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Tuesday, November 04, 2008

Grim, just grim

Guest post from Macquarie's Rory Robertson

**The financial and economic damage from the global credit crunch has been accumulating since the "music stopped" in money and credit markets in August 2007. For starters, equity markets in most countries have suffered falls of around 30-40% over 2008 so far, with many commodity prices, and property prices in many places, also having come under severe downward pressure.

**Across the world, economic activity now is either slowing sharply or shrinking. And the global economic backdrop continues to deteriorate. A growing number of indicators have "fallen off a cliff" in October, suggesting that households and firms pretty well everywhere are "hunkering down" in the wake of the dramatic intensification of financial turmoil post-Lehmans' collapse in mid-September. Business investment in Q4 and beyond seems likely to show jaw-dropping slumps in many economies.

**Disturbingly, the famous "paradox of thrift" seems to have taken over for now, with households and businesses across the world suddenly "saving for a rainy day", thus ensuring that the coming economic weather is indeed bleak. As an example, Christmas parties now are being cancelled as "an acknowledgement of the need for restraint in the context of the current economic climate"...

**The US economy - the world's biggest by far - obviously is in a deepening recession, with employment looking set to shrink for another couple of years. Friday's Payrolls report probably will confirm that job losses increased in October, from 159k in September.

**Indeed, each of the big developed (G7) economies - the US, Japan, the UK, Germany, France, Italy and Canada - now is either in a severe recession or well on the way. The BRICs too - the big developing economies of Brazil, Russia, India and China - are slowing significantly. Unemployment is rising or set to rise sharply in most places.

**Accordingly, the outlook for policy rates seems clear: as unemployment rises and inflation subsides, central banks will (continue to) cut aggressively, towards 2% in the UK and the Euro-zone (from 4.5% and 3.75%), and towards 4% in Australia and New Zealand (from 6% and 6.5%). The US and Japanese economies too still need all the help they can get: from 1% and 0.3%, Japan's previous ZIRP - Zero Interest Rate Policy - is a growing prospect.

**Unfortunately, the nature and size of today's global economic and financial problems have become increasingly clear as time has passed. A vicious "feedback loop" is playing out between tighter credit, weaker economies and lower asset prices, and around again.

**Despite unprecedented official efforts, credit availability for households and businesses continues to deteriorate pretty well everywhere. Many lenders - like most everyone else - are hunkering down to survive any worst-case scenario. The obvious problem is that if lenders won't lend, then economies can't grow. Moreover, the availability and price of credit - as we saw in boom times - are big-time drivers of asset prices.

**We've experienced a serious financial panic in recent months, with dramatic falls in global equity prices, commodity prices and (non-US$, non-yen) currencies. It's been a particularly wild and woolly time since Lehmans collapsed in mid-September.

**That event sparked a sudden intensification of "risk aversion", a massive global rush to the safety of cash and other risk-free assets. In a period of about six weeks, many equity- and commodity-price indexes generally dropped by around 30%, and many (non-US$, non-yen) currencies experienced dramatic if smaller drops.

**Why that savage episode of liquidation? Well, since the early-2000s, there had been strong market uptrends in global equities, commodities and many (non-US$, non-yen) currencies. Buying bred buying, increased leverage and higher prices on the way up. Now, "deleveraging" of hedge funds and financial institutions in particular is underway on a massive scale, selling has bred selling, and prices have been forced sharply lower.

**While there's been some welcome stability in recent days, no-one knows how the current extraordinary episode will end. Despite governments across the globe intervening aggressively to support their banks and other intermediaries at the core of their financial systems, and central banks cutting interest rates aggressively, the global credit crunch of the late-2000s rapidly is becoming the most damaging financial event in our lifetimes.

**It's not exaggerating the seriousness of the current situation to say that global financial disaster still is possible. For starters, growing economic weakness - and falling revenues - will turn many loans "bad", and undermine the balance sheets of lenders everywhere.

**Moreover, as noted above, the availability and cost of credit are critical drivers of asset prices. Unfortunately, the ability of capital-constrained financial systems in the G7 economies to sustain recent levels of credit - let alone produce credit growth - is under extreme stress.

**With demand having slumped recently in most economies, equity prices sharply lower and credit conditions tighter, trading conditions for many businesses are extremely difficult, to say the least. Across the globe, large numbers of firms - both big and small, financial and non-financial - will cease operations over coming quarters and years. As the volume of insolvencies surges, assets will continue to be transferred from weak balance sheets to strong balance sheets, at lower prices.

**The good news is that G7 inflation no longer is a problem, the "Third Oil Shock" is dead - buried by the more-than-halving of the US$ oil price since mid-year - and interest rates are being reduced. Earlier widespread worries about excess inflation have been crushed by growing excess capacity and rising unemployment globally, alongside sharp falls (reversals) in oil and other commodity prices.

**Policy rates are falling towards record lows across the G7 and the OECD. In the US, the Fed last week cut its funds rate by a further 50bp to 1%, revisiting 2003-04's rock-bottom rate. The US policy debate now is turning towards "deflation" and the merits of ZIRP.

**As noted here previously, US headline CPI inflation will be less than 1%, perhaps less than zero, by this time next year. The drop from recent 5-6% headline rates will be dominated by the reversal of the earlier surge in petrol prices, but trend wage and price pressures also will subside significantly as US unemployment trends to 8%, maybe higher.

**In Canada - an economy "joined at the hip" to the deepening US recession - the BOC already has halved its policy rate to 2.25% (from a peak of 4.5% last December), probably on the way to 1% as unemployment trends from 6% towards 8%.

**In Japan, there's the prospect of a return to deflation and ZIRP. The BOJ last week surprised pretty well everyone by cutting its policy rate by 0.2pp to 0.3%, rather than by 0.25pp to 0.25%. Why Governor Shirakawa felt strongly enough to hold back 5bp worth of cut is unclear, not that it matters much.

**In the UK and the Euro-zone, meanwhile, the BOE and ECB have looked hopelessly flat-footed in 2008. Embarrassingly, they chose not to cut rates in the six months to September, despite their economies trending towards recession. Indeed, the ECB actually hiked in July (just after GDP shrank in Q2!), and then managed not to cut at its meeting a fortnight after Lehmans' collapse.

**On 8 October, with the Fed reportedly leading the charge, both the BOE and the ECB were dragged by the nose to a co-coordinated 50bp rate cut. Both institutions will need to cut rates by 100bp this Thursday (6 November), if critics are to be convinced that Europe's policymakers have much of a clue about the current dire situation. With local recessions just warming up, the BOE and ECB probably will both find themselves cutting to 2% (from 4.5% and 3.75% at present) over the coming 6-12 months.

On a more positive note...

**Given the savage "hunkering down" now underway in businesses and households across the globe, the Australian economy may not be able to avoid recession. The main worry is that our record-breaking uptrend in business investment may already be in full retreat. In any case, there are at least four factors that give the Australian economy a fighting chance to outperform in a serious global downturn:

(1) The RBA's effective policy framework, and plenty of monetary ammunition. The RBA has cut its cash rate by 1-1/4pp at its past two meetings, and the standard-variable mortgage rate has fallen by a similar amount. The Fed, the ECB and the BOE can only dream of such powerful pass-through. Moreover, the RBA's cash rate still is a relatively high 6%, so there's plenty of room for lower rates as required. I'm guessing the RBA will cut to a "neutral" 5% by Christmas, dragging mortgage and business-borrowing rates significantly lower.

(2) The weak A$ now is Australia's new best friend, given the substantial recent drops in global commodity prices. The A$'s 25-30% decline from mid-year highs is a huge free kick for Australian exporters and import-competers. Yes, global demand is weakening fast but at least our tourism, agricultural, manufacturing, education and other tradeable sectors will sell more with the A$ below 70 US cents than above 90 US cents (or with the TWI in the 50s rather than in the 70s).

(3) Canberra's pristine balance sheet means there is plenty of fiscal ammunition. As now is well known, there's plenty of room for counter-cyclical fiscal-policy efforts, including tax cuts, cash injections, and the further expansion of infrastructure programmes. (Both those already announced, and those that will be announced over the next year or two.) Importantly, with a no-net-debt starting point - and Australia's lenders well regulated and still-very profitable - Canberra's guarantee of financial system deposits and selected (new and existing) debt securities is absolutely credible.

(4) Australia's housing sector is widely seen as having the problem of "under building" rather than "over-building, as in the US. In particular, net immigration rising from 100k towards 200k over the past decade has collided with a flat two-decade trend in new home starts of only 150k per annum. That is, Canberra has overseen the biggest immigration programme in Australia's history, without initiating the construction of extra homes. ("Land release" and "planning" for home-building generally are overseen by State and local governments.) The dismal lack of co-ordination between Canberra and the States on immigration and housing long has been seen as a problem, putting upward pressure on home prices and rents, and reducing "housing affordability". Now, Australia's slow-moving housing-supply response suddenly seems a good thing, limiting somewhat the size of any future home-price falls.