Overview of 2008 Outlook for 2009 Dominique Sabassier, Philippe Waechter and Franck Nicolas look back over the past year and outline the macroeconomic and financial outlook for 2009. Read on for their views and forecasts. Dominique Sabassier Chief Investment Officer
Philippe Waechter Chief of Economic Research
Franck Nicolas Head of Global Allocation & ALM
Overview of 2008 2008 is easily summarized and the conclusions are unequivocal: a year of dismal records marked by a spectacular re-calibration of financial risks, which ultimately led to a substantial increase of investor risk aversion. This aversion was fuelled by a loss of confidence in the global financial system and a major slowdown of economic activity in the second half of the year. n In less than six months, the financial markets moved from a generalized concern about inflation to a distinct fear of deflation. n US equities markets posted their sharpest one-year fall since 1871 (launch date of the first Dow Jones index). n European equities markets lost 45% of their value, far exceeding the 31% fall in 2002 or the 27% drop in 1974, which were the two sharpest contractions of the post-war era. n Emerging markets suffered major economic slowdowns (with stock markets tumbling by more than 60%), largely discrediting decoupling theories. n Credit spreads widened to unprecedented levels: in the United States, they exceeded 600 basis points on investment grade bonds (vs. 350 bp in 2002, and 500 bp in 1932 at the height of the 1930s crisis). n The lowest-yielding product on the ITRAXX index at December 31, 2008 had a wider spread than the highest-yielding product did before the crisis began. n 10-year government bonds became a safe haven for investors: despite the sharp rise in budget deficits, the German 10-year Bund was in fact offering its lowest yield since 1800. n In the same year, oil prices doubled and then subsequently fell by nearly 70%. Major adjustments reflecting the strong shocks to the global economic system.
The macroeconomic outlook for 2009 After the shocks and major trend changes that occurred last year, 2009 will be a year of reconfiguration and reconstruction. However, the first part of the year will almost certainly see a continuation of the slowdown observed towards the end of 2008 before some degree of stabilization takes hold after the summer (driven notably by more interventionist economic policies).
www.am.natixis.com
Overview of 2008 Outlook for 2009
Major adjustments follow severe economic shocks In the majority of countries, both industrialized and emerging, the economic environment has been characterized by simultaneous and profound trend reversals since the end of 2008. These trend changes have emerged simultaneously in various economic surveys around the globe (ISM, IFO and INSEE), on industrial production (France, Germany, Japan), household spending, and exports, from Taiwan, South Korea and China.
Declining labor markets will dampen domestic demand The deterioration in the economic climate has been extremely sharp. Its effects will gradually filter through to the rest of the economy, generating numerous adjustments - particularly on labor markets. This is already happening in the United States and will probably continue in spite of the sharp fall in employment already observed since September. In past recessions, the destruction of jobs and hours worked was proportionately larger than the cutbacks we have seen in recent months. In Europe, the bulk of job losses will occur in the first half of the year. In Germany and France, labor markets are always slower to react than in the United States. We therefore expect to see rapid increases in the unemployment rates of both countries over the coming months. Spain, on the other hand, has already seen large-scale job losses in its collapsing real estate market. We also expect to see substantial cutbacks in capital investment - an inevitable reaction to a climate of uncertainty, declining levels of business activity, diminishing demand and shrinking profitability. A rapid decrease in orders for capital goods has already been observed. In Germany, past experience suggests that the drop-off in this category of orders will lead to a sharp reduction of capital investment throughout the OECD countries. As a result, domestic demand in the industrialized countries will be markedly weak in the first half of 2009.
n Industrialized countries can no longer depend on emerging markets… The global slowdown has also affected activity levels in emerging countries that were importing heavily from industrialized countries. The contribution from emerging markets to global growth will therefore be reduced. Slowing economic growth rates, particularly in the big regional leader countries, will no longer boost the exports of industrialized countries, and will impact significantly on regional trade. Exports to emerging markets will therefore no longer act as growth drivers for the developed countries. Faced with sharp rises in unemployment and the contraction of export demand, Western governments will have to take far-reaching action in order to reverse these trends.
n…hence the need for government economic stimulus programs. These programs generally have two features: fiscal measures such as tax reductions aimed at stimulating demand, particularly among households and consumers, and increased government spending, which has a broader and longerlasting effect than tax cuts over the medium term. Of these two policy levers, the second is probably the most effective. In view of the uncertain climate, it is quite possible that a portion of the tax cuts will end up in savings accounts. This is likely to be particularly evident for middle-income households in the United States who are concerned about the sharp falls in house prices and financial assets eroding the value of their pension plans (401k plans).
The role of government policy in determining the outlook for 2009 n A slowdown of economic activity… Major adjustments will take place in the first half of 2009 as economies adapt to the violent shocks of the latter part of 2008. These adjustments are likely to be very substantial considering the magnitude of these shocks. We cannot therefore anticipate any degree of stabilization before the summer of 2009, as activity levels will continue deteriorating until then.
n…and a very diminished risk of inflation… For the time being, the fall in commodity prices has led to a very marked slowdown of inflation rates. This movement is likely to continue and may even push prices into negative territory during the spring in the United States (and also in some European countries).
www.am.natixis.com
Overview of 2008 Outlook for 2009
n… allowing central banks to adopt long-term accommodative monetary policies. With economic growth and inflation rates likely to remain very low for quite some time, we can expect monetary policies to remain accommodative, or - in countries and blocs where they are not already - to become accommodative. The Federal Reserve will keep its target rate low throughout the year, as will Japan's monetary authorities. The Bank of England will continue reducing its key rates in order to lighten the constraints on the UK economy as much as possible. The ECB will also adopt a much more accommodative strategy by cutting its refinancing rates to as low as 1%, or maybe even lower.
n Economic activity will be further impacted during the first half of 2009… Economic activity in the industrialized countries is starting the year after a sharp contraction in the last quarter of 2008. The adjustment to shocks, notably on labor markets and to productive investment, will lead to a significant slowdown in economic activity during the first half of 2009 with a more pronounced impact in the first quarter. Within economies, these major shifts will progressively allow a reduction in the extent of the adjustments. Then, associated with the virtuous effects of economic policy, they will engender a convergence towards a more balanced situation.
n… before a positive stabilization. As of the autumn of 2009, activity should begin to stabilize. Unlike the recovery scenarios seen after past recessions, we do not expect to see any strong rebound of economic activity led by an acceleration of US household spending. In fact, a key feature of the current crisis is the deceleration of US consumer spending. Its growth had become too dependent on debt and a simultaneous reduction of the savings rate. Neither of these two growth mechanisms will play a significant role for the foreseeable future. Consequently, the recovery in consumer spending will likely be more gradual than in the past. This implies that 2010 will see only moderate growth rates, even after the sharp slowdown in 2009 activity.
A few specific factors n Europe is lagging… In this overall scenario involving an initially sharp and profound adjustment followed by a progressive stabilization, Europe is at a disadvantage. In effect, the European economic cycle is heavily dependent on trade with the rest of the world and its internal consumer spending dynamic is much weaker than that of the United States. Moreover, the European countries in which consumers were the most spendthrift are also those that have experienced the fastest property market rises over recent years. The contraction of housing markets is therefore likely to have a serious impact on economic activity, employment and spending. This is notably the case for Spain, Ireland and, to a lesser extent, France. Furthermore, In Europe, the negative dynamic is unlikely to be offset by a massive - and coordinated - economic stimulus program. We would not, therefore, expect to see any significant recovery of Europe's economic growth rates until a global recovery takes hold...and that may not be until after 2010.
n…compared with the United States. The US economic cycle is more centered on an internal dynamic and, in the longer term, it will benefit from a greater degree of autonomy than the European cycle. Considering the size of the economic stimulus package announced by the new US administration and propelled by very low interest rates over a long period, we may reasonably expect to see a faster recovery of economic activity in the United States than in Europe.
n China's economy will have to adjust before returning to a rapid growth path. A number of signs suggest that the Chinese economy slowed very sharply at the end of the last quarter of 2008: housing prices started to fall, the rate of industrial production slowed, and exports and imports (excluding commodities) both declined. In spite of the government's nearly 600 billion-dollar economic stimulus package over two years announced on November 9, 2008, China's economic activity will continue to slow during the first half of 2009. Thereafter, it should begin to benefit from the favorable effects of the stimulus package and from an accommodative monetary policy. This will provide gradually increasing support for the global economy in the ensuing period.
www.am.natixis.com
Overview of 2008 Outlook for 2009
Portfolio allocation: which asset classes should be favored? Although it is particularly difficult to be precise about the exact timing, we suggest a two-stage approach to investment during 2009: first bonds and then equities
What market profile should be adopted? n First bonds… First of all, following on from 2008, all the macro-financial variables are likely to remain volatile for several months. The Fed's quantitative easing (and several rate cuts from the ECB) will push up the prices of government bonds, making this asset class an imperative investment while there is an the absence of visibility on other markets. In effect, we would expect to see a strong flattening of the euro yield curve with long rates falling, marking the last stage of the cycle. In this context, riskier asset classes will continue to post strong volatility without any real constancy of performance. In the second half of the year, we expect to see a progressive recovery of global activity with growth forecasts moving back into positive territory for 2010. These forecasts will be above 5% in emerging countries.
n ...then a recovery of interest in equities. This scenario - it goes without saying - is largely founded on the assumption that the economic stimulus programs (monetary, budgetary and fiscal) will be “successful”. By successful we mean, inter alia, that they succeed in a) reflating economies (with a stabilization of the US housing market), b) restoring confidence to the interbank market, and c) allowing a gradual attenuation of the risk aversion currently gripping markets. These conditions would favor a return to grace of riskier assets, firstly in the shape of investment grade bonds (which are currently posting very attractive yields), then via equities and lastly via high yield bonds. But we are not expecting anything spectacular. For many investors, the fear of “false starts” will undoubtedly be omnipresent throughout the year. But an improvement allowing some degree of positive visibility on 2010, thereby avoiding a long period of deflation, would already be very beneficial. By region, the United States, where economic policy is more aggressive, looks a little better placed than Europe with respect to equities; but this observation is probably true only for stocks in the most cyclical sectors.
n And emerging markets? It is still probably a little too early to re-invest in emerging markets (despite their strong beta) except for China, which appears to have plenty of monetary and budgetary elbow room and will benefit substantially from the lower commodity prices. Assuming that the economic stimulus plans effectively succeed in reflating the economy, the new scenario would be unfavorable for long-term interest rates (which would anticipate the change in the cycle with the sale of bonds) and for the dollar and yen, which both benefited substantially from the crisis. In addition, commodity prices would return to a growth path, although at a slower pace than emerging market equities. This trend would in effect manifest itself as demand for commodities increases once production takes off again, i.e. probably in 2010.
The uncertainties n Dependence on the economic stimulus programs… If the stimulus programs work and the deflationary spiral is effectively stopped, governments and central banks will have clearly demonstrated that economic growth is their priority, even at the price of a little inflation.
n…in an environment that will change in any event… The new profile of global growth is both disinflationary and inflationary. “Disinflationary” because of the capping of unit labor costs via industrial relocation (a less popular subject nowadays), but also “inflationary” because of the injections of liquidity into monetary bases around the world and, potentially, via the strong demand for commodities from emerging countries. In terms of bond-picking, a switch to inflation-indexed securities at the expense of nominal bonds when the cycle restarts could well be a wise move (i.e. in the spring for anticipatory positioning).
www.am.natixis.com
Overview of 2008 Outlook for 2009
n …fuelling new risks The risks in 2009 are numerous. The primary risk of a failure of the stimulus packages would imply a continuation of deleveraging, which would lead to forced asset sales (by hedge funds and banks for example). This scenario could impact on private equity and LBO structures, which are already hampered by difficulties in accessing investment funding, and in many cases by disappointing levels of real returns compared with initial expectations. This would resuscitate, although perhaps on a smaller scale, the risk of systemic meltdown that was narrowly averted in 2008.
The key questions for 2009 The emergence of a new paradigm? This latest financial crisis, after that experienced in 2002, raises the same concerns as many criticisms of the system - such as the overwhelming emphasis of management on finance, with all its excesses (leverage, salaries, short-termism), the impression that globalization has only benefited a minority, and the possibility of a shift in global economic leadership - and should be given some serious consideration. The criticisms of the dominant model of the last 25 years, combined with the massive government interventions under way and the hostility of the majority of populations to the current model, could well contribute to a gradual, but effective, modification of the current system of global governance that may or may not lead to a better world. While we can certainly hope that a more project-focused and sustainable model of growth emerges, we should be wary of the imposition of draconian rules, hidden protectionist measures or even a sharp deterioration of value added that would damage business interests. In any event, these types of pressures are likely to be the source of considerable uncertainty and could possibly have negative consequences on all asset classes. They might, however, provide encouragement for a more socially responsible approach to investment.
Comparisons to past crises The current crisis is severe and deep. There is a considerable temptation to compare it to past crises that may look similar. The two most frequently cited are the 1929 stock market crash and Japan’s crisis of the 1990s. These were both severe and deep, but they did not unfold in the same way as today’s crisis. The parallel may therefore be misleading.
n “Japanization” of the economy? There are certain similarities with the Japan’s crisis of the 1990s, such as a banking system encountering major difficulties, plummeting property prices and interest rates at zero. However, there are also a number of differences. In Japan: • Fiscal policy was tightened over the first four years of the crisis and stimulus measures arrived too late. • Interest rates were cut very gradually and therefore failed to “kick start” the economy because quantitative easing only started after 2000 when the Japanese economy had already suffered several years of deflation (Japanese businesses and consumers incorporated the reality of deflation into their economic choices, thereby perpetuating it, as the central bank was very slow to act). • The problems, both in the financial and the banking system, were concealed and the toxic assets remained on the banks' balance sheets for nearly 10 years (there is one very marked difference with the current situation: even if the identification and valuation of toxic assets remains a highly complex task today, at least the problems are being acknowledged). • In Japan, the demographic situation was quite specific with a marked aging of the population (this is far from being the case in the United States of today). • Japanese companies were slow to adjust their costs and restore profitability (adjustments in the United States are taking place much more quickly; drastic measures aimed at reducing costs have already been introduced in order to improve corporate profitability over the longer term).
www.am.natixis.com
Overview of 2008 Outlook for 2009 n 1929/2008: a similar path? While the two crises are comparable in terms of severity and depth, the differences are inescapable and draw a clear distinction between the two periods: • The current crisis has not unfolded in the same way. There were three stages to the events of 1929-1931: first an economic crisis (autumn 1929), then a banking crisis (October 1930), and lastly a real estate crisis (October 1931). This order of events does not correspond to our current situation as the real estate and banking crises preceded the economic crisis. • I n October 1931, the banking crisis was not endogenous: it resulted mainly from the Fed's errors in managing the economic crisis. it was the lack of liquidity in the banking system that triggered a series of bank runs. • The real estate crisis of 1931 was caused by the very high unemployment rate (20%) that resulted from the economic crisis and the rudimentary nature of mortgage lending arrangements (short-term bullet loans). Households unable to refinance their loans ended up defaulting: at the height of the crisis, foreclosures accounted for one in ten homes. To cope with this property financing crisis the government set up new institutions in 1933, which survived until the current crisis. (It may be necessary to find a new mortgage industry model for property financing to start functioning smoothly again.) • Today, the property and banking crises are endogenous and reflect excessive risk-taking in a number of areas. • During the 1930 crisis, trade volumes shrank as the United States hiked its import tariffs following the implementation of the Smoot-Hawley Tariff Act, as many other countries raised theirs in retaliation. This protectionist reflex, which exacerbated the 1930s crisis by stifling international demand, must not be allowed to influence the measures designed to improve the current economic situation. Though tempting, they constitute the worst possible direction for economic policy and would delay a return to economic growth. • The international exchange rates system was inflexible as most currencies had gold parities. The close relationship between currencies meant that a shock in one country was immediately relayed to other countries. Today, currency values change via a system of floating exchange rates. This acts as a buffer to the contagion of economic shocks. In conclusion, the causes and origins of the 1929 and 2008 crises are fairly distinct. While the 1930s crisis marked the end of Britain’s economic supremacy in favor of the United States, it is too early to say whether the current crisis will produce a similar shift, but this may be a useful prism through which to watch developments over the coming years.
Protectionist reflex? In 2009, the biggest risk facing economies is protectionism. Historically there is a correlation between economic growth and growth in the volume of international trade (though trade usually increases more rapidly than economic activity). Today, however, trade has contracted sharply, and this trend reversal is harming growth. Taiwan is suffering as a result of weaker demand from China, which in turn is suffering as US consumer spending slows. The economic logic of the current situation is a self-fuelling downward spiral: the drop in activity reduces trade, which impacts further on economic growth. Protectionism would depress international trade, leading to production cutbacks and towards deflation. The role of economic stimulus policies is to break this pattern. Moreover, in a global economy with complex networks of international trade, a large number of goods are produced in different locations around the globe. Strategic goods like computers are no longer manufactured in the industrialized countries. Protectionism would therefore make little sense in this system.
What will happen to interest rates when monetary policies are very accommodative and governments are issuing debt? n We suspect that the current low level of government bonds yields is temporary and reflects both the current crisis and the risk of deflation, especially in the United States. In other words, when the economy is in better shape, these rates should move towards their historical levels because monetary policy expectations will be radically different. As a result, asset switches will also change direction. Government bonds will become less attractive.
www.am.natixis.com
Overview of 2008 Outlook for 2009 n The role of the authorities is to ensure that the return to historical levels occurs smoothly without any excessive overadjustment. To do this, it is also necessary for central banks to act and communicate to limit excessive expectations in respect of inflation.
n Here, the growth of public debt reflects two objectives: • The first is to absorb the excess savings inevitably set aside in periods of economic deceleration. Public expenditure thus substitutes private expenditure and the public deficit absorbs the savings surplus. This mechanism does not therefore, in the short term, generate pressure in the area of interest rates. • The second is the need to finance business as part of a response to a very sharp negative shock: expenditure needs to be funded by absorbing the excess savings (there will be plenty of time to repay later). Thus, if governments’ economic policies work, GDP figures will improve quite quickly, thereby limiting the deterioration of the public debt/ GDP ratio. In this scenario, the pressure on interest rates will not be as pronounced as is often predicted. This latter aspect of the public debt issue highlights the link between debt and monetary policy: a very accommodative monetary policy does not engender an excessive cost of additional public debt. The additional debt is in fact issued with a very low nominal interest rate, and the shorter the term structure of the issued debt, the lower its cost. In this context, we think there is little risk of a bond market crash leading to a rapid surge in long-term interest rates.
Disclaimer This document is destined for professional clients. It may not be used for any purpose other than that for which it was conceived and may not be copied, diffused or communicated to third parties in part or in whole without the prior written authorization of Natixis Asset Management. None of the information contained in this document should be interpreted as having any contractual value. This document is produced purely for the purposes of providing indicative information. It constitutes a presentation conceived and created by Natixis Asset Management from sources that it regards as reliable. Natixis Asset Management reserves the right to modify the information presented in this document at any time without notice. This document do not constitute a commitment on behalf of Natixis Asset Management. Natixis Asset Management will not be held responsible for any decision taken or not taken on the basis of information contained in this document, nor in the use that a third-party may make of it. Intended for professional clients only.
www.am.natixis.com