Monday, September 28, 2009

Risk of a double-dip recession?

The opinion of most market players globally is that the global economy seems to be showing signs of stabilisation and recovery, as coined in the term "green shoots". Markets have been responding positively to this feeling, as seen in the world equity markets, oil prices, and commodity prices.

One of the arguments which has not received similar attention is the very real risk of a double-dip recession, which is also referred to as W-shaped recovery. In other words, the economies would recover somewhat and then dip again into a recessionary environment before making a full recovery. At the very least, the market has been talking about a U-shaped recovery, which is a very long recovery period.

Real possibility
In my view, the risk of a double-dip recession is a very real possibility given the underlying fundamentals that still exist. The fact is that markets never move in a straight line, whether up or down, and what is needed for a full recovery is still not present in the major economies.

These economies, such as the USA and UK, are still facing significant job losses, tight credit, and increasing credit card delinquencies. In addition to this, we are seeing where financial institutions are again starting to re-package loan securities and selling them to investors, albeit with less risk, but the fact is that the productive value is still not there to support these new derivatives.

Undoubtedly, recent data (this week) shows that there are indeed some signs of recovery. Out of the US, August 2009 industrial production has shown both month-over-month and year-over-year increases and retail sales have shown significant month-over-month and yearly increases in the same period. On the other hand, business inventories month over month have shown a decline of 1.0 per cent, which indicates that there are no robust projections of better times ahead from the point of view of Main Street.

These positive signs, however, could be the middle of the W-shape and we could still see another dip before the full recovery takes hold. This is especially as the positive indicators we have been seeing recently have, to a large degree, to do with the stimulus packages being implemented by the major economies, and not with any real growth in income levels, at the company and individual levels on a sustained basis. The fact also is that total wealth in the US has fallen off by about 35 per cent since last year and debt levels still remain very high.

In order for us to be sure of a sustained recovery we need to see a trend of at least three to four months of positive data coupled with net jobs being created. It must be remembered that 75 per cent of the US economy depends on consumer spending, and stimulating this spending with debt or government expenditure is not a sustainable solution.

The only way that sustainable recovery can return to the global economy is to increase production of goods rather than services. It still seems apparent that the US, in particular, is still trying to rely on services and credit as a way to grow the economy. This lack of real production in the world's largest economy still makes for a very fragile global economy, as even though there is production happening in markets such as China, the US still contributes around 25 per cent to world output. The greater risk in the US, in my view, is that the financial institutions return to increased risk too soon in a market where the consumer is still very vulnerable and debt levels are still too high. It also seems that much emphasis for increased financial activity is being placed on the increases in the equity markets that could see a pull-back in the very near future.


In fact, the Dow Jones Index (DJIA) chart shows that the market is in a critical place and it is very possible that we could see a significant pull-back (see chart). In order to see the continuation of the uptrend in the equity markets, the DJIA will have to close above 10,000 and should ideally close above the one-year 72 per cent retracement level of over 10,400. In any event, one can expect a pull-back from the current levels and if this occurs before the DJIA closes above the 10,000 to 10,320 range we could be looking at a significant pull-back.

The implication of the DJIA effect on the market of course, is that, if the pull-back is severe, then we could once again see a contraction in spending and the US economy would face contraction again and further job losses.

On the other hand, if the DJIA expands above 10,400 too quickly, then the market could face a sharp correction if real production does not keep pace with this rise in wealth. The fact is that a big factor causing the credit crisis was that spending grew at a much faster rate than the supporting real output value.

THE opinion of most market players globally is that the global economy seems to be showing signs of stabilisation and recovery, as coined by the term "green shoots". It is going to be very important then to watch the personal income, employment, and production data more than the retail spending going forward, to look for signs of a real recovery. It is also important that spending and financial market growth do not continue at a pace that far exceeds real output growth. One way of measuring this, of course, is to look at the companies that are reporting profits; that is real production versus services; and also, what price earnings ratios are trending to.

As the US economy stands now, there is still the high risk of a double-dip recession occurring and the signs of recovery that everyone is warming to could be a misplaced feeling of relief.

The other factor that could cause some amount of inflationary pressure is the fact that a lot of stimulus money has been pumped into these economies, which are not based on any real output increase, but rather on Keynesian economics. Keynesian economics says that when an economy is in recession, one should expand fiscal spending in order to reduce the negative effects of the economy.

This has worked to stimulate some demand and stability in the major economies but is a double- edged sword, as, if not properly monitored, it could cause significant inflationary pressures as there would be too much money chasing the goods in the economy.

Because of this fear, it is very important for the Federal Reserve, for example, to ensure that the money does not stay in the economy too long, and hence their intention to start pulling the stimulus money out of the economy come October 2009.

The downside to this, of course, is that if real output does not start to increase by the time the money is being pulled out, then demand will again contract and again raise the possibility of a double-dip recession. It is therefore a very delicate situation that must be carefully managed.

In any event, the increased fiscal deficit in the US could lead to a need for future tax increases, which could serve to further dampen consumption, and this is why a return to increases in real production is necessary to lessen that effect.

The increasing oil prices also run the risk of slowing down output and demand. From all indications, as long as people believe that the economic recovery is underway, then oil prices will continue to climb and could reach US$90 per barrel by the middle of 2010. If the DJIA contracts sharply, however, we could see oil prices heading back down to the U$40 to US$50 per barrel.

The other factor that could cause contracting demand in the US economy is the weakening value of the US$. The weakness of the US$ is expected to continue into 2010 and would result in a reduction in the real income levels of the US consumer. The implication of this is that in real terms the US consumer would be spending less, thus causing a contraction in real spending in the US economy.

These are some of the real possibilities facing the US economy, and by extension the world economy, which could lead to a double-dip recession in the US. The main indicator to look at will be the employment and production data, without the stimulus impact.

The careful management of the US economy is going to be critical to what the final outcome is, and it is necessary not to be too quick to make announcements contrary to the trend until one is certain, just as the Fed and treasury said the US economy was in good shape while it was headed to recession in 2007.

This risk of a double-dip recession, of course, has far-reaching implications for countries such as Jamaica.

Jamaica has the US as its main trading partner and so, any devaluation of the US$, in relation to other major currencies, means that the real spending power of Jamaica when purchasing goods from other countries, such as China, will decline.

Any return to a decline in the US economy also means that the US consumer will be negatively impacted and that in itself would have a negative impact on our main foreign exchange earners.

The best bet for Jamaica then is to see, first, a return to net employment in the US; and, secondly, the US$ starting to appreciate against the other major currencies. Both these scenarios, however, are not expected to occur before 2010.

Until then, Jamaica has no choice but to manage the fiscal situation effectively and to manage the fallout in business activity that will inevitably occur in the country through policies aimed at encouraging small business development, and reducing crime and bureaucracy.

Friday, September 04, 2009

Demanding more of a shrinking pie

Over the past few weeks the fiscal accounts have taken centre stage in economic news, whether it is because of the ratings from credit agencies, the need to reduce fiscal expenditure, or the industrial environment as a result of greater wage demands on the fiscal accounts.

What we need to be careful of is that we do not focus all our energies on finding solutions to the fiscal at the expense of the longer-term viability of the country, as the fact is that the fiscal accounts are nothing but a symptom of the underlying problem. The fact is that, even if we fix the fiscal accounts this year, and ignore the other fundamentals of the economy, we will sooner or later be caught in a much worse fiscal and economic situation.

This is the approach we have always taken for most of our independence and is why we are in the current predicament today. Instead of fixing the fundamental structural faults in the economy, we have always sought to borrow money to postpone the inevitable collapse of the economy.

At a crossroads

So once again we are at a crossroads, and based on utterances, it seems as if some are pressing for the same solutions to be implemented that have resulted in us being where we are today. This is no surprise to me, however, for many Jamaicans have always had a "big fish in a small pond" mentally. That is, they would much rather own 100 per cent of $10 rather than 10% of $1,000. Underlying this sort of philosophy I think is the "Great House" way of thinking, as well as the need to be the big fish, even while the water is being drained from the pond. So we would rather that every one dies, but in the end at least be the biggest dead fish.

So when decisions need to be made about cutting expenditures to fit the lifestyle or making decisions for a more efficient way of doing things, we tend to shy away from the practical approach. Instead, we seek to borrow funds to support a lifestyle that our income cannot afford. And not many of us can point to the government alone about this type of behaviour, as it is a daily part of the lives of many Jamaicans.

Two such examples that come to mind are (1) someone I know was going through a very difficult financial period but refused to sell his Land Rover because it would affect his profile; and (2) someone I heard of who rented a very expensive house and paid a big car loan (in order to drive a BMW) and in the process placed his family's financial future in doubt. And both cases occurred before the economic downturn started to take its toll. There are many other examples.

What we do not understand is that the accumulation of these individual behaviours is what results in the total debt levels in the country. But what governments must do is ensure that this fever is not replicated in government and put policies in place to prevent this. Well, we have failed to do so for a very long time and have now found ourselves in the situation where the prime minister has had to (and rightly so) announce significant expenditure cuts.

But while these necessary cuts are being announced, some of us still do not realise that the only way for us to see future development is to live within our means. There is no other way. The problem is that we have grown fat for so long on debt that we have forgotten about how to produce and earn for ourselves. So this has resulted in a situation where we were satisfied with becoming international beggars, through remittances.

The fact is that the tide has changed, and we are in a situation now where we must understand that no more can the country go along borrowing money to support consumption expenditure. It is not enough to have two cell phones and a car. We need to be placing emphasis on more agricultural lands in production and more factories.

Bail-out mentality

This paradigm shift in our thinking is proving very difficult for us to adapt to, and I think primarily because we have got accustomed to being bailed out. When the EU was going to cut the subsidies for sugar and banana we demonstrated against it and told them how to give away their money. Each year we budget income for grants. And finally, we are satisfied with training 80 per cent of our University graduates to seek employment overseas and send back what they will in the form of remittances.

Similarly, the government is facing a cash crunch and the economy is facing significant decline this year, and our efforts are consumed with dealing with industrial relations issues. I have no inside knowledge of the negotiations and cannot say what the arguments are for either side, but what I know, is that the country will suffer and at the end of the day we will be like the participants in the Iran-Iraq war. That is, what we are fighting for will have deteriorated so much that what the victor gets in the end will be much less than they had before the war started.

Just as the by-elections came and went and the country did not benefit, so this industrial climate will come and go eventually and the country will not benefit. I am certain that the teachers, police, and nurses deserve every cent of the money they are clamouring for, and I am also sure that the Government does not have the money. So what do we do in this situation? I would like to propose that the more logical solution is for both parties to sit down and try to create a win-win situation, so that it could be that the Government says to the teachers, for example, that if the pass rates can be improved in a measured way then instead of getting $8 billion you will get $12 billion (adjusted for inflation). The reasoning behind this is that the output of teachers, nurses, and the police do have an impact on GDP and government revenues indirectly.

Whatever is agreed to finally, it is clear that (1) the teachers, nurses, and police do deserve more money, but also have a responsibility to deliver quality service; (2) the Government has no money and the economic situation will worsen; (3) students must go to school, patients must be treated, and crime must be controlled. So being aware of all these facts, it must be within all of us as Jamaicans to find a win-win situation and this is going to mean that we have to sit down and talk to each other as Jamaicans, not as though we all live in a different country.

As far as I can remember we have always had industrial action for better wages, which has caused many disruptions, in our productivity and progress as a country. After all those disruptions can we truly say that, individually and as a country we have all improved? If the answer is yes, then we should continue in the same vein, but if the answer is no, then it makes no sense trying to get more out of a pie that is shrinking every day. What we need to do is sit down and recognise the limitations we have and find a way to increase the pie so that even if we end up with a lower percentage, it is more than what we had before.