Green shoots?

Global macro outlook

Professor Andrew Clare – June 2009

2

Overview

Green Shoots

But now for the bad news

And what about the UK ?

Our G4 forecasts

Green shoots ?

4

Sharpest global recession on record – global growth hardly ever turns negative

Surprisingly, worse so far in EA than in US or UK – Japan worst hit of all developed economies.

Sharp slowdown in inflation too, as commodity prices and interest rates fall

Japan and US in deflation already, EA heading that way.

UK will probably avoid deflation on headline measure, thanks to sterling

Synchronised global recession

5

A very sharp recession in the US

Industrial production much worse than average recession and still fallingUnemployment worse than average recession and still rising

6

Survey says: “the worst is over”

PMI survey data suggest the worst is over – in a “second-derivative” sense at least: the rate at which activity is contracting has slowedSimilar picture across manufacturing and servicesInventory cycle is likely to cause a bounce back in GDP growth in coming quarters

7

Commodity prices up

Commodity prices have bounced International freight costs have also recovered and are back to the levels seen in the early 2000sMuch of this bounce is related to China

8

Credit conditions have eased

Interbank spreads are down to almost pre-crisis levels – close to their average of the late 90sCorporate bond spreads have also narrowed, but remain elevated – particularly in the UK, and particularly for lower-grade bonds

9

The equity markets are back to the races

Equity market have bounced at the sight of all the green shoots

But now for the bad news

11

Are we really past the worst?

For several quarters now we have argued that resolving the financial crisis almost certainly begins with a resolution of the crisis in global housing markets.By contrast, consensus seems to be moving towards a view that the global economy could recover, even as house prices fall and unemployment rises, echoing the UK experience of the early 1990s, but on a global scale.We feel this is too sanguine a view. Headwinds remain very strong.

Real annual percentage changes

House prices

Average 2000-06 Latest quarter

Source: OECD

US JP GE FR IT UK CA OZ FI IR NL NZ SP SW

-15.0

-12.5

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

Ratios, relative to long-run average

House prices

Price-to-rent ratio Price-to-income ratio

Source: OECD

US JP GE FR IT UK CA OZ FI IR NL NZ SP SW

-40

-20

0

20

40

60

80

12

Bad news: US

Employment in the US is still collapsing – in spite of ‘better-than-expected’ payrolls dataThe ‘improvement’ in payrolls means “not falling as fast”Falls have to slow down and eventually stop. But that is not a recovery...

13

More US bad news

Housing market is still in freefallConsumer confidence uptick is based on expectations – present situation is close to historic lowCEOs do not share consumers’ confidence – balance is at an all-time low

14

EA bad news

Retail sales and industrial production tankingCapacity utilisation disastrously lowWe should not look to EA business to pull the world out of recession...

And what about the UK ?

16

The Agents’ survey looks bleak

BoE business surveys much more negative about prospects for investment-led recovery than PMI dataAnd the LCCI’s Business Price Index (constructed by Fathom) confirms this – business costs growing by 5.1% pa

17

Our housing troubles are not over

Household debt is unsustainably high relative to incomeHouse prices have another 20% to fall (though when is uncertain...)Mortgage approvals are extremely low

18

And… the UK fiscal position

Beyond 2009/10, the threat to growth in the UK comes from the massive deterioration in the government financesImplies a mixture of low growth and potentially high inflation

That is reflected in the value of sterlingThe UK government debt to GDP ratio is set to more than double over the next few years, probably pushing through 100%That kind of deterioration has, in the past, been associated with tolerance of higher inflation, which helps the government by inflating away the real value of its debtIn our view, there is a serious risk in the UK, and perhaps also in the US, that after the current period of low inflation or even deflation, we will see the inflation genie let out of the bottle once again...

19

Structural issues

UK fiscal position is terrible: 9.8pp of the 12% of GDP deficit is apparently structural. A structural deficit worth 10% of GDP implies that we need a fiscal tightening of that magnitude just to STABILISE government debt as a share of GDPTo bring it back to where it was when Labour took office would require the same magnitude of fiscal tightening again. The impact on growth of such a tightening would be huge – looking at a decade or more of growth around 1% at best – Japan style. The alternative is inflation.

Per cent of potential GDP

Structural deficits 2009

Source: Reuters EcoWin / Fathom / OECD / HMT

Germany UK Italy Japan US-10

-9

-8

-7

-6

-5

-4

-3

-2

-1

0

20

HMT forecast for debt-servicing costs is very benignWe apply three different scenarios to the interest rate charged on government debt.The ‘worst-case’ only takes rates back to their 1997 levels, when net debt-GDP was less than half its projected rate.

Rising interest

21

Are our debt levels sustainable ?

What would need to happen (or not happen) in order for the UK’s debt position to move onto an explosive path?

A longer recession than HMT forecastA slightly lower trend growth rateThe ‘worst-case’ interest rate scenarioNo further fiscal tightening than in the Budget

Implication – without a huge further fiscal tightening (IFS estimates), either inflation rises dramatically or government debt explodes

0

2

4

6

8

10

12

2009 2010 2011 2012 2013 2014 2015 2016 2017

% paCPI inflation profiles

HMT

Fathom - no further tightening

22

What’s the best way to cut public spending ?

Your guess is as good as mine!

5,000

5,250

5,500

5,750

6,000

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Pub

lic s

ecto

r em

ploy

men

t, 00

0s

Source: Fathom Chartbook Service

Public sector employment

Our G4 Forecasts

24

The scenariosScenario one: “Consensus” (50% probability) Taken from a combination of economists’ forecasts and market pricing.

Embodies a deep, yet relatively short-lived global recession. Positive growth across the G4 resumes towards the end of this year. US suffers a brief period of deflation; JP suffers for longer. EA inflation hits zero in 09 Q3; UK escapes deflation on the CPI measure, but only just. Policy remains exceptionally loose for some time, with tentative rate rises priced in for the US and the UK around the turn of the year.

Scenario two: “70s revisited” (25% probability) The drying up of credit markets has lowered trend growth across the G4.

UK worst affected, then US, EA, JP. Policy ‘works’ in that nominal demand recovers but this comes through as higher inflation and higher inflation expectations. Aggressive tightening takes place starting next year risking a second recession.

Scenario three: “30s revisited” (25% probability) Again, trend growth is lower across the G4, just as in the 70s scenario. The

distinction this time is that policy ‘fails’ and inflation expectations do not rise. Inflation expectations fall as debt-deflation takes hold.

GDP summary

25

Annual percentage changes

Euro Area GDP growth

Source: Fathom / Reuters EcoWin

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1

06 07 08 09 10 11

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

Annual percentage changes

US GDP growth

Source: Fathom / Reuters EcoWin

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1

06 07 08 09 10 11

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

Annual percentage changes

Japan GDP growth

Source: Fathom / Reuters EcoWin

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1

06 07 08 09 10 11

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

Annual percentage changes

UK GDP growth

Source: Fathom / Reuters EcoWin

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1

06 07 08 09 10 11

-8.0

-6.0

-4.0

-2.0

0.0

2.0

4.0

Inflation summary

26

Annual percentage changes

US inflation

Source: Fathom / Reuters EcoWin

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1

06 07 08 09 10 11

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Annual percentage changes

Euro Area inflation

Source: Fathom / Reuters EcoWin

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1

06 07 08 09 10 11

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Annual percentage changes

Japan inflation

Source: Fathom / Reuters EcoWin

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1

06 07 08 09 10 11

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Annual percentage changes

UK inflation

Source: Fathom / Reuters EcoWin

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1

06 07 08 09 10 11

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

27

Forecast summary

The ‘means of means’ mean that Japan will win the race to the bottom this year, followed by the UK. G4-weighted growth falls by more than 3%.Divergent inflation trends as oil prices push the US into deflation, but absence of housing costs in CPI keep UK and EA above the zero line.2010 is a different story: inflation dominates. But this does not represent much growth optimism. UK expected to contract, despite highest inflation forecast.

Per cent

Means of distributions for 2009

GDP Inflation

Source: Reuters EcoWin / Fathom

US EA JP UK G4

-6

-5

-4

-3

-2

-1

0

1

2

Per cent

Means of distributions for 2010

GDP Inflation

Source: Reuters EcoWin / Fathom

US EA JP UK G4

-0.25

0.00

0.25

0.50

0.75

1.00

1.25

1.50

1.75

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Summary: History repeats itself “What we are seeing is the return of that vital ingredient - confidence. The green shoots of economic

spring are appearing once again.”

Norman Lamont said that in October 1991. Widely ridiculed ever since, but in a sense he was right – growth was flat for the first half of 1992, and positive after that.

But the amount of slack in the economy did not reach its peak until a year later, and unemployment followed suit.

Very similar conjuncture now. Confidence does appear to have turned up, along with equity prices, and some official data have followed. But:

GDP has not stopped falling yetUnemployment has a long way to goCredit conditions have eased but remain tightHouse prices have a long way still to fall in the UKFiscal position is terrible (US, UK, JP) and will be a long-term drag on growth

Will the green shoots survive a frost?

Thank you