Economic recovery has yet to materialise. What we are witnessing is a slower pace of contraction... Last month’s Update started by highlighting the fact that we had seen some encouraging initial signs that the global economy might be stabilising. Over the past month, press articles and politicians have been trumpeting signs of the 'green shoots of recovery' increasingly loudly. But it is important to keep things in perspective. While several surveys of economic activity have stopped falling or even started to rise, the vast bulk of them remain at levels consistent with the global economy continuing to contract – albeit at a slower pace than at the turn of the year – rather than returning to outright growth.
…which has gone hand in hand with improving credit conditions. In addition, there are signs that the authorities are starting to win their battle to get cheaper - and a greater quantity of - credit flowing to companies and households , via a combination of government and corporate bond purchases, which push down borrowing rates directly, and measures to clean up and recapitalise the global financial system. Credit spreads have narrowed somewhat and loan officers’ surveys show that slightly fewer banks are tightening credit standards in the US and Europe. In the UK, the availability of lending to households is declining less quickly, while lending to companies is expanding. ,
Together, they make for a much more promising picture than a few months ago. Of course, a recovery has to start somewhere, and even our relatively gloomy forecasts assume that the economy’s rate of contraction will slow markedly over the coming quarters . The recent improvement in activity surveys and credit conditions increases our confidence in this view and decreases the tail risk that we are in the early stages of a depression rather than in the midst of a long recession.
Short-term deflation pressures may give way to concerns about inflation further out. Annual inflation rates in the US and the UK have now turned negative for the first time since the 1950s. With global excess capacity at an elevated level, inflation will move further into negative territory in 2010, boosting households' real incomes. But, in the UK, wages are also falling, blunting the impact of declining prices and raising the spectre of debt deflation. At the same time, some warning signs are emerging of inflation over the longer term - a development that has not escaped the attention of the index-linked bond market . Broad money is currently growing at close to the levels that precipitated accelerating inflation in the 1970s. As yet, though, with banks keen to shrink their balance sheets, credit growth – a critical ingredient of longer-term inflation pressure – has been missing this time around. Nevertheless, we can’t help feeling nervous about the longer-term outlook for inflation.
US banks' stress tests should provide some insight into the current state of the banking system and, hence, the outlook for equities. Growth-sensitive assets, be they equities, cyclical sectors, emerging markets, commodities or corporate bonds, have enjoyed a powerful rally since early March. With sentiment now looking dangerously bullish and talk of 'green shoots of recovery' rife, equity markets may struggle to break above their long-term moving averages, which continue to indicate that this remains a bear market rally. Yet plenty of major players have yet to re-enter the market, suggesting that, for the time being, the rally still has legs. Critical to it being sustained, and perhaps even becoming the foundation of a new bull market, will be further signs that the economy is starting to turn a corner and that the financial system is on the road to recovery. Consequently, we await the results of the US banks’ stress tests on 4th May with considerable interest. After all, a well-capitalised and functioning banking system is a prerequisite for an enduring recovery in both the economy and risk assets.
