Encouraging signs could still hide nasty shocks

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The Independent Online

Whether it's engineers from Europe or burger flippers from Britain, economic activity is picking up fast

Sometimes, everything seems simply wonderful but there are problems below the surface. Sitting here writing this, I can see blue skies and the early morning sun, giving the impression that summer has arrived early this year. But the truth is a little different. There's a cold frost. People are still wrapping up warm. And the King family's central heating system has broken down.

Just as appearances can be deceptive with the weather, the same is true in economics. Having just returned from holiday, I'm impressed by the encouraging economic data that's been released since the beginning of April. Survey data from the UK, from the eurozone and from America have all been highly encouraging. Whether it's manufacturers from America, engineers from Europe or burger flippers from Britain, the message has been entirely consistent: the level of economic activity is picking up fast compared with the trough reached at the tail end of 2001.

My two charts this week provide the key evidence. The first chart, from the UK, shows the Purchasing Managers' Survey for manufacturing industry tracked against manufacturing production. You don't need to have a degree in advanced econometrics to see that the improvement in the survey – reflecting greater confidence within the manufacturing community – should be followed fairly quickly by an improvement in actual output. The second chart, from the eurozone, shows the Purchasing Managers' expectations index for service sector industries. If our optimistic friends across the Channel are to be believed, the eurozone's service sector economy is about to return to the growth rates last seen at the beginning of 2000, at the height of the global economic boom.

These results are very impressive. They suggest that monetary policy has been highly successful in pulling the world away from the recessionary abyss. Indeed, my colleagues at HSBC have been revising up their forecasts for economic growth for this year, primarily based on the good news from survey data and, for the US, Korea and Taiwan, hard evidence of actual increases in output levels.

Despite all this good news, I still have underlying doubts. It would be nice to think that the world economy could avoid the same fate as the King's central heating system and, certainly, it appears that a number of key repairs have been made to ensure decent economic growth over the next few months. But, as to the sustainability of this story, I remain concerned. Three factors stick out as potential threats to our economic health. First, debt levels. Second, the failure of equities to mount a significant recovery. And, third, the impact of higher oil prices.

These factors are linked with one another. Increases in consumer debt have been partly encouraged by central bankers who, quite reasonably, wanted to ensure that a corporate downswing did not become a downswing for the broader economy. Aggressive rate cuts were designed to encourage additional consumer spending at a time when companies were cutting back right, left and centre. So far, the policy has worked well. With low levels of interest rates, high debt levels can be serviced relatively easily, leaving consumers a long way off the kinds of difficulties encountered at the beginning of the Nineties.

The level of interest rates, however, has both direct and indirect effects. One standard result for financial markets coming out of an economic downswing is a robust recovery in equity prices. As interest rates fall and a recovery in profits is anticipated, so equity prices rise. Higher equity prices in turn support capital spending – companies have greater and more liquid access to capital markets – and consumer spending – consumers who own equities should benefit from a positive "wealth effect".

This time around, the recovery in equity prices has been very disappointing. Maybe they simply didn't fall far enough in the first place. Maybe the outlook for profits is still very poor. Maybe companies are still facing a significant hangover from earlier investment excesses. Whatever the reason, equities appear to be playing a much smaller part in nurturing economic growth this time around compared with earlier periods of recovery from recession or economic downswing.

This failure of equities to pick up also has longer-term implications. Consumers may have run up debt levels today in part because interest rates are so low. That's fine but, over the longer run, consumers will ultimately have to pay off the capital as well as the interest on their debts. If they have assumed that their savings will offer the same capital growth enjoyed by savvy – or maybe lucky – investors over the past 20 years, they could find themselves in for a nasty shock a few years down the road. Alternatively, if they really are savvy, they may simply have to save more out of current income to pay off debt, implying an end to the borrowing binge that's been so helpful for economic growth over the past few years.

Oil prices are also a key part of this story. In the old days, we thought of oil prices as either a cause of inflation or as a key part of an inflationary process. Today, it's difficult to reach the same conclusions. In fact, there is no reason why, theoretically, higher oil prices should lead to rising inflation, at least beyond the very short term. Higher oil prices represent an income – or terms of trade – gain to oil producers and a terms of trade loss to oil consumers. On the whole, the western world is a terms of trade loser. Higher oil prices raise the import bill, increasing costs to both producers and consumers, thus eating away at real incomes. Only if companies and consumers are able to respond to this increase in costs – by raising prices or wages – is there likely to be a pick-up in inflation on a sustained basis.

Is there any evidence of this kind of pricing power? Not really. Companies have found it increasingly difficult to raise prices in the face of stiff global competition. Meanwhile, although unions in some parts of Europe continue to strut their stuff, the reality is that wage growth has been a lot more muted over the past 10 years than was the case in either the Seventies or Eighties. Consequently, higher oil prices provide a greater threat to output than to inflation, either by squeezing profits, thereby leading to lower investment, or by squeezing household incomes, leading to lower consumer spending.

Squeezed incomes, lower equity returns? Neither of these is good news for final demand, whether of the consumer or investment variety, particularly against a background of high debt levels. So although the pilot light of economic recovery has been lit, there are no guarantees as yet that we are on the verge of a warm and cozy period of economic expansion. As I have discovered to my frustration, igniting the pilot light is all very well but means nothing unless the initial blue flicker gets the whole boiler rumbling away. For the world economy, the pilot light is back on but, as yet, we cannot be sure that the boiler is functioning properly. Raising interest rates now would be akin to sending the plumber away before the central heating system had been properly put through its paces.

Stephen King is managing director of economics at HSBC.

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