Special Report: Dramatic Repricing of Growth Expectations and Risk - but Recession ...?
August 9, 2011 (SmartPros) In a brief to members, The Conference Board Economics Team examine the implications on global financial markets of Standard & Poor's decision last week to downgrade U.S. long-term debt. Their analysis breaks down the move in a broad, global context, including a review of The Conference Board current and leading economic indicators, manufacturing employment, the policy environment, and assessments of the growth rates for both advanced and emerging economies around the world.
Dear Member of The Conference Board:
The global economic recovery is in serious trouble – that much you’ve learned from media and analyst reports of the past few weeks. Now is the time to take a step back and look carefully at our portfolio of economic indicators, to see whether our moderate growth projections for the next half year, the next two years, and beyond need to be adjusted from orange to red alert.
Perhaps the greatest danger right now is that the current fear of another global recession becomes a self-fulfilling prophecy. For this reason, coordinated global policy actions that finally move ahead of the curve, as opposed to lagging behind, are needed to show leadership and to halt the current sharp sell-off in financial markets.
Our assessment of the current state of most advanced economies, including the United States and most European countries, is one of weakness and has been so for quite a while. Yet it does not warrant the belief that recession is inevitably around the next corner. At the same time, the market’s assessment of the failing policy environment does pose a serious risk to global financial markets, which can spill over into a further weakening of our economic indicators.
In our view the risk of recession has increased slightly, but overall it remains low – about a one-in-three chance.
What the data tell us
There is no doubt that the recent weak economic data in the U.S. and around the globe, and ongoing concerns about the U.S. and European debt problems, including the downgrading of the credit rating of U.S. sovereign debt, have undermined confidence in the global economy, and dramatically altered expectations for future economic growth of the world’s advanced economies. In response, the financial markets are rapidly and aggressively pricing in the downgraded growth expectations and commensurate increased risk.
Given what we perceived earlier this year as being overly optimistic consensus forecasts of 3% and higher GDP growth for the U.S. for this year and next, we are not entirely surprised by the weaker economic data and the ensuing correction in the financial markets. The latest economic readings are a bit softer than we anticipated, and we now see real GDP growth averaging just 1.6% for the U.S. this year versus our prior forecast of 2.2%. For 2012 we predict growth of 1.8%, which is down from 2.2%. The bigger problem now is that the challenging policy issues both in the U.S. and in Europe are widening the margin of uncertainty around these modest growth forecasts.
On the basis of current and leading economic indicators, the risk of recession has increased slightly, but it remains low at less than 35% according to our recession probability measures for the United States. The most recent reading of The Conference Board Leading Economic Index® for the United States (with measures up to June) continues to show positive growth, even though it is strongly driven by financial indicators, such as money supply and the spread between the interest on 10-year Treasury bonds and the federal funds rate, rather than “real economy” indices such as consumer confidence, manufacturing orders, and working hours. The Conference Board Consumer Confidence Index®, which had declined in June, improved slightly in July. While consumers remain apprehensive about the future, some of their concerns about future expectations have abated. Consumers’ appraisal of current business and employment conditions, however, was less favorable as concerns about the labor market continue to weigh on consumers’ attitudes. From this viewpoint, it is encouraging that the very latest economic report shows that after two very disappointing jobs reports, which attest to the slow growth performance of the U.S. economy during the first half of the year, employment increased a little faster in July.
As manufacturing employment increases are constrained by ongoing global competitive forces in the manufacturing sector, which demand a lean and highly productive labor force, the key sector that needs to lead employment gains is “core” services (which excludes health and education). So far, however, job growth in this important sector has been disappointing and lackluster. To spur greater gains, an improvement in overall economic demand, especially from the consumer sector, is required. With gasoline prices, but not grocery prices, easing, there could be a little more spending on other consumer goods and services. But that suggests only slow improvement at best through the second half of 2011.
On the optimistic side, however, the July employment report suggests many businesses appear to believe they can maintain profits, while adding cautiously to payrolls. If that view is maintained, the labor market will slowly come back, but it’s a long way back.
Any relief from Europe or the rest of the world?
In Europe, economic indicators and the quarterly estimates for growth also suggest weakening during the second quarter. In Germany, supplier delivery times have continued to lengthen, though at a slower rate than before. The sovereign debt crisis in Europe has surely intensified with the adding of Italy to the group of “high risk” economies. However, the widening of the crisis to countries with very different debt risks also points at the more fundamental problem in Europe, which is their slow growth rate. While the Euro Area’s growth rate for 2011 may in fact turn out somewhat better than for the United States, mainly because of solid growth in Germany and several other northern European countries, their medium-term trend growth rate of about 1.5% is too slow to help bring the Euro Area debt ratio down to a more manageable level. The slower growth in several emerging economies, notably China, does not add to the confidence that the European countries, which are most dependent on exports to the emerging markets, can accelerate their growth rate any time soon.
China’s economy, while certainly slowing, seems to be moderating only slightly, and poses no short-term risk to the global economy. The readings from The Conference Board Leading Economic Index® for China for May (the most recent month for which data is available) showed a continuation of the slight upward trend of the past three months, suggesting that economic expansion will likely continue through the rest of 2011. The risks for China’s growth model are much more medium and long term – therefore no less of a concern — and the strong Chinese reaction to the U.S. debt situation may be a sign that their concerns about their own forward path have risen.
Overall, we continue to predict very sluggish growth in the U.S. and Europe, which likely will not average above 2% for this year and next as the economies continue to deleverage following the implosion of the credit bubble and subsequent financial crisis. Globally, growth may fall below 4% for this year, but the adjustment from our previous projection of 4.3% is limited as most emerging markets, including China, will still post strong growth.
Will the policy environment provide help any time soon?
We do not want to downplay the outlook risks. These risks depend primarily on the assessment of the slow movements on the policy side to stay ahead of the situation. The initial relief that investors, business leaders, and consumers felt after the late-hour debt ceiling deal was reached in the U.S. quickly faded as the reality of fiscal retrenchment amid a rancorous political environment moved center stage. This is in part highlighted by the downgrade by Standard & Poor’s of the U.S. long-term debt rating to AA+ from AAA. However, ironically, Treasury yields may continue to decline in the near-term as concerns about the slowing global economy continue a flight-to-safety into U.S. Treasuries, which outweighs any negative effect of the credit downgrade – the U.S. 10-year yield, which fell to 2.5% last week, has fallen even further today. Even in the medium term, the credit downgrade may be more of a psychological hit to U.S. confidence, however, it could eventually translate into slightly higher borrowing costs for the U.S. government, consumers and businesses.
The good news about the recent fiscal drama in the U.S. is that there is now widespread recognition that the debt/deficit problem needs to be urgently addressed. Further, there is some good news that most of the proposed $2.1 trillion to $2.4 trillion in spending reductions are back-loaded. However, if the Congressional Joint Select Committee on Deficit Reduction, charged with the goal of reducing the deficit by at least $1.5 trillion between 2012 – 2021, fails to find a way to do so, then automatic reduction in spending would start as early as Q4 2012, which could result in a drag of around 0.8 - 0.9 percentage points on real GDP during that quarter alone. This may prove too much for the still fragile economic expansion.
In Europe, the recent action of the European Central Bank (ECB) to purchase Italian and Spanish bonds has helped push long-term interest rates back below the punishing 6% level and is a good step towards bolder action. However, it does not come without risks as the ECB must again increase its balance sheet to hold these assets. And the ECB’s action reflects the inability of the European governments to collectively agree to a plan that would stop the contagion and effectively deal with the debt problems. In response to the volatile and declining financial markets, the G7 has issued a communiqué stating it will “take all necessary measures to support financial stability and growth” and the G20 has issued a similar statement.
However, overall, we should not expect much relief from government interventions in the short term, though all eyes will be focused on this Tuesday’s Federal Open Market Committee to see if the Federal Reserve embarks on another round of quantitative easing – QE3. However, with short-term interest rates already near zero, there is no room to cut rates, the traditional policy prescription monetary policy officials offer when the economy starts to slow. If the slowdown turns into outright contraction, we might see some continued modest policy response, but large meaningful action seems unlikely in the current political climate.
Again, this IS a structural crisis, which started off with the widely discussed origins of the economic and financial crisis of 2008/09. It doesn’t seem likely that there will be a fundamental change in government policies around the world over the next 18 months. Even if it comes earlier, it could take more than three years before the global economy can recover to a faster growth trend — as the budgetary measures are unlikely to provide much relief any time soon.
Our Economics Team will provide regular updates………..stay tuned!
Over the past months we have communicated our views on the economy in our regular programs and publications, such as The Conference Board Economics Watch® report and StraightTalk® (available to member companies at Guideline), along with our regular statements on the employment and GDP growth releases. We also have detailed our views in several other publications, some of which are listed below. In the coming months we will continue to do so, and when needed, will do so with more frequency. While our indicators and growth measures cannot tell the whole story and do not guarantee the right prediction, they are the best anchor on which to base our assessments.
Please, let us know what questions or comments you have about the economies in the U.S., Europe, and elsewhere.
With best wishes,
Bart van Ark, Senior Vice President & Chief Economist
Kathy Bostjancic, Director, Macroeconomic Analysis----- 2011 SmartPros Ltd. All rights reserved. Source: The Conference Board