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Thursday, March 28, 2024

AND NOW FOR THE HARD PART….

MUST READ: AND NOW FOR THE HARD PART….

Courtesy of The Pragmatic Capitalist

I’ve spent a lot of time here talking about the major differences between the current recession and the types of recessions that most investors have grown accustomed to.  This literally isn’t your father’s recession.  Unfortunately, many are making the mistake of applying recent recessionary data to come to the conclusions that we’re going to experience a ‘82, ‘91 or ‘02 type of recovery.  I believe they are sorely mistaken.  There is no doubt that we averted a serious crisis last fall, but that doesn’t mean we are out of the woods.  I have often noted that there is a huge difference between real recovery and the deceleration in economic declines.  This means the the hardest part of the cycle  is likely ahead of us.  As we’ve said before, this is a two part credit crisis.

In a recent research report HSBC notes:

The progress seen so far could yet prove to be the easiest part of the recovery…with a number of formidable, structural challenges awaiting on the horizon.

However, financial markets, we suspect, may be about to find out that it’s often better to travel than arrive. Despite all the developments of the past year, we believe that the most formidable challenges may lie ahead, and that the more demanding questions are yet to be answered. It now seems likely that the worst outcomes which threatened last autumn have been averted, but it’s far from certain that a solid, durable recovery will emerge over the coming twelve months or, when abstracting from the cycle entirely, just what economic underpinnings remain.

Among the greenest of the green shoots has been China’s sharp rebound in recent months.  HSBC, however, is skeptical of China’s positive impact and believes the optimism is a bit overdone:

At first glance, the sharp rebound in China’s fixed investment (up 34% year-on-year in May) certainly sits oddly with the continued collapse in imports (down 25% over the same period), but the steep decline in import values is at least partly explained by commodity prices, which are still much lower than a year ago. China’s import volumes of iron ore and oil are, in fact, among the few that have shown any significant revival recently and the ongoing infrastructure investment suggests this is set to continue, bringing obvious benefits to its main suppliers of these products: India, Russia, Australia, Brazil, South Africa and the Middle East. Other areas of high government spending such as energy conservation should also prompt greater imports of specialist machinery and equipment and new technology, providing some benefits to the likes of Japan, Germany and the US (see Riding on China’s recovery by Qu Hongbin, 27 May 2009). But any support from China will likely prove only a modest positive when placed against the weakness of investment spending in the excess capacity-ridden developed world.

To put the numbers in into context: for every 1% point rise in the US household savings rate, China’s consumer spending growth would have to accelerate by nearly 7% points to compensate.

chncon, china consumer spending

They go on to note that China’s rebound is actually contributing to the price increases we’re experiencing in most major commodity markets.  David Rosenberg noted last week that consumers are suffering from debilitating wage deflation. The rising commodity prices are compounding the problems:

In all of the major economies energy is detracting significantly from the annual change in consumer prices and will continue to do so over the next few months. But with oil prices having risen steadily since the start of the year, the consumer price index is drifting up again, suggesting the boost to quarterly real wages is now over. Indeed, assuming oil prices remain at current levels, energy will be detracting from the quarterly change in real wages as early as Q3 (chart 9).

realwags, income, energy prices, wages

Higher oil prices could also raise inflation expectations, as in H1 2008 when they rose to such a degree that it prompted the ECB to raise rates in July 2008. A repeat of this appears highly unlikely given the degree of slack in the economy and the much lower potential for a wage response.  Wage growth in the US and UK has already slowed sharply and although nominal wage growth in the Eurozone has recently held up fairly well, this is primarily a consequence of the delayed labour market adjustment in the major economies which we expect to come through later this year. In Eurozone countries where employment and consumer spending have already fallen sharply – notably Spain and Ireland – so has core inflation.

The same point applies to the developed world generally given that the unemployment rate is now higher than the peak during the early 1990s recession (chart 11). Looking at capacity more broadly, the global output gap, which we expect to exceed 4% of global GDP by the end of 2009, also suggests that the cyclical position of the global economy is not conducive to generating inflationary pressures (chart 12). Judging by their recent communications, this view is also shared by the major central banks, for whom the prospect of rising structural unemployment and a perhaps prolonged reallocation of resources across their respective economies will represent substantial analytical challenges.

capac, spare capacity, broad economy

A recent McKinsey report comes to similar conclusions.  U.S. consumers are wilting under the pressures of deflating  wages, job losses and debt (of course, American’s aren’t the only ones deleveraging).

US consumers have responded to the global economic crisis by curtailing their expenditures, paying down debt, and saving more—all logical responses to a recession. Yet most consumers have acted by choice, not necessity, according to McKinsey. Spending, saving, and debt averages are not at abnormal levels today but rather returning to long-term trends.

It was the behavior of US consumers during the past two decades, our research shows, that was the aberration. The return to traditional spending patterns will cause companies to adjust to a fundamentally altered playing field.

In a McKinsey survey conducted in March 2009, 90 percent of the US respondents said that their households had reduced spending as a result of the recession—33 percent of them “significantly” so. The survey, which included 600 households in three consumer segments comprising around 40 percent of all US homes, found that 45 percent of those who reduced spending did so by necessity, 55 percent by choice.

HSBC attributes the rapid deleveraging to three key factors:

These key issues, therefore, cannot be ignored, particularly as the degree of adjustment in the US household sector over the past year has actually been fairly quick, with the savings rate having risen to 6.9%, back towards its average of the last 50 years. The UK household savings ratio has risen moderately, while even Spain has seen a marked turnaround in the household financial balance. The unusually rapid pace of this deleveraging reflects three key factors:

1.  The exceptional contraction in credit in late 2008 and early 2009. Flow of funds data for both the US and UK showed a net fall in new lending in Q4 for first time since these series began (see chart 15). Demand for credit will have played a role in this given the collapse in confidence post-Lehman which is borne out by the bank lending surveys. However, many households will have had no choice but to curtail their borrowing.
2. The dramatic reduction in interest rates has lowered the interest burden sharply, particularly in the UK, allowing households to pay down significant amounts of debt merely by keeping monthly payments unchanged.

hholdcred

3.  The boost to real incomes from the fall in oil prices meant households were able to pay down debt without curtailing spending too dramatically.

household_debt_1

In order to try to understand the size, scope and duration of these problems it’s useful to look back at Japan’s deleveraging cycle.  We’ve noted that the crisis in the U.S. appears to be very similar, though occurring at mach speed.  Nonetheless, this doesn’t mean we’re near the end of the current crisis and likely still have years of economic difficulties ahead.

After Japan’s bubbles burst, private non-financial companies undertook a decade-long de-leveraging, reducing their collective debt-to-GDP ratio from 125% in 1991 to 95% in 2001. Firms massively reduced their spending on investment, shifting their financial balance from deficit to a large and growing surplus.  There are clearly differences, which we have discussed in the past, but if US households were to undertake a similar de-leveraging, their debt-to income ratio would need to drop to around 100% over the next 10 years. That would return it to the level that prevailed in 2002. The FRBSF estimates2 that the household saving rate would need to rise to 10% by the end of 2018 and that a rise in the saving rate of this magnitude would subtract about three-quarters of a percentage point from annual consumption growth each year, relative to a baseline scenario in which the saving rate did not change.

japvsusa, Japan vs. USA

Despite recent progress and chatter of green shoots, it’s unlikely that this deleveraging process will end quickly or in anything close to a v-shaped recovery.

Source: HSBC Research & McKinsey

 

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