GLOBAL GROWTH : SOFT PATCH OR STALL SPEED ? / ROUBINI GLOBAL ECONOMICS ( A MUST READ )

Global Growth: Soft Patch or Stall Speed?

Nouriel Roubini

20/06/2011 03:33 a.m.

• Since the end of April, a more persistent correction of U.S. and global equity markets has started in earnest, driven by worries that U.S. and global economic growth may be slowing down much more than expected by the consensus.



• The optimists argue that this is just a temporary soft patch in global growth, driven by the Japanese earthquake, rising commodity prices, Middle East turmoil, eurozone concerns and political noise in the U.S. on debt and fiscal issues.


• But there are good reasons to believe that this is not just a soft patch but rather a more persistent slump that may lead to a growth stall, a growth recession or even an outright double-dip recession in some advanced economies.


• If the more negative scenario materializes, the equity market correction and increase in credit spreads would become more severe, feeding back negatively to the real economy. Moreover, given that policy makers in advanced economies are running out of policy bullets, the ability to counter such economic weakness and an asset price downturn would be much more constrained than in the past.


Until a month ago, financial markets, especially equity markets, seemed impervious to the “black swans” causing turmoil in the global economy in 2011. Indeed, the year started with rising commodity prices raising the specter of high global inflation, followed by widespread unrest in the Middle East—from Tunisia to Egypt, Libya, Yemen and Syria—that drove oil prices even higher. Then a terrible earthquake struck Japan, severely damaging its economy and global production through supply chain channels. Next, Portugal, following in the footsteps of Greece and Ireland, lost market access and required an IMF-EU bailout package; then the initial bailout of Greece failed and the country did not regain market access, prompting an ugly debate among European policy makers on whether to give Greece another official bailout or a bail-in of private creditors. After that, concerns about the unsustainable U.S. fiscal deficit resulted in an ugly political fight on spending cuts that almost led to a government shutdown. Another nasty fight on the debt ceiling is now brewing and may even lead to a “technical” default on U.S. public debt sometime this summer.


Until recently, equity markets seemed to discount these tail-risk events and continued their upward rally, apart from a few days when panic over Japan or the Middle East or a U.S. government shutdown led to a temporary correction and a rise in volatility. But since the end of April, a more persistent correction of U.S. and global equity markets has started in earnest, driven by worries that U.S. and global economic growth may be slowing down much more than expected by the consensus. Data from the U.S., UK, eurozone (EZ) periphery, Japan and even emerging market (EM) economies are signaling that parts of the global economy—especially advanced economies—may be headed for stall speed if not double-dip recession. Global risk aversion has also increased because the option of kicking the can down the road in the case of Greece is becoming less likely and desirable, while the social and political backlash against recessionary austerity has reached the streets of Athens and led to political turmoil, making a disorderly debt workout more likely.


The optimists argue that this is just a temporary soft patch in global growth, driven by the Japanese earthquake, rising commodity prices, Middle East turmoil, eurozone concerns and political noise in the U.S. on debt and fiscal issues. Firms and consumers reacted to these shocks by “temporarily” slowing consumption, capital spending and hiring as high and rising uncertainty created the option value of waiting. As long as these shocks don’t get worse and some become less acute, the optimists say, confidence will be restored. After all, the Middle East unrest has been contained to a few countries rather than igniting the entire region, oil prices have fallen somewhat from their recent highs and the EZ periphery problems are likely to be patched over. Japan may soon recover once productive capacity is restored and reconstruction spending starts in earnest, while bond vigilantes will give the U.S. until after the presidential elections of late 2012 to come up with a credible program to cut the deficit. Viewed with an optimistic spin, the recent shocks are transitory, growth is set to recover in H2 2011 and the recent market correction is bound to reverse itself, leading to the resumption of the market rally.


But there are good reasons to believe that this is not just a soft patch but rather a more persistent slump that may lead to a growth stall, a growth recession or even an outright double-dip recession in some advanced economies.


• First, the problems of the EZ periphery in some cases involve insolvency, not illiquidity: Large and rising private and public deficits and debt; damaged financial systems that need to be recapitalized and cleaned up to restore credit growth; a massive loss of competitiveness; a lack of economic growth; and rising unemployment. Public and/or private debts in Greece, Ireland and Portugal eventually will have to be restructured. The issue is not whether they will be restructured but when (sooner or later) and how (orderly or disorderly, with the latter more likely if Europeans kick the can down the road and postpone debt restructuring).


• Second, the factors slowing U.S. growth are chronic. Private- and public-sector deleveraging is slow but persistent, despite a recent pause in household deleveraging due to even more releveraging of the public sector. Rising oil prices are crimping growth. Job creation is barely meeting the increase in the labor force, keeping unemployment high, labor growth anemic and consumer confidence low. The housing market is in a double dip, with prices falling, quantities moving sideways at the bottom and no end in sight. Severe fiscal problems at the state and local levels are leading to a serious fiscal drag. At the federal level, an unsustainable deficit has gone unaddressed, while some spending cuts and the phase-out of transfer payments threaten to lead to increasing fiscal drag in 2011, 2012 and especially 2013. A second round of quantitative easing and third round of fiscal easing (US$1 trillion in tax cuts and transfer payments for 2011-12) gave us a meager 3% y/y growth handle for just one quarter—Q4 2010—before growth slumped to 1.8% in Q1 2011 and likely stayed in that vicinity in Q2. Given the deleveraging, the fiscal drag and the global economic shocks, H2 2011 and 2012 are not likely to be much stronger.


• Third, the outlook is no brighter for many other developed economies. Growth has been flat in the UK on average over the last couple of quarters as front-loaded fiscal austerity takes a toll. Meanwhile, rising inflation not only prevents the Bank of England (BoE) from easing; it may even force it to raise policy rates by the fall. Japan is already double dipping because of the earthquake; though modest reconstruction funding will give a temporary boost to GDP, the stagnation is likely to resume by late 2012.


• Fourth, the robust growth in EM economies may be softening because the recent overheating is leading to inflation and the need for monetary and credit policy tightening. Plus, the economic weakness of the G3 countries will take a toll on EMs via trade channels, including softer demand for commodities.


Overall, the various shocks of early 2011 that increased risk, uncertainty, volatility and risk aversion have hit growth in advanced economies that were already growing anemically because of ongoing deleveraging that required a slowdown of private and public spending. And this is happening at a time when monetary and fiscal stimulus has been or is about to be removed, leading to a monetary and fiscal drag. Thus, if the current slowdown in growth turns out to be worse than a temporary soft patch, the equity market correction and widening of credit spreads will weaken growth further through negative wealth effects on private spending and the rise in borrowing costs for private agents.


In this more adverse economic scenario, the equity market correction could severely worsen in the next few months. Until recent quarters, earnings had been surprising on the upside while profit margins had been surging to new highs, but now margins and earnings may be squeezed. The rise in commodity prices increases input costs at a time when firms are not able to transfer these cost increases to highly leveraged consumers via increases in retail prices. Plus, the slowdown in GDP and productivity growth increases unit labor costs and squeezes margins. The softening in final demand affects the bottom line through weaker top-line revenue growth. And, for any given earnings expectation, valuations will also suffer because of the increase in risk aversion due to tail risks and uncertainty.


The high-grade corporate sector is the only one that has undergone significant balance sheet repair. After massive cost-cutting, these firms are now lean and mean; highly efficient, productive and profitable; and sitting on trillions of dollars of cash. Indeed, households are still pressured by high debt; the public sector (at the federal and the state local and provincial government levels) needs to deleverage from high debt and deficits; banks and other financial institutions are still damaged and in risk management and deleveraging mode; and smaller and/or highly leveraged firms are also under pressure. All these sectors need to spend less and save more so as to reduce their high levels of debt and leverage. But the high-grade corporate sector, the only one that has done its balance sheet repair and thus is able to spend more, is very cautious about increasing capex and hiring. The optimists argue that this is due to the shocks of this year that led to an option value of waiting. But if uncertainty persists and earnings and profit margins get squeezed, capex and job creation will remain anemic, thus preventing the only sector that could lead a stronger growth recovery from stepping up to the plate.


Unlike in 2007-10, when every negative growth shock and market downturn was countered by more policy action, policy makers are running out of policy bullets and may not be able to trigger more asset reflation to jump-start the real economy. Indeed, to avoid a fiscal train wreck, most advanced economies (especially the eurozone and UK and even gradually the U.S.) are starting to implement much-needed fiscal austerity, which will have a negative effect on growth in the short run. Governments’ ability to backstop their banks via more bailouts, guarantees and ring-fencing is constrained by already high public debt and many near-distressed sovereigns. Another round of quantitative easing may not occur as inflation is rising (albeit slowly) in most advanced economies, and thus some central banks, including the ECB, are starting to tighten, and others (the BoE, the Fed) will follow in time. Indeed, after the end of QE2, even the Fed will not implement QE3 unless there are glaring signs of approaching stall speed and the market correction is much sharper.


Thus, if this period turns out to be something more serious than a temporary soft patch for the global economy, a number of advanced economies would risk falling into stall speed or outright double-dip recession as economic and financial market weakness feed off each other with few policy bullets left to reverse this new vicious cycle.