NEWSLETTERS 

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REVIEW OF 2009

Even the most prescient of forecasters failed to see the storm that would hit the UK in 2008 and 2009, with the FTSE 100 posting it's worst ever return over 12 months to March 2009 and then staging a dramatic recover - but not a complete one.. 

Will it last?

The global economy emerged from intensive care during 2009. A year ago financial markets were left reeling after enduring a systemic failure of the banking system and one of the sharpest, deepest recessions on record. Throughout the course of the year policy makers undertook extraordinary measures to rebuild confidence in the financial system and stimulate economic activity. As we head into 2010, economic data has begun to improve and financial markets have responded with enthusiasm. 

As the financial crisis intensified last year, prompt action by policy makers across the globe successfully prevented the global recession turning into something far worse. As 2009 draws to a close, growth has now returned to most parts of the world. Emerging markets have led the way,rebounding strongly. Among the major developed countries, only the UK failed to provide a positive reading on economic growth (GDP) for the third quarter.

The return to economic growth has been accomplished by a combination of an unprecedented policy response and a pronounced global inventory cycle. As global credit markets seized up last year and trade finance became prohibitively expensive, firms drastically cut back on production and met sales demand from their existing stock of inventory. While demand clearly suffered at the height of the crisis, a combination of lower interest rates, fiscal support and reduced energy costs helped to stabilise consumer spending through 2009. This has led to a rapid reduction in inventory levels. This inventory cycle is remarkably synchronised across the world. By the middle of the year companies could see that production levels were insufficient to meet demand. Unless production increased, inventories were set to become too lean. Subsequently, global trade and production has enjoyed a sharp rebound in activity.

Our calculations suggest that at the start of the fourth quarter of 2009, the world was around half-way through the process of bringing production back towards the level of final sales. This should lead to some decent GDP readings for the final quarter of the year. But by early next year, destocking should be largely complete. There is a risk that companies decide to embark on a period of over-production to restock. But we feel firms will be comfortable holding a lower level of inventories than before the crisis given the fall in demand, caution about the outlook and unwillingness or ability to access credit.

As destocking ends, this should be reflected in either a stalling or perhaps even some softening in many business surveys. This could trigger fears of a ‘double-dip’, even if such an outcome is avoided.

The outlook for 2010

The developed world

Once the boost to growth from firms rebuilding inventory levels and various fiscal stimulus measures wears off, we expect underlying demand to be sluggish and the developed economies to only gradually strengthen through 2010.

Exports typically lead a recovery following a recession but this channel doesn’t work when your trade partners are a also struggling. UK & US exports should perform relatively well given their currency weakness. Emerging market lso struggling. UK and US exports demand should provide some support, but at the moment it is not large enough to offset the lack of demand from developed countries.

The other route to recovery is lower interest rates. Cheaper debt typically encourages those still in work to borrow more. But credit conditions remain tight and households are in the process of repairing their balance sheets. Debt is likely to be paid down and saving rates will rise, especially in those countries which have suffered the steepest falls in house prices. This makes consumption growth heavily reliant on wages and salaries.

While we expect job shedding to ease, we think companies will be slow to hire. With unemployment high, wage growth is likely to be subdued. The corporate profit outlook has improved and companies are beginning to generate sufficient cash flow to fund an expansion in business investment. Unfortunately, with so much spare capacity and an uncertain outlook for final demand, companies are unlikely to commit to new investment spending beyond the level necessary to cover depreciation.

In an environment of high unemployment, excess capacity (where firms are producing less than optimal levels of output) and only a modest recovery in demand, we expect inflation pressures to remain muted over the next year.

Headline inflation is likely to increase sharply over the next few months as energy prices have risen, but we see little impact on core inflation (a measure which excludes volatile items such as food and energy). Higher commodity prices probably pose more of a risk to growth as they squeeze real incomes.

Given the subdued growth and inflation outlook, it is too early to withdraw from ultra-easy monetary policy. We don’t anticipate either the US Federal Reserve, Bank of England, ECB or Bank of Japan raising rates next year.