Overview - International economy

The extraordinary stimulus provided by governments and central banks around the world have finally gained some traction and have helped stabilise the global economy. Nowhere is this more evident than on credit markets where spreads now show some semblance of normality.



While growth in China continues to exceed expectations, courtesy of measures that have induced strong domestic demand, there are also some signs of growth emerging in the United States but these remain tentative for now and it must be said the situation remains extremely fragile.



From a macro sense, the erosion of household wealth brought about by the potent mix of falling house prices, falling stocks prices and rising unemployment was always going to lead to a decline in consumer spending (in the United States, consumer spending accounts for around 70% of GDP and so the importance of this sector cannot be understated).  To address this problem, Governments set about adding liquidity and reducing interest rates to encourage lending, together with unprecedented levels of government spending.



With industrial production and business confidence beginning to improve in the United States, you could be forgiven for thinking that the worst is over. Yet the reality is that the situation remains extremely fragile. Most of the improvement has been stimulus driven. The health care sector has benefitted from the Government’s plan to extend health care to the masses. The auto sector has benefited from the ‘Cash for Clunkers’ program, the financial sector has benefitted from the low interest rates and Government contractors have benefited from the infrastructure programs. All of these policies have been positive for the US economy and in the short term we may see further growth as inventory de-stocking is reversed. But ultimately these effects are all stimulus driven and are unsustainable.

The reality is that the fundamental cause of the current crisis needs to be fixed before a sustainable growth path can be assured. Make no mistake that this repair process is happening but it was never going to be fixed overnight.  The banking sector has started the deleveraging process but this is not yet complete and systemic risks remain while equity levels remain low.  Outside the financial sector, the corporate sector is in reasonably good shape but the consumer is little advanced and so they must continue with the deleveraging process before they can start to spend again in a sustainable fashion.  Without equity in the family home, low interest rates, designed to entice the consumer into spending once more, may have little effect. Meanwhile, unemployment continues to trend higher and, at the same time, Government debt has soared.



So, while the consumer is undertaking the painful and prolonged process of deleveraging to restore their own balance sheets, the irony is that the government has tried to fix the problem by borrowing even more money. This of course, has created a new, and highly dangerous, imbalance in the economy. Budget deficits must be funded in some way shape or form. If policymakers try to rein in the deficit by reducing spending and increasing taxes then they risk undermining any recovery. On the other hand, if policymakers continue to maintain large deficits and provide liquidity then the prospect of higher inflation and (hence) higher interest rates may also counteract growth.  In addition, there is now little room to manoeuvre should another shockwave hit the economy broadside. Where is the money going to come from next time to fund future stimulus measures?

All of this may sound overly bearish. In the short term we actually remain confident that a recovery is emerging in the global economy - but we expect growth to remain very weak indeed. In the medium term our concern focuses on how Central Banks and Governments are going to extricate the liquidity in the system without causing another recession.  Therein lies an enormous challenge to policymakers.