Last week’s economic news is broadly consistent with global recovery in the second half of the year. However, persistent uncertainties related to the strength and sustainability of final demand imply a significant risk that the incipient recovery will be aborted or short-lived.
Four developments raise the likelihood that recovery will take hold:
1. Credit Conditions Continued to Improve Gradually
- The 3 months LIBOR-OIS spread – the premium over expected central bank interest rates that commercial banks charge each other – continued its decline to 0.28 percent, nearing pre-crisis levels. The spread was 3 basis points below its value from the previous week and 7 basis points below its value from a month ago. The TED spread – the difference between what banks and the Treasury pay to borrow money for three months, narrowed to 0.30 percentage points, from 0.32 percent a week earlier and a high of 4.64 percentage points in October.
- Emerging markets have seen a remarkable improvement benefiting from the easing of the credit crunch and increasing commodity prices. The EMBI spread – the extra yield investors demand to own emerging-markets bond instead of U.S. Treasuries – has narrowed by 35 basis points compared to a month ago. However, it was wider by 3 basis points for the week. The cost of credit to high-yield corporate borrowers is now below pre-Lehman levels. Year-to-date corporate bond issues in both the United States and Europe have surged relative to the same period last year.
2. Wealth Effects Are Helping
Global equity markets have been rallying recently and signs of stabilization in the housing sector strengthened, contributing to stronger consumer balance sheet and facilitating equity sales and asset disposals for capital-constrained banks.
- Global equity markets finished with modest gains last week, after economic data around the world encouraged hopes that the end of the recession is in sight. The Dow Jones, S&P 500 and NASDAQ rose by between 0.6 percent and 0.9 percent. Germany’s DAX gained 0.7 percent, while other major indices in Europe rose by more than 0.6 percent. In Asia, Japan’s Nikkei 225 was up by 4.1 percent. The MSCI Emerging Markets Index added to the previous week’s gains to take the year-to-date returns to a massive 48.8 percent. Ems have now recouped their post-Lehman losses.
- In the United States and UK, home prices improved adding to hopes of stabilization in the sector. The U.S. S&P/Case-Shiller home-price index rose 0.5 percent (month-to-month) in May, the first monthly gain since July 2006, and new home sales increased 11 percent (m/m) in June. In the U.K, the average price of a house rose by 1.3 percent m/m in July, increasing for a third consecutive month.
3. Government Policies Expected to Remain Supportive
- Major central banks opted to either reduce or hold their target interest rates unchanged. The central Bank of India maintained its key interest rate unchanged at 3.25 percent. The Bank reiterated that it will maintain an accommodative monetary stance until there are definite and robust signs of recovery. Hungary’s central bank cut its key interest rate by 100 basis points to 8.5 percent, more than the 50 basis points more than the market expected. Poland’s central bank left its interest rate unchanged at 3.5 percent.
- China’s central bank pledged to keep pumping money into the financial system to support a recovery, reiterating that it will maintain a “moderately loose monetary policy.” Chinese President Hu Jintao also said the country should stick to its proactive fiscal policy and moderately easy monetary policy to ensure a stable economic growth as the recovery is not yet solid.
- In another stimulative measure, the U.S. House of Representatives approved a $2 billion extension of the government’s car sales incentive program, “Cash for Clunkers”. The $1 billion program, which gives drivers a rebate to turn in an old car to buy a new one, found success immediately and ran out the budget in less than a week.
4. Production Indicators are Broadly Improving
- China’s Purchasing Manager’s Index (PMI) increased by 0.19 percent (m/m) to 53.3 in July, signaling a continued expansion of production. Japan’s factory output increased 2.4 percent (m/m) in June and 8.3 percent (q/q) in the second quarter, while a measure of capacity utilization had been stable near 70 percent for April-May, after a first quarter low of 60 percent. Hong Kong’s exports slowed their seven month decline, with improved trade with mainland China causing exports to decline by 5.4 percent (y/y) in June to HK$211.1 billion, following a 14.5 percent (y/y) decline in May.
- While Asia is clearly standing out in its early recovery, output is stabilizing across the globe. U.S. GDP in the second quarter contracted by a better than forecasted 1 percent, led by a 5.6 percent increase in government spending, following a 6.4 percent GDP contraction in the first quarter. In Europe, the Eurocoin index, which measures economic expansion in the Euro region, sustained a five month increase, of 31.1 percent (m/m) in July, indicating that the economy had bottomed out in the first quarter. This view was further corroborated in slower GDP declines from the first quarter to the second quarter in Spain, from a 1.9 percent (q/q) decline to 0.9 percent (q/q) decline, and Sweden, from a 6.5 percent (y/y) decline improved to a 6.2 percent (y/y) decline.
- Inventory levels have been cut to the bone (the decline of inventories lopped off 0.8 percent of U.S. GDP in the second quarter), and this bodes well for a continued output recovery in the short-term.
- Firmer production is having an effect on the demand for commodities. The commodities market has surged on optimism a global economic recovery will revive demand for industrial metals. Copper has surged 84 percent this year.The price of Brent crude oil closed at U.S. $70.88 per barrel, up from $69.74 at the end of the previous week.
Doubts Remain About Final Demand
Ultimately, a sustained recovery will hinge on consumer spending and its effects on investor confidence. A forceful consumer recovery will depend in part on a turn in labor markets, which is many months away, and a strong recovery in business investment will require that firms reduce unused capacity first.
- Unemployment has continued to increase. Japan’s jobless rate rose 0.2 percent to 5.4 percent (m/m) in June, while the Euro region unemployment rate reached a 10 year high of 9.4 percent in June, with the help of 30,000 new jobs lost in Germany alone.
- U.S consumer spending declined by a worse than expected 1.2 percent in the second quarter, following a 0.6 percent first quarter increase. Durable goods orders declined by 2.5 percent in June. Japan also experienced a consumer spending decline of 1.7 percent in June, while retail sales declined a further 3 percent (y/y) in the same month.
- Despite the decline in major demand indicators consumer confidence rose in some economies, though from very low levels. In South Korea a consumer sentiment index increased 2.8 percent (m/m) to an almost seven year high of 109 in July. Consumer confidence indexes recorded an eight month high in the Euro Region and a fifteen month high in the U.K in the same month, with the exception of U.S where the Conference Board confidence indicator declined by -5.5 percent (m/m) to 46.6 in July.
Looking Ahead
For confirmation that recovery is in sight, watch retail sales and capital goods orders in the U.S. and Europe in coming weeks.
Prepared with the help of Shimelse Ali and Mihir Narain
