City & Business: No recession, but we're not home and dry
Sunday 25 April 1999
The FT-SE now stands nearly 2,000 points higher, with the Dow Jones more than 3,000 points up, and we know now, of course, this was the global recession that never was. How come? The emerging markets crisis of 1998 turned out to be a good cop-bad cop for industrial countries. It took the legs away from global manufacturing but propelled consumer confidence and spending in a way most people expected, but under-estimated. The pro-active and decisive interest rate cuts by the Federal Reserve and the Bank of England turned financial market sentiment around very fast. This, plus the lagged effect of the sharp fall in bond yields last year, helped to ensure the fear of a recession stayed just that. It's now been replaced by optimism about global economic recovery and financial markets that's almost as unnerving as the doom and gloom.
At Warburg Dillon Read, our forecast for the world economy in 1999 now stands just shy of 2 per cent, rising to 2.6 per cent in 2000. We now expect the US to grow by 3.8 per cent this year, almost double the forecast of last October, but the most likely scenario for the US into 2000 is a slowdown. In the UK, we have taken up our forecast for this year from 0.3 to 1 per cent and in 2000 from 1 to 2.5 per cent. The critical factors are the effects of the 2.25 per cent interest rate fall since 8 October; budgetary policy; and employment boosts to disposable income. We estimate household gross incomes will grow by just over 10 per cent this year, after just 2.6 per cent in 1998.
The outlook for the world economy is far brighter than most feared last October. But it is quite fragile in many countries and regions, and it is rife with financial imbalances that are likely to prove unstable.
Evidence continues to mount that global demand and growth are gaining momentum, reflected for several weeks in financial markets and commodity prices. The spreads at which corporate and emerging market bonds trade over government bonds have continued to narrow as investors take on more risk. Capital has been flowing back to Japan, where foreigners (mainly) have driven the Nikkei 225 up by more than 25 per cent since 1 January. Cyclical stocks - such as steel, cement, paper, engineering - have been the "hot" game, rising sharply as investors have "rotated" away from the growth stocks, such as telecoms, pharmaceuticals and IT. The blue- chip FT-SE 100, for example, has risen by 16 per cent since January, but the broader FT-SE 250 is up 27 per cent, and the FT-SE smallcap index 29 per cent higher.
In the UK, last year's recession fears were rather more of a close- run thing than in the US. Britain's economy grew by just 1.2 per cent annualised in the second and third quarters, and stalled in the final quarter and the first quarter of 1999 with a paltry 0.4 per cent expansion. And the index of manufacturing, that had barely risen in the summer, ended 1998 below the January level.
But the economic data that has emerged recently - especially the record numbers in work, the low 4.6 per cent jobless rate, and improving industry surveys, housing market and retail sales - suggest the economy has troughed. Now a pick-up is most probable.
In the tepid economy of the euro zone, the recent 0.5 per cent cut in interest rates by the European Central Bank will be some help, and the weakness of the euro a modest support. But manufacturers in Europe have suffered more than in the US, and consumer demand compares poorly in view of double-digit jobless rates and much softer growth in disposable income. GDP growth in the first half of 1999 will continue to show a slide from 2.3 per cent in the year to end 1998 to 1.75 to 2 per cent. But by mid-year, we should be looking at enough high-frequency data to expect this to have been the low point. The trouble is that Germany, France and Italy, together accounting for three quarters of the euro zone's GDP, are the countries in the dog house.
By far the biggest problem for the global economy is the imbalance between the US on one hand and Japan and the EU on the other. Last year, for example, domestic demand growth in the US accounted for around 50 per cent of the growth in world demand. Not much seems to have changed this year.
If America continues to grow so rapidly, alone, with clear signs of overheating already present (but not in the conventional inflation numbers), the yawning trade gap would become of even graver concern. We might be faced with the nasty spectacle of a tighter monetary policy and a falling US dollar. No prizes for guessing what happens to equities then. So canthe US slow down? It could happen without the Fed raising interest rates: capital investment is looking tired, profits are being squeezed and both jobs and income growth are slowing. The soft landing is the kinder outcome for asset prices. If the Fed does tighten, we had all better look out for some portfolio insurance.
We are witnessing an explosion in trade and current account imbalances unparalleled since, and likely to surpass, the mid-Eighties. Last year the US current account deficit was almost $300bn (pounds 185bn), or 3.25 per cent of GDP. This year it will be higher still. The rest of the world has to keep buying US assets to finance this gap plus whatever Americans invest abroad. The ensuing build-up in America's external liabilities could reach almost $1,500bn by the millennium. For the world's reserve currency country, this is nowhere near as serious as for other nations. But there are limits to how many US assets foreigners are willing to buy at today's exchange and interest rates, given such expectations.
Finally, it is worth remembering what a strange year 1999 is turning out to be: there's a war going on in Europe with still uncertain but potentially serious consequences, and then there's the year 2000 bug. Unlike money - for which there is a lender of last resort to address possible shortages - commodities and physical goods are hostage to the sentiment swings which Kosovo and the bug may or will be influencing. So we may see bouts of economic optimism and pessimism related to these issues. Last year's global recession didn't happen, and probably won't in 1999- 2000. But the health-check on the world economy still says "keep it in for observation".
George Magnus is chief economist at Warburg Dillon Read.
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