Forward Markets: Macro Strategy Review for November 2012
by Jim Welsh, Macro Strategy Team, Forward Markets
At the 2012 Olympics, the weightlifting gold medal was won by Behdad Salimikordasiabi from Iran, after lifting a total of 1,003 pounds in two events. Salimikordasiabi stands six feet six inches tall and weighs 270 pounds. On his way to gold, he lifted 459 pounds in the “snatch” event, and 545 pounds in the “clean and jerk” event, or 123% and 146% of his body weight. This got us thinking. If Salimikordasiabi was standing with both feet firmly planted, would we be able to knock him over? Not only do we think we would not be able to knock him over, we suspect we would probably injure ourselves trying. However, if he was balancing himself on just one leg, we think most of us would be able to topple him. By standing on just one leg, the strongest man on Earth would be vulnerable to a shove by someone half his weight, and certainly far weaker.
The economic corollary is straight forward. When economic growth is strong, unexpected shocks are readily absorbed, without denting growth much. For instance, 25 years ago the stock market crashed on October 19, 1987, losing 22% of its value in a single day. Emotionally, the crash had an immeasurable impact on investors’ psyches. Economically, it didn’t even register as a blip on the radar.
In 1987, nominal GDP, which includes growth due to inflation, was 6.3%. In 1988, nominal GDP actually increased to 7.7%. This was possible, in large part, because growth was so strong before the crash. The same cannot be expected when growth is slow, since
unexpected shocks are likely to have a greater impact on growth, potentially leading to recession. This common sense analysis applies to individual countries, but is also applicable to the global economy.
The integration of cross-border lending and the growth in global trade were obvious drivers of globalization and global growth. During the last 40 years trade has grown from 5% of global GDP to almost 20%. The underside of this positive development is that those same positive factors which had the power to transmit growth have the potential to transmit weakness when crosslending contracts and trade growth slows. The contraction in lending by European banks around the world, and especially tradefinancing, is dampening growth well beyond the European Union.
Earlier this month, the International Monetary Fund (IMF) reduced its estimates for global growth in 2012 and 2013, from estimates made just three months ago. The IMF cut their July estimate for 2012 from 3.5% to 3.3% and lowered their expectation for 2013 from 3.9% to 3.6%. Although these downward revisions may not sound like much, they are significant. Last April, the IMF placed the odds of global GDP slowing to 2% at a miniscule 4%. They now believe there is a 17% chance global growth could slow that much in 2013.
In the wake of the 2008 financial crisis, every major central bank slashed interest rates, and governments around the world ramped up spending, producing budget deficits of 10% of GDP, a previously unheard of level. The combination of extraordinary monetary accommodation and fiscal stimulus succeeded in rejuvenating growth. In 2010, global GDP was 5.1%, a solid response led by recoveries in the emerging economies in Brazil, China, India, South Korea, Mexico and Taiwan. In 2011, global GDP growth slowed to 3.8%, as the European sovereign debt crisis emerged despite a second round of quantitative easing (QE) by the Federal Reserve.
The extreme fiscal stimulus enacted by legislatures throughout the world in 2009, 2010 and 2011 is progressively becoming a headwind, as governments slow spending growth or are forced to actually cut government spending through layoffs of government workers. This has been painfully obvious in Greece and Spain, which have stiffened austerity measures while in recession. In the United States, municipalities and states have balanced their budgets with layoffs of teachers, firemen and police officers.
Historically, the most powerful monetary policy tool in stimulating economic growth has been lowering the cost of money, especially if a recession was preceded by central bank rate increases and a reduction of credit availability. This was certainly the case in the United States following World War II. The one exception was the period of 2004-2006 when the Federal Reserve raised the federal funds rate from 1% to 5.25%, without tightening credit conditions.
Although the Fed increased the cost of money, it did not restrict the availability of credit, as credit spreads and long-term corporate and Treasury yields declined well into 2007. The Federal Reserve has held the federal funds rate just above 0% since 2008, but this did
not elicit the economic response it has historically. This is why the Federal Reserve felt compelled to launch quantitative easing. After this unprecedented monetary policy action only achieved muted economic results, the Fed launched a second round of quantitative easing (QE2).
Since 2008, the Federal Reserve has expanded its balance sheet from $900 billion to $2.8 trillion. A year from now it will top $3.5 trillion, if the Fed is still in QE3 mode. But most of the expansion in the Fed’s balance sheet has not made it into the economy. Banks have parked $1.421 trillion in excess reserves with the Fed, and that money is going nowhere fast. It is noteworthy that after all of the Fed’s efforts and extraordinary monetary accommodation, the velocity of money fell to its lowest turnover rate in 50 years at the end of the second quarter.
With GDP growth slowing in 2012 and unemployment higher than desired, the Fed has now initiated a third round of QE. Will the third QE be the charm, or will it be three strikes and out? We don’t know, but clearly the impotence of monetary policy as an effective economic policy tool is on display for all to see.
Any further slowing in the global economy in 2013 will be more difficult to reverse than in 2008, since the two policy levers used to reverse that contraction have been spent. Large budget deficits are forcing fiscal policy to shift from adding to economic growth, to becoming an ongoing drag on growth in a growing share of global GDP. Central bankers in every developed country are already pressing the pedal to the metal, with some commentators suggesting recent actions by the Fed and European Central Bank (ECB) have pushed policy through the floorboards.
Sure, China can lower rates, but that will only stabilize growth in China. It will not spark a resurgence of growth in the European Union, or in the United States. Global growth of less than 4% is hovering just above stall speed, so any unwelcome surprise could easily prove problematic. The instability in several Middle East countries, and rising tensions between Israel and Iran could overnight have a profound impact on oil prices. We don’t have to remind anyone that soaring oil prices and recessions have become well acquainted over time. In the European Union and the United States, monetary policy is in full throttle mode, which leaves the outcome primarily in the hands of the politicians. Why doesn’t that prospect fill us with confidence? They must first do no harm, and hopefully, act like leaders. As noted in the IMF’s World Economic Outlook,
“Risks for a serious global slowdown are alarmingly high.”