Growth, but not as we know it

‘Green shoots of recovery’ are the buzzwords of the moment - and for good reason - given the improvements in forward-looking indicators of growth, particularly in manufacturing and consumer surveys, and the slowing pace of job losses in the US and the UK. So widespread are the improvements that our long-standing forecast, that growth will return to the UK early next year on the heels of a US recovery in the third quarter of this year, may prove to have been too pessimistic. In fact, with policies increasingly gaining traction, the upturn could well start late this summer on both sides of the Atlantic.

But a return to growth is one thing; a resumption of normal service is quite another.

Because of the heavy fallout from the credit crisis, this has been an unusually long and severe economic downturn, and the aftershocks will reverberate for some time. When growth eventually comes, it is set to be distinctly anaemic, at least for developed economies. UK GDP in 2010 is likely to fall far short of growth in the recent boom, with both our forecast of 1.0% and the consensus of 0.8% meagre in comparison with the recent trend rate of 2.7%.

One of the reasons for a sub-par recovery is that governments, faced with yawning budget deficits built up during the recession, will need to take back their stimulus and embark on fiscal tightening through spending cuts and tax rises. Muted growth in bank lending, as the sector takes time to recuperate, will also subdue momentum. So too will greater regulation and state planning of the economy, and the growing trend for consumers to save rather than shop as they rebuild their overstretched balance sheets in the face of stagnating wage growth and rising joblessness.

Also casting a shadow over the economic outlook is the steep rise in bond yields over recent months (see graph below). This rise has been caused by improving data, government indebtedness and concerns that inflation could reignite in the medium term as credit growth accelerates, particularly if quantitative easing (QE) is not skilfully reversed. In the absence of a fully functioning monetary transmission mechanism, QE (or printing money) was introduced in order to lower mortgage rates for households and borrowing rates for companies. After initial success, these policies have faltered more recently, with US Treasury ten-year bond yields doubling and pushing mortgage rates back up. Should yields become particularly elevated, the markets will be at risk of treading the green shoots of recovery underfoot.

The rise in bond yields has had a number of drivers. In the UK, the ten-year gilt yield jumped from a low of 2.9% in March to a peak of 4% in June in response to rallying equity markets and the improved economic outlook. Another reason was that investors shifted the focus of their concerns from deflation to inflation, as well as worries about the level of bond issuance needed to fund mammoth budget deficits.

In May, ratings agency Standard & Poor’s announced that it had put a negative outlook watch on the UK’s sovereign debt triple-A rating (the highest possible) in acknowledgement of this last point. That spooked US markets, amid anxiety that the same could happen there. Against this backdrop, government bonds do not look cheap at current levels – although, given our belief in a sub-par economic recovery, they do not appear particularly expensive either.
 
In fact, at this stage of the economic cycle – with the economy improving gradually – we expect higher potential returns from riskier assets, such as equities, corporate bonds and commodities. In particular, they should outperform cash, as interest rates are set to stay low for a considerable period.

That said, with markets remaining volatile, broad diversification of assets remains as crucial as ever. Within bond markets, we see the best opportunities in credit, namely investment-grade and high-yield, where spreads appear to have further to fall and yields look attractive. Within government bonds, the rising inflation concerns sparked by QE suggest that inflation-linked bonds may outperform their conventional counterparts.

Excess capacity in the economy may be stifling price pressures at present, but inflation risks are likely to grow in the medium term – particularly if the need to finance fiscal deficits leads to political pressure being applied to central banks to keep printing money, in order to buy newly issued debt.

This article expresses Coutts views as of 5 August 2009.

Carl Astorri, Global Head of Economics and Asset Strategy.