The case for optimism: Three reasons why global GDP growth will accelerate in 2010

By: Eric Chaney

End of 2009 business cycle and market indicators were not as bullish as they were in the first phase of the global recovery, which, tracked by the global trade of manufactured products, started in June. Various signs of a global slowdown have recently appeared in business surveys, from China (PMI) to the US (see our Surprise Gap built from the ISM survey) and Germany (industrial production). Global stock markets have moved sideways since the end of October, as uncertainties about the continuation of the recovery grew. In addition, the announced restructuring of Dubai World’s debt, the downgrade of Greece and the bailout of an Austrian bank have raised the markets’ awareness that, in a still deflationist world, debts do not vanish in thin air, they just move from hands to hands, like hot potatoes.

 

 

 

US Surprise Gap: from acceleration to more stable growth

Source : US ISM survey, AXA IM Research

Against this backdrop, it is natural that the risk of a double-dip catches the attention of decision makers in the corporate world. However, I believe that these concerns are overblown, at least in the short to medium term.

 

There are three reasons for my non consensual optimism:

 

1. The global inventory cycle will prove more powerful than generally assumed.

What happened after Lehman’s bankruptcy still matters for what is going on today. My working assumption is that most goods producing companies in the world liquidated inventories to cut production, not because final demand was collapsing, but because they feared a full blown credit crunch and decided to heap up as much cash as possible as an life insurance policy. The fear of a generalised liquidity crunch, rather than its reality, was at the core of the global recession. Since central banks have conjured away this fear, companies need to replenish their inventories even if the recovery in final demand is sluggish. For what it is worth --this is the first global recession of the modern globalisation age-- historical evidence suggests that the positive leg of the inventory cycle could add as much as 2 percentage points to global growth over the period spanning from mid 2009 to mid 2010.

 

The global inventory cycle may add up to 2 pp to GDP growth in 2010

Source : US, Euro area and Japan Quarterly National Accounts, AXA IM Research

 

2. The global effect of fiscal stimulus is most probably underestimated

According to the IMF, the fiscal stimulus plans decided in early 2009 and progressively implemented across the world amount to roughly 2% of the combined GDP of the G20. The consensus view among professional economists and modellers is that the fiscal multiplier is at best 1, i.e. 1 dollar of stimulus increases output (temporarily) by no more than 1 dollar. Two factors are often evoked to explain why multipliers are relatively low: import substitution reduces the impact of government spending, and households may save tax cuts instead of spending the fiscal mana or, in case of increased government spending, may save in anticipation of higher taxes in the future. With a global fiscal stimulus, the first offsetting factor does not hold, since we do not trade with other planets. As regards to the second limitation, saving behaviour, a growing body of academic work shows that things may be different when the central bank does not (or cannot) react to a fiscal stimulus. This is clearly the case when it cannot cut short term interest rates as much as would be necessary, because of the zero bound for interest rates. Lawrence Christiano of Northwestern University or Robert Hall of Stanford University estimate that, in these conditions, the fiscal multiplier might be as large as 1.7, up to 2. Given the relatively long time lags (4 to 6 quarters) associated with fiscal policy changes, it is fair to assume that most of this enhanced fiscal booster should show up in GDP growth in the course of 2010.

 

The fiscal multiplier may be higher when monetary policy is stuck at the zero bound

Source : AXA IM Research, inspired by Christiano and alii, NBER Working Paper 15394

 

3. In the short term, the price of crude oil is likely to decline

Although the spot price of crude oil is more and more driven by bullish long term expectations and a very cheap cost of carry due to lax monetary policies, oil markets cannot totally ignore the balance of supply and demand. The current picture is that of an oil glut on the supply side and declining needs on the demand side. Since the price of oil is the ‘fair price’ of the extra barrel delivered to the market, what matters is the behaviour of the marginal supplier and the marginal consumer. As for the former, OPEC increased crude output by 140mb/d in 3Q vs. 2Q (according to OPEC), while Nopecs boosted production even more. As for the marginal consumer, Chinese apparent oil demand exceeded all expectations in September. Yet the ongoing slowdown engineered by Beijing authorities should trim the quarterly GDP growth rate from 10% (annualized) in 3Q to around 5% in 4Q/1Q 2010 (this would still be consistent with respectively 10% and 7% year-on-year rates) and thus should significantly reduce oil demand. If gasoline and heating fuel prices ease, as I expect, this would be good news for the global recovery, since it would boost consumers’ purchasing power in the US and Europe, where job creation is still choked.

 

The longer term assessment is more uncertain. To become sustainable, the global recovery will have to start walking on its own legs, as policy crutches are either removed (monetary policy) or crumble under their own weight (fiscal policies). My conviction is that, in its second stage, the global recovery will be driven by government spending on infrastructures, the supply and distribution of energy being the most important spending item, and by private companies’ capital expenditure, as new lines of products emerge from the crisis and competition becomes, again, the main driver of corporate decisions, in contrast with the ‘survival behaviour’ that prevailed during the crisis. On the other hand, consumer spending is likely to be the junior partner in this cycle, with US consumers constrained by the imperious need to rebuild their depleted savings, and Chinese consumers not yet able to take over from their US or European counterparts, even if Chinese authorities deliver on their goal to stimulate domestic demand.

 

Three headwinds will test the global economy during the transition from a policy-fuelled recovery to sustainable growth.

 

Headwind #1. The credit crunch. It is still biting, as traditional financing channels remain partially clogged, especially intermediated credit. Central banks have no other choice than keeping nominal rates at zero and managing their inflated balanced sheets until money multipliers start recovering. In this regard, the recent contraction of money supply in the euro area (M3 down 1.7% in November 2009, on a quarterly annualised basis) is worrying;

 

Headwind #2. Uncertainties about monetary and fiscal exit strategies, and a possible lack of international coordination. Note that coordination does not mean synchronisation. In my view, the first best would be the Fed exiting before the ECB, because intermediation is more critical for the real economy in the euro area than in the US. Unfortunately, the opposite seems more likely;

 

Headwind #3. A possible negative feedback on credit supply from hardened banking and insurance regulation (capital requirements, leverage ratios). Note that, even if regulators give time to banks to adjust their capital structure, the impact on credit supply may come quickly, as a result of competition between companies.

 

At this juncture, I am tempted to give the benefit of the doubt to policy makers, since they have, so far, done the right things to fend off the worst possible outcome of the financial crisis, i.e. another Great Depression with unpredictable social and political consequences. Once short term uncertainties dissipate and with abundant liquidity in the system, equity markets might well resume their upward trend.

 

Eric Chaney is Chief economist of the AXA Group

---