In a dramatic move the International Monetary Fund (IMF) has cast aside the mantle of fifth rate marionette on the pier at the end of the world and aggressively lowered its forecasts for economic growth in 2008.
The organisation, formerly regarded with some derision for its habit of forecasting using the rear view mirror, has emerged with a particularly downbeat assessment of prospects which will almost certainly rattle Western central bankers as they grapple to get on top of the ongoing credit crisis, the economic slowdown and stubbornly high inflation.
Most significantly, the organisation has cut its forecast for US growth from 2.7% (in April 2007) to just 0.5%, a figure commensurate with technical recession and a protracted period of below-trend growth thereafter. This view contrasts markedly with a much more upbeat assessment from the Federal Reserve which continues to forecast on a Q4/Q4 basis.
The justification for the IMF’s position lies in the continuing credit crisis, with regard to which it sees no near-term resolution and the impact of adjustment as governments, households and, to a lesser extent, companies repair balance sheets in the wake of a debt-induced spending binge. By implication, the IMF is profoundly negative on the outlook for consumer discretionary spending.
World Economic Outlook
Global GDP Growth (% chg year on year)
|
|
April 2007 forecast
|
2008 forecast |
|
US |
2.8 |
0.5 |
|
|
1.9 |
1.4 |
|
Euro 15 |
2.3 |
1.4 |
|
|
2.7 |
1.6 |
|
|
9.5 |
9.3 |
|
Emerging |
8.0 |
7.5 |
|
World |
4.9 |
3.7 |
Source: IMF World Economic Outlook
The IMF is on the right track
We have, from time to time, hinted that the duration of prevailing problems in the financial sector have more than a whiff of the depression conditions of the 1930’s about them. The Federal Reserve’s decision to invoke rules passed at that time allowing it to extend its support beyond the banks has served to reinforce that perception and now the IMF has emerged from its bunker to suggest that the current environment has caused the greatest shock to the financial system since the Great Depression.
Judging from the table (above) the IMF, in common with everyone else, is pinning its hopes that the global economy can avoid a recession (in its view three consecutive quarters of global GDP growth below 3.0%) due to continued strong growth in Asia. We agree with this view and have noted in the past that Asian activity will be impacted by the Western slowdown but not to the extent that inter-regional trade should be too seriously impacted.
The IMF’s forecast for UK activity is in line with our own and reflects the negative outlook for consumer discretionary spending as the housing market comes under pressure. Indeed, the IMF’s view that average UK house prices are some 30% overvalued is amongst the most pessimistic assessments of a market which is now coming under very clear downside pressure.
Near-term inflation pressure
I am also concerned, as I have consistently highlighted, by the stubbornly high levels of near-term inflationary pressure.
Only in the US have monetary authorities fully grasped the severity of the deteriorating backdrop and eagerly embraced vague criticism regarding “moral hazard” as an acceptable price to pay for ongoing attempts to drive the super tanker away from the rocks.
The Bank of England and European Central Bank continue to wield fears over near-term inflation pressure like a sword on the point of being driven into consumers’ hearts, however, I believe that with core inflation quiescent and base effects likely to improve as the year progresses and activity slows: inflation is yesterday’s problem not tomorrow’s. The IMF is right to voice concern that by not cutting base rates both central banks run the risk of making an already bad situation much worse.
UK interest rates
We also recognise that simply cutting base rates will not solve the credit crisis. Central bankers have gone to great lengths over the past few months to emphasise the differences between their efforts to ease the credit crunch and their position on base rates. By their actions, in particular boosting liquidity, they hope to improve the transparency of asset values or their quality.
Here in the UK, residential mortgage backed security issuance is down by approximately 90% over 2008 on the equivalent period in 2007, aggressively limiting funding for banks to write mortgage business. The Bank’s own recent ‘credit conditions’ survey confirms further increases in mortgage spreads and even tighter lending criteria in the months ahead.
This is already being felt at the sharp end as mortgage offerors reduce product ranges and raise costs. As a consequence, although the MPC has cut UK rates to just 5.0% (following last week’s decision to cut by a further 0.25% points) conditions in the mortgage market are consistent with rates significantly higher than that.
The deterioration of credit conditions
The Bank’s accompanying comment regarding ‘a margin of spare capacity will emerge during this year’ is interesting in the context of a corporate sector where credit conditions have deteriorated markedly even since the beginning of the year (at which point they were already stretched), with risk premia at elevated levels and issuance having been cut back sharply.
Furthermore, given ongoing concerns amongst financial institutions regarding the health of their own balance sheets and liquidity, lending to each other and to other areas of the economy has been hugely scaled back, as reflected in markedly higher loan rate spreads and a sharp reduction in credit lines.
Therefore, while the MPC wishes to see spare capacity across the economy increase, in order to keep the lid on inflation, the deterioration in credit conditions threatens an even more marked economic slowdown. Whilst the Bank is well aware of this threat, it also knows that there is a significant risk that the credit crunch and slower growth could feed off each other to create a downward spiralling whirlpool of despair.
Deepening a global recession?
A couple of recent developments make eye-catching reading in the light of the above. Firstly, recent quarterly results from both Citigroup and Bank of America have revealed that both are vulnerable, following the cut-back in credit ratings on billions of dollars worth of bonds, thus adding to already severe pressure on capital ratios. This is to the extent that under existing rules, neither might be considered sufficiently well capitalised. In order that capital ratios might be preserved banks must cut the flow of credit which, in turn, could limit the flow of loans to corporate and individuals alike.
That this could deepen the US recession goes without saying. As a sector, regulated US banks now have a total risk-based capital ratio of just 12.79%, lower than at any time since 2000 (i.e. just before the last, shallow, US recession).
Secondly, Moody’s reports that the percentage of companies with debt trading at levels associated with distress rose to 24.7% in March from 22% in February, a new five-year high. This is not just a US problem, with Moody’s pointing out that global default rates have risen from 1.3% to 1.5%. The figure is low, but it is rising and Moody’s thinks that the number is likely to rise in the future.
Thirdly, the IMF has added pessimism to its economic outlook by stating that total losses associated with the credit crisis could hit $1tr. In a scathing damnation of banks, regulators and governments, the organisation remarked that there was “a collective failure to appreciate the extent of leverage taken on by a wide range of institutions”. The IMF estimates that mortgage market losses from rising home owner delinquency and falling house prices could hit $565bn, while losses from securities associated with commercial real estate and consumer loans would account for the remainder.
The ‘write-down-ometer’ currently stands at c$230bn and it is noticeable that the IMF takes a position even more negative than that of both UBS and Merrill Lynch (both forecasting c$600bn write-down and credit losses) and significantly more than the relatively optimistic Standard & Poor’s at just $290bn.
Finally, we note that the IMF, with far better timing than the UK government, has chosen this moment to make good its own income short-fall by selling $13bn worth of gold. Although this pressurised the metal’s price in early April it looks likely that the dollar’s ongoing travails will ensure that investors retain their support for this poorly correlated asset.
A beginning, not an end
Despite all that I prefer to “say hello” rather than “wave goodbye”. Whilst I cannot be sure that we’re out of the woods, the financial markets are fulfilling their role as discounting mechanisms and to the extent that bad news is no longer being met by waves of selling pressure, I believe that equity markets are now pricing much of this bad news into valuations.
Whilst we accept that the economic backdrop is deteriorating and that corporate earnings remain under downward pressure, we also know that this is already well known. Historically, I have watched the shape of the bond yield curve and the trend in analyst earnings expectations as key leading indicators of potential turning points. Whilst neither is currently sending an outright positive signal, the shape of the yield curve has altered (more favourably) and the trend in global earnings expectations is already in deeply pessimistic territory.
Maybe, just maybe, recent aggressive central bank action (particularly Federal Reserve action) will be viewed with hindsight as forming a watershed moment.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley