bit of decline can be magnified. So it really is not just a debate of semantics when it comes to econometric models. Still, if we had to label the last couple quarters, we would be more inclined to call it a mid-cycle slowdown than a recession.
I do, however, completely understand that it is just a matter of semantics for people have lost a job or even a home. Still though, distinction is important when assessing whether or not a lousy US economy will drag other countries into a recession (however you might want to measure one) or if it will just negatively affect the globe.
There is, unfortunately, a large risk that this quarter, the second quarter, will see negative US GDP growth. Although one month into this quarter is too soon to make an accurate prediction, (we have not yet even had a chance to get most data for April), we expect US GDP to contract by about 0.5%. We then expect a rebound in the second half of the year due to massive amounts of stimulus in the system. The slow growth of the last two quarters combined with the contraction of this quarter definitely has and will continue to harm the global economy. But, due in part to the expected resumption of growth in the US business cycle, we do not expect a global recession.
The two biggest risks to the US economy (and thus to the global economy) are housing and employment. One (employment) will continue to be bad but will not play as significant a role in affecting the global economy as it has in past downturns, slowdowns, recessions, or whatever description you would like to apply. The other (housing) has already experienced the bulk of its pain in terms of both duration and magnitude. But it still has the greatest risk of negatively affecting (and infecting) the global economy.
The pace of job declines is consistent with, at most, a mild contraction and not a collapse. Last week’s first-time jobless claims fell by 18,000 and brought the 4-week moving average to 367,000. That compares to the 400,000 new jobless claims that you typically would see during recessions (a number that hasn’t been revised for population inflation).
Similarly, in the last four months there have been about 250,000 jobs lost, with “only” 20,000 jobs lost in April. During the 2001 and the 1990-1991 recessions, monthly job declines averaged 181,000 and 142,000 respectively. Considering that the recession probably started in December 2007 (five months ago), the average monthly decline in payrolls has been a relatively modest 44,000.
Consistent with other recession and mid-cycle slowdowns, we expect unemployment to continue rising into early 2009, peaking close to 6%. That’s not a good thing on an absolute basis, but it is relatively good.
Housing problems are, undoubtedly, the root of the US’ economic concerns. There continues to be a contraction in home sales, housing construction, and, most importantly, house prices. The Case-Shiller index of house prices is down about 15% from its peak, which was hit two years ago. And now there is a self-reinforcing feedback cycle because foreclosure sales are become a greater and greater percentage of nationwide home sales. Foreclosed properties are being sold at steep discounts to the price of their previous sales price, forcing homebuilders and other sellers to cut their own prices. This has pushed an estimated 8.5 million homeowners underwater (where their mortgage debt is greater than the value of their homes) which in turn plays a role triggering additional foreclosures.
As long as house prices fall and foreclosures rise, the value of mortgage securities and other assets prices will not stabilize. This lack of stabilization shakes confidence and wounds the credit markets.
The Global Economy
So far the global economy has been resilient to the US credit crunch and financial meltdown, both of which were triggered by the US housing downturn. Europe, however, has experienced collateral damage. While the press has not given it as much attention, Europe’s financial institutions – like the US’ – have seen their balance sheets beaten and their income statements battered. But most other nations/continents have so far remained mostly unscathed. Emphasis on “so far” and “mostly.”
But the US has taken extraordinary steps in trying to right their wrongs. Not the least of those steps is that real interest rates (nominal rates minus inflation) are negative (which is bullish for the economy) for the first time since late 2005. The US Federal Reserve has been very aggressive, but we have also seen interest rate cuts from the Bank of England and the Bank of Canada. And while the European Central Bank has kept their rates steady they have been very generous in using non-interest rate tools to free up liquidity to feed the European economy.
The European economy, while aggregately performing better than the US, is very much so linked to what happens in America. To the extent that this quarter will be weak for the US and that the second half will experience trend-like growth, we can expect much of the same for Europe.
The Indian economy “cooled” to a mere 8.9% in 2007 compared to 9.5% in 2006. The biggest risk to India’s expansion is US-driven exports. Look for India’s GDP to drop a full percentage point in 2008 and then to rebound to above 8% next year.
China’s economy has a similar story, except that it has mainly been their European exports that have slowed down. Also, the Chinese government has taken measures to slow down their economy and their stock market (until recently, when they actually reduced taxes directly aimed at stimulating the stock market). Their efforts had worked as Chinese GDP will probably be about 9.5% in 2008, down from 11.9% last year. The story here is still similar to India, the US, and Europe – slower growth this year and faster growth the next.
Like in Asia, South America has limited exposure to the troubled debt instruments that have so greatly affected the US financial markets. It has been decades in the making, but the fiscal reforms made by Latin American countries have begun to take hold. Balance sheets of both corporations and citizens are much stronger than they were in the 1990s and, aggregately, have also improved more recently over the last few years.
In the last few years Latin American economies have become more and more tied to Asian (Latin American exports) and less and less dependent upon the US (Latin American domestic demand). So as Asian gets pinched in 2008 due to the US and Europe, so too will Latin America – but likely to a much lesser extent and with a much greater delay.
The Bottom Line: The old adage used to be that “if the US sneezes the rest of the world catches a cold.” In other words, a little US pain used to translate to major difficulties for the rest of the world. While this may no longer true, the concept of decoupling is a myth. The direction of the US economy has significant implications for global growth.
The US has not entered a recession (as defined by two consecutive quarters of economic growth) but 1) growth has been weak for two quarters and 2) this quarter may experience a contraction. This has and will negatively affect the global economy, but will not push us into a global recession.
There are higher levels of correlation between certain countries/continents, but as the US economy rebounds in the second-half of the year the rest of the globe will follow suit.