De-leveraging is taking its toll on output, and history suggests it has further to run. Over the past ten years, financial deregulation and low interest rates fuelled a rise in leverage which in turn enabled the global economy to enjoy strong, synchronised growth. The credit crunch has thrown that leverage machine into reverse . An examination of the aftermath of previous severe financial crises shows that they tend to have deep and lasting effects on asset prices, output and employment. Rises in unemployment and house price declines have on average lasted five and six years, respectively. By contrast, declines in output average a relatively modest two years. So, even recessions sparked by financial crises eventually end, though almost invariably accompanied by massive increases in government debt.
As trade hits the wall, US job losses are intensifying, as are house price declines. In recent months, trade volumes have shrunk rapidly, reflecting both slowing demand growth and the increased cost of trade finance . This has hit the regions and sectors most dependent on external demand particularly hard and has led to a large rise in inventories. At the same time, the pace of job losses in the US has also accelerated. Reflecting the worsening labour market, US house prices are again falling at a faster rate.
With rates nearing zero, central banks are turning to quantitative easing... In response, policy-makers have been hyper-active . The major central banks have continued cutting policy rates as close to zero as operationally feasible. In the US and the UK, the emphasis has switched to quantitative easing. That is understandable, as the outlook for US growth and inflation suggests that interest rates should be negative. Recent comments from European Central Bank officials have also mentioned the possibility of ‘unconventional policy measures’. Hence, the risks to the euro against both the dollar and sterling are to the downside.
...and governments to fiscal stimulus and further support for the financial system, but markets were not convinced by the US proposals. In addition, the new US administration has passed a second fiscal stimulus package . If half of the tax cuts are spent rather than saved, growth should be boosted by 3.5% (annualised) in its first quarter of operation and by 2.0% the next quarter. After that, the package will support the level of output but not boost growth. So it’s important to the outlook for 2010 onwards that banks become more willing to lend. Unfortunately, the recently announced US Financial Stability Plan was disappointing in both its magnitude and its lack of detail. As a result, it failed to offer a conclusive solution for US banks’ solvency issues.
Bonds - especially highgrade corporates - look set to outperform equities. Although valuation points to positive equity returns over the coming decade – in stark contrast to the -13% return over the past ten years – investors tend to ignore valuation during recessions. So the current good value offers little protection against further equity market weakness in the near term, and we expect bonds to outperform equities over the next few months. We still see scope for government bond yields to fall further as investors come to accept that policy rates will not only fall to zero but also stay there for an extended period. Government bonds may look very fully priced, but they are set to get more so before this is all over. With yields on government bonds and cash now so low and likely to stay that way, high-quality corporate bonds offer an attractive yield pick-up. Within equities, we retain a preference for developed rather than emerging markets, which are more cyclical and, though no longer expensive, are not yet cheap on a relative basis.
