The balance shifts, decisively

The credit crisis has entered a new phase. Over the summer, rising inflation was the major worry. The focus is now on preventing a prolonged global recession. Bold and coordinated moves by policymakers appear to have pushed the global economy back from the precipice. Yet history suggests that deflating asset bubbles/financial crises generally result in deeper and longer downturns. If 2008 was defined by inflation and volatility, 2009 will be defined by unemployment and financial consolidation for households and business.

A synchronised downturn is already underway. Activity ground to a halt in the UK in Q2 for the first time in sixteen years. Japan and the Eurozone saw outright contractions. An unexpected pick-up in the US in Q2 proved short-lived, as the impetus from tax rebates faded. Even the firebreak separating emerging markets from the slowdown in the industrialised nations appears to have been breached. The sharp decline in commodity prices (oil fell from $147 in June to less than $70 in October) reflects weaker growth prospects for the developing world. So much for de-coupling.

The credit crisis, which ebbed and flowed over the past twelve months, reached new extremes in Q3. Key money markets froze, threatening to curb the supply of credit - the lifeblood of the modern economy. Investors recognised the scale of the threat, prompting a stampede from risky assets. Global equity markets fell by record amounts. In October, the FTSE suffered its biggest weekly fall since 1987 (21%), wiping £170bn from the value of the UK's largest companies.

Thankfully, policymakers are determined to get ahead of events. Coordinated action on liquidity, funding and capital, as well as support for the real economy by means of coordinated rate cuts, have significantly reduced systemic risks. There are tentative signs that money market tensions are starting to ease, although "normalisation" is likely to be a slow process. Inter-bank lending rates, which feed through to the cost of credit for households and firms are edging down, but remain elevated by historic standards.

Falling inflation should give policymakers room for further aggressive rate cuts in 2009. Rates are expected to fall towards the generational lows seen in the aftermath of the 2001 global downturn. Policymakers also have the option to increase public spending or cut taxes. But this is not a one-way bet - more public debt risks pushing up borrowing costs for governments and the wider economy further out.

The outlook is sensitive to the extent and effectiveness of policy, but the real economy will deteriorate further from this point. Rising unemployment and deleveraging (returning credit to more sustainable levels) will dominate events and we expect outright contraction in the UK, US and Eurozone in 2009. Despite the best efforts of policymakers, downturns dominated by falling asset prices and debt reduction tend to be characterised by a deeper and more prolonged period of weakness than normal cyclical slowdowns. Global growth will remain sluggish into 2010 and possibly beyond. (RG)

UK - End of an era
The UK economy ground to a halt over the summer, breaking a 16-year winning streak of continuous growth. The worst isn't over yet. The UK is highly indebted, historically and by international standards. Hence, a combination of falling asset prices and financial sector adjustment is likely to take a heavy toll on activity. Aggressive policy action will play a crucial role in helping to cushion the fall.

The package of measures supporting the financial sector will help prevent the destructive reduction in lending that the UK had been facing, where good quality borrowers could have been starved of credit. Further aggressive interest rate cuts and increased government spending will directly support demand. Nevertheless, the economy is likely to contract by 0.8% in 2009, with weak growth (1.3%) in 2010. It may be 2012 before growth returns to trend (2.5%).

Activity grinds to a halt

Intensifying price pressures, together with more restricted access to credit, are bearing down heavily on domestic demand. Household budgets are under pressure. Wage growth has consistently failed to keep pace with inflation over the past year. Now unemployment has started to rise, reaching 5.7% in September, up from 5.2% in May. Initially this trend was driven by the supply side, as the number of jobs wasn't increasing fast enough to absorb the number of people entering the labour market. But firms are becoming increasingly cautious and have begun to cut back their workforces. The number of people in employment fell by 122K in the three months to August. Given the expected downturn in activity, the unemployment rate could reach 8% (an 11 year high) by the end of 2009.

Wealth is also taking a significant hit. In October, housing and equity markets were 12% and 37% down on the year, wiping more than £500bn from household balance sheets. Given this gloomy backdrop, it's hardly surprising that consumer confidence has plunged to all-time lows and the focus has shifted towards consolidating finances (and lower spending). In 2009, consumer spending is likely to contract in real terms for the first time since 1991. This will mark a sea change in the composition of UK activity (in the year to June consumer spending accounted for more than three quarters of growth).

Businesses are also in a tight spot. Firms are constrained in passing higher input costs on to their cash-strapped customers (industrial input prices were up a massive 25% y/y in September while output prices were up just 8.5%). This is denting businesses' profit margins and their willingness to spend on new plant/equipment. To make matters worse, firms' finances are deteriorating due to balance sheet re-structuring (see box on next page). The PMIs, a key leading indicator of activity, suggest that output in both the manufacturing and service sectors will contract in the months ahead.

Tailwinds not strong enough to stave off recession
Trade is providing much needed support, despite the global slowdown. This is partly a reflection of the competitive level of sterling. The decline against the euro (13%) and dollar (20%) over the past year is helping to offset the impact of weakening demand in developed markets. The move against the dollar is also supporting trade with emerging economies in Asia, which are still growing strongly and link their currencies to the dollar. At the same time, weaker household and business spending is keeping a lid on imports.

Without the lift from trade the UK economy would have contracted by 0.3% in Q2.

Most of the increase in inflation over the past year was the result of rising energy and food prices. With commodity prices now falling sharply, the implication is that inflation will follow suit next year. This will support real purchasing power directly in the same way that rising inflation squeezed it. A more benign inflation outlook will also provide scope to lower interest rates more aggressively, with rates likely to be lowered towards 3% next year.

Nevertheless, this easing will take time to have its effect on activity. Moreover, rate cuts are likely to have a less potent impact than in the past, as credit market conditions remain far from "normal" and businesses and households remain focused on financial consolidation rather than spending. (RG)

Eurozone - From bad to worse
At the start of the year a resilient north (Germany/France) stood in stark contrast to a weakening south (Italy/Spain). This picture has given way to an across the board downturn. The second quarter proved a milestone, but for all the wrong reasons, as the Eurozone contracted for the first time since the introduction of the single currency. The European Central Bank (ECB) has been much more nimble than expected, cutting rates by 50bps in October after hiking them during the summer, but a quick rebound in activity is unlikely. Germany is failing to take up the role of regional growth engine, while smaller economies struggle with bursting asset price bubbles and a lack of competitiveness.

Germany was supposed to come to the rescue - it hasn't
After recording the strongest rate of growth for nearly two years in Q1, it looked as if the German economy was finally achieving self-sustaining forward momentum. The improving labour market offered the promise of domestic demand to come, offsetting the emerging weakness from exports to the rest of the region and the wider world. Over the past two years, employment rose by over one million people to a record high. The unemployment rate fell to a record low. Household balance sheets were in good shape (German households appear to have been saving up forever to buy something nice!) Indeed, we looked for Germany to become the engine of demand for the rest of the region and help countries like Italy and Spain, where domestic demand was already faltering.

But our hopes appear to have been in vain. German domestic demand is not offsetting the slowdown elsewhere. Despite the solid underpinning for the household sector, retail sales have continued the declining trend that has been evident since the start of 2007. Indeed, in real terms, spending is at the same level as it was five years ago. With a recession in the Eurozone's largest economy looking likely, the outlook for the region as a whole is darkening, as many other economies have already gone into reverse.

Structural as well as cyclical issues to resolve
The PMIs for Italy, Spain and Ireland fell below 50 (signalling contraction) around the turn of the year. In July, Dutch manufacturing and the French service sector joined them. Outside Germany, the problems are not just cyclical, suggesting that a quick rebound in activity is unlikely. Some economies have to cope with deflating asset bubbles (especially in the property sector). In Spain and Ireland, a construction boom saw the share of construction in GDP move well above long-term averages and looks extremely high by international standards. Re-deploying these resources from construction to other productive areas of the economy may lead to significant frictional unemployment.

A glance at relative unit labour costs suggests that Italy and Spain face an uncomfortable period of structural adjustment to regain their competitiveness within the region. Productivity growth has been persistently weak in Spain, suggesting more of the adjustment may have to come through wage restraint. It's a similar story in Italy, although the fractious political situation will make structural reforms, which could boost productivity, difficult to agree and implement. Ireland and Spain could raise public spending, given their low levels of public debt. Spain has provided a stimulus, but Ireland has announced an austerity package, raising taxes and limiting public spending growth which threatens to exacerbate the downturn. Many don't have room for manoeuvre - Italy and

Greece already have public debt to GDP ratios of over 100% and sizeable budget deficits.

ECB to the rescue?
Despite inflation running at almost twice the target ceiling, the ECB bit the bullet and lowered Eurozone interest rates by 50bps in October. Further rate cuts are likely, especially since falling commodity prices will drag down inflation through next year. Policymakers remain concerned about a potential wage price spiral emerging, but given the grave risks to growth, these will have to wait for another day. Despite the weakening labour market across the region, wage growth has edged up. The economy is likely to contract in 2009 and growth is likely to be a sluggish (1.2%) in 2010. It's going to be a tough couple of years. (Robbie Denoon)

US - Giving up the ghost?
Despite the economic headwinds of falling house prices, a weakening labour market and high oil prices, the US economy managed to avoid a contraction in the first half of the year. In fact, the economy grew by 2.3% y/y, close to its long-term trend rate.

But this was almost entirely due to a boost from international trade and the fiscal stimulus package.

The slowing world economy and a stronger dollar will reduce the lift from exports, while the fiscal stimulus cheques have largely been spent or saved. What's more, unemployment has risen sharply since the beginning of the year, to 6.1% in September from 4.9% in January. Problems in the financial sector are also diminishing the availability of credit. A contraction in consumer spending, and in the overall economy, is expected in the second half of 2008 and in the first half of 2009 before growth begins to grind higher through 2010.

Weakness becomes pervasive
2001 was an investment recession, this downturn will be more broad-based. The weakness started in the construction sector in 2006 in the wake of the housing slump. By Q2 2008 residential investment was a massive 39% below its peak. With both manufacturing and service sector output contracting, it's hardly surprising that business investment is now retreating. Indeed, the retrenchment is likely to accelerate as spare capacity builds and firms anticipate weaker demand ahead. But the most worrying development is that the weakness has spread to the consumer, which accounts for over 70% of all spending in the economy.

US consumers had, until recently, performed remarkably well under the burden of negative real income growth, rising unemployment and a loss of wealth (via falling asset prices).

Those headwinds are now taking their toll. Retail sales continued to decline in October, falling across almost all major categories, particularly discretionary goodsf.

Forward-looking indicators suggest there is worse to come. In October, consumer confidence fell at the fastest rate since records began 30 years ago. Real consumer spending could decline for three consecutive quarters for the first time since World War II.

Policymakers have taken aggressive measures
The Federal Reserve slashed interest rates at the beginning of the year from 4.75% in January to 2% by April 30th and cut rates again by 50 basis points (to 1.5%) on 8th October as part of a globally coordinated intervention by central banks. Given the weakness in the economy and financial system, a further rate cut of 50 or 25 basis points is possible this year. Either way, rates are likely to remain at historically low levels for a prolonged period.

Efforts are being made to remove troubled assets from the financial system and to help recapitalise banks, which should limit the contraction in credit in the wider economy. Congress approved Treasury Secretary Paulson's proposed $700bn fund to buy mortgagebacked securities and other distressed debt from financial institutions. The Treasury has since announced that it will use part of this fund to directly buy equity stakes in banks in order to improve their capital position. This follows similar moves in the UK. If successful, the plan will gradually help unclog the financial system and allow it to function more smoothly.

Growth is unlikely to return to the pre-credit crisis pattern
These policy actions will take time to have their effect, with growth expected to remain sluggish at 1.5% in 2010 after contracting in 2009. When growth returns it is unlikely to return to the pre-credit-crisis pattern. In recent years household saving fell towards zero for the first time since the Great Depression. Consumers increasingly relied on debt to finance expenditures and on rising asset prices, especially housing, to support their wealth position.

A significant proportion of outlays were spent on imports, resulting in a rise in the trade deficit to an unsustainable 6% of GDP (requiring the US to borrow c$3bn from the rest of the world every working day). In future, growth is likely to be more balanced, relying more on investment and trade and less on household spending. (JS)

Asia - Insulated?

The strict version of the 'de-coupling' hypothesis - the idea that growth in emerging Asia would be unaffected by the slowdown in the rest of the world - is a myth . The region will slow, but the pace of growth will still put the rest of the world to shame.

To some extent, a modest slowdown is welcome, allaying fears of overheating. A continuation of the above-trend growth trajectory of recent years could have ended with spiralling inflation, forcing policymakers to jam on the brakes, triggering a hard landing for growth further out. Encouragingly, the mix of growth is shifting away from exports towards domestic demand, helping to insulate the region from the worst of the global downturn.

But from investors' point of view, Asia is still no safe haven. With risk aversion on the rise, investors have aggressively reduced their exposure to some of the countries that are more reliant on capital inflows (India and Korea), sending domestic asset markets and currencies down. Concerns remain over policymakers' commitment to keeping inflation in check at the expense of short-term growth. Despite the recent drop in oil prices, inflation looks set to stay stubbornly high. Energy subsidies are likely to be scaled back, increasing the costs to end-consumers. Wages are also on the rise due to supply bottlenecks. Inflation as well as growth concerns could yet dent confidence.

China
Chinese GDP growth is likely to fall back into single digit territory in 2008 after 11.9% the previous year. But the projected 9.4% is still robust. With external demand slowing, almost all growth will be due to gains in domestic demand (which was already responsible for 85% of growth in 2007). A continuing correction in the housing market and significant declines in equity prices (the Shanghai Composite Index is down more than 60% since the beginning of the year) are unlikely to dent consumer spending - most households continue to be net savers.

Public finances are also in a robust shape, giving the government scope to turn on the spending taps, if necessary. So far, tamer investment demand seems to be behind much of the slowdown - unsurprising given the steady tightening of credit conditions until the middle of September. Policymakers have temporarily stopped the yuan's appreciation, partly to strengthen competitiveness, but also because inflation fell to 4.9% in August. However, due to supply shortages for labour and raw materials, inflation threats remain, which may prompt policymakers to resume currency appreciation as a deflationary tool.

India
The commodity rally in the first half of the year pushed up inflation sharply, forcing the Indian Central Bank on to a tightening path (a cumulative 125bps increase in rates, to 9%, between May and August). The rupee was also allowed to appreciate to further dampen growth and bring down the cost of imports. But, the economy is now slowing more sharply than expected, while recent commodity price falls are easing inflation concerns. As a result, the central bank has performed an about-turn, cutting rates by 100bps in October.

Increasing risk aversion amongst international investors means that currency appreciation is off the menu - capital outflows have seen the rupee fall 12% against the dollar between mid-August and mid-October. With the public deficit already high, policymakers will not be able to fully offset falling private demand in the run-up to general elections in 2009. Expected growth of 6.8% in the twelve months to March 2009 represents a dip below trend. More rate cuts next year therefore look odds-on.

Japan
While Japan shares the same problems as the rest of the region - slowing growth and rising inflation - the magnitudes are strikingly different. The economy contracted by 0.7% q/q in Q2, driven by weak investment and net exports. With ongoing difficulties in the US and the Eurozone and a stronger yen, net exports are unlikely to lift growth back into positive territory, a feat repeatedly accomplished in the past. But chances of a monetary stimulus are slim. At 2.1% in August, inflation dipped from a decade-high, but the very low level of interest rates (just 0.5%) leaves little room for cuts. All of this points to a technical recession in the second half of 2008 and weak growth through 2009. (RB)

Oil - Past the peak
A lot has happened in energy markets since the last Global Economic Outlook was published in April. Crude oil reached an all-time high of over $147 per barrel in July, but has since fallen back by half to less than $70 per barrel. In October oil prices actually fell annually for the first time since August 2007. Demand reduction in the developed world is the dominant theme. Nevertheless, market conditions remain volatile with daily swings in crude oil prices of 2% or more still common. Geopolitical instability, sharp movements in the dollar, and the hurricane season have provided plenty of impetus for short term momentum.

Demand destruction is the main story
The dominant force in energy markets has been slower demand growth. In fact, consumption has declined in most advanced economies. A combination of slower economic growth and high energy prices has been responsible. In the US, which still accounts for a quarter of global consumption, demand was down more than 5% y/y in October. Demand is still growing in emerging markets, partly because consumers and businesses are insulated from higher prices through subsidies, and partly because economic growth is still holding up. We will see slower demand growth in emerging markets eventually, as the export-orientated industries cool.

Supply is finally responding
At the same time that global demand growth is slowing, there are encouraging signs that new supplies are finally coming online. We have been puzzled for some time by the coexistence of strong investment and flat supply growth. Sharply higher costs that have undermined the real value of investment spending and a shortage of skills and equipment are part of the explanation, as are increasingly complex extraction projects.

Still, we would expect supply to respond to higher prices and this is starting to happen. With prices now moderating, OPEC would ideally like to cut production in order to stabilise prices but that is a difficult task in an environment of falling consumption and revenues.

The dynamics of any cartel suggest that members face an incentive to try to make up part of the revenue shortfall by expanding production. In short, it becomes increasingly difficult for OPEC to coordinate supply as prices fall because the incentives to cheat (that is, keep supply higher than agreed) increase.

The rapid decline in consumption and the prospect of new supplies has altered the underlying demand/supply balance and there are now signs that some excess capacity will emerge in 2009. That has weakened the appeal of crude oil for investors. Low real interest rates, volatile equity markets and a weak dollar made commodities attractive for investors. But a successful investment strategy still needs an underlying tightness of demand and supply. As the balance eases, betting on commodities is less attractive. The dollar's recent comeback also helped.

The challenge: persistent underinvestment
With the credit market turmoil spreading into the real economy, a new equilibrium in the $60-$80 dollar range feels right, but depending on global demand, we cannot rule out further falls. A shortage of investment is the main reason that crude oil prices won't come down to levels seen at the beginning of this decade. The dominance of national oil companies and geopolitical issues dominate supply-side concerns. This view is also justified by a rebalancing global economy. With the rise of emerging markets, global growth has become more energy-intensive.

The recent rally would have been unthinkable without geopolitical tensions and threats of supply disruptions, especially in an environment where spare capacity was non-existent. Thus, any new eruption of conflict could still bring another spike in oil prices. However, the ability of geopolitical crises to impact markets has diminished - a more acute threat to Western Europe's energy security than August's flare-up in the Caucasus is hard to imagine. Yet the conflict failed to drive prices permanently higher. (TF)