Global economic recovery likely to begin in H2

Global economic recovery will begin in the second half of the year and gather steam in 2010, according to research released separately by the International Monetary Fund and Bank of America Merrill Lynch yesterday.

The swine flu outbreak in Mexico and other nations could prove to be the only fly in the ointment. "If the outbreak turns into a pandemic, this could cause another dip in global economic activity, offsetting the forces that are currently slowing the global downturn and should, in due course, pull us out of recession," BofA-ML Economist Riccardo Barbieri warned in the bank's Global Economic Weekly.

"However, the effect would be temporary, and we are encouraged by the view expressed by epidemiologists that the flu strain is not particularly virulent, though it may mutate adversely as it spreads among humans."

Masood Ahmed, Director of the IMF's Middle East and Central Asia Department, said he expects the world economy to contract in 2009 by around 1.25 per cent before recovering gradually in 2010.

Financial markets remain highly stressed and emerging economies face dramatic drops in capital inflows, demand for their exports, and commodity prices, he said yesterday. "A third wave of the global financial crisis is hitting the world's poorest and most vulnerable countries."

Turning around global growth depends on concerted policy actions to stabilise financial conditions, as well as sustained strong policy support to bolster demand, the IMF said.

The latest data releases from around the world have brought further evidence that consumer and business confidence is improving, although from extremely depressed levels.

Signs that the pace of contraction in the economy is slowing are also becoming increasingly evident, as positive data on Japan's industrial production and UK retail sales flows in.

"The improvement seen thus far in the economic data is still a feeble one, which is why the swine flu outbreak is a potential threat. Furthermore, while consumer confidence is an important leading indicator, the timing of the recent rise was highly correlated with the equity markets, and spending has not yet picked up as much as confidence (in fact, in the US it decreased over the course of Q1 after an initial spike in January)," Barbieri said. "Thus, there is always the risk of a relapse."

The economist expects a slow recovery in H2 and "more meaningful gains" in 2010. "We believe that the global real GDP will experience a further contraction in the current quarter, but at a slower pace than in Q1. For the G3, for instance, we estimate that the contraction worsened slightly from -7.0 per cent at an annual rate in Q4 to -7.1 per cent in Q1, but will then decelerate to -3.3 per cent in the current quarter.

"On our current estimates, the G3 economy would eke out a decent increase in Q3 (2.4 per cent) and a slightly better one in Q4 (2.5 per cent)," he said.

Agreeing that equity markets and consumer confidence may be stabilising, albeit at very low levels, the IMF, on the other hand, believes that systemic risks remain elevated "despite forceful policy efforts".

Contraction moderating

Although GDP is still falling across the globe and unemployment is rising, the pace of contraction in economic activity is showing "tentative signs of moderating", Ahmed said.

Barbieri said he expects recovery to stem from the massive fiscal and monetary policy stimulus measures adopted by most nations' central banks and from the inventory cycle. "Data for the G3 economies, for instance, show that final demand collapsed in the second half of last year, while (unwanted) stock-building initially provided some support, as firms were surprised by the sudden stop in final demand.

"In the first quarter of this year, the contraction in final domestic sales became slightly less severe. In the US, private consumption actually rose modestly, while investment continued to drop.

"Companies, however, strived to cut their inventories, and output thus fell more than final demand. This process of de-stocking will probably continue to some extent in Q2, but by the third quarter companies should be able to re-align production with demand. Stock-building will probably add to growth in the second half of the year," he said.

The improvement in consumer confidence in April, both in Europe and in the US, suggests that consumer spending could increase moderately in coming months, BofA-ML said.

Investment spending is likely to remain low throughout the second half of the year, but could pick up in 2010, allowing the global recovery to gain momentum, its report said.

The average growth rate of the global economy in 1990-2008 was 3.4 per cent. "Coming from a contraction that our team now puts at -0.7 per cent in 2009, the 3.3 per cent growth we are currently estimating for 2010 would not be particularly high, though it is a lot more optimistic than the 1.9 per cent growth predicted by the IMF," he said.

On the monetary front, the extent of unconventional policies and the growth in the monetary base is unprecedented, particularly in the US, BofA-ML said. "Monetary conditions, however, are not as loose as in previous phases due to exchange rate movements. If we consider the euro area, for instance, the monetary conditions index computed by the European Commission [and updated to April with our own estimates] shows that conditions have become more stimulatory, but are nowhere near the level at the beginning of this decade," it said.

According to the IMF, recovery in 2010 is predicated on several factors: concerted policy actions to stabilise financial conditions; strong macroeconomic policy support to bolster demand; a gradual improvement in credit conditions; and the cushioning effect from sharply lower oil and commodity prices. "Nonetheless, output gaps will continue to widen through 2010, implying rising unemployment," Ahmed said.

Gloomily projecting that "risks for the world economic outlook are to the downside", the IMF said deflation risks could reinforce a deeper and longer downturn. Other risks include a rising threat of corporate defaults in emerging economies, trade and financial protectionism, and sovereign fiscal sustainability concerns.

Fed purchases

BofA-ML expects Fed purchases of Treasurys will double to $600bn (Dh2.2trn) in coming months and that the program will be completed by year-end. The Fed will then hold its balance sheet at a high level for some time and then start winding it down in 2010-11.

The bank's US Economist Drew Matus expects the Fed balance sheet to reach as much as $4.5 trillion (from $2.1trn currently) and the first Fed funds rate hike to take place no earlier than 2011.

"Considering the exit strategy, a recent speech by Don Kohn suggests that the Fed sees the natural unwinding of some of its special financing facilities such as the TAF as the first step in reducing its balance sheet.

"In addition, it plans to rely on Treasury issuance of short-dated bills and, if congressional approval is granted, issuance of central bank paper as the key tools to drive down the monetary base without 'dumping' Treasurys, agencies and other securities acquired as a result of 'credit easing' on to the market," Barbieri said.

The bank's European team expects that the European Central Bank will make its first rate hike no earlier than Q2 of next year.

"We would expect the exit strategy of the ECB to go through the following phases. First, accommodating a natural decline in the allotment of refinancing operations, as the value of ABS, MBS, securitisations and bank bonds rises and banks no longer wish to pay the haircut required by the ECB.

"Second, moving from providing unlimited liquidity in the Long-Term Refinancing Operations (LTROs) to fixed amounts. Third, shortening the maturity of LTROs while mopping up any additional excess liquidity via fine-tuning operations. Issuance of ECBB debt may also be considered. Fourth, moving to variable-rate LTROs. Fifth, hiking the reference rate," BofA-ML said.

"Given that the ECB is likely to announce a one-year fixed-rate operation next week, and given that there may be concerns on year-end effects, the scenario currently entertained at the ECB must be that the reversal of unconventional policies will be a gradual process and will only gain momentum in early 2010."

In a nutshell, BofA-ML economists believe that the rate-cutting process is almost complete in advanced economies but still has some way to go in the emerging markets. Unconventional policies will stay in place for at least a year, but possibly a lot longer than that, they said.

Inflation risk

The sharp rise in unemployment in the US and to a lesser extent in Europe and other parts of the world, China included, and the drop in capacity utilisation rates suggest that near-term inflation risks are extremely low, Barbieri said.

"Things look different for the medium and long term – say on a three-year or longer view. Indeed, the key risks seems to be that the extraordinary degree of monetary accommodation will ultimately boost growth in the emerging markets and this will put significant upward pressure on commodity prices, and oil in particular.

"This could present the advanced economies with the unpalatable scenario of slow growth and rising inflation and complicate the task for central banks. On a short- to medium-term view, it seems to us that the most likely effect of monetary accommodation will be to boost asset prices, notably the equity and credit markets – which is indeed one of the goals if not the key goal, of quantitative easing," he said.

In the longer term, the crisis will cause debt hangover, and probably inflation. "The fiscal story is the most worrying side of the current crisis. Budget deficits are set to rise to record levels this year, especially in the US. Even assuming that banking bailouts will have a smaller impact on budgets in 2011, deficits will remain extremely high and, with sub-par growth, government debt ratios will likely rise to over 100 per cent of GDP in most advanced economies within the next three years," Barbieri said.

In the near term, the key reasons for the rise in debt/GDP ratios are that primary fiscal balances have worsened dramatically and governments have taken on board large actual (and contingent) liabilities from the banking sector.

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