AS EQUITY AND real-estate markets soar, it might be worth taking a step back to judge whether the increasing optimism about an economic recovery will last. It is important to look beyond the headline numbers to see whether the major economies are making the adjustments needed to sustain recovery beyond the impact of the extraordinary but unsustainable government stimulus packages. When we do this, what we find is that while there are encouraging trends, the global economy is still not making the right adjustments.
Aggregate demand in US not self-sustaining yet, could weaken again
Putting all the data that has come out from the US economy recently together, we find some worrying aspects:
- Activity indicators up but in di cate fragile and patchy recovery. The Institute for Supply Management (ISM) manufacturing index weakened in September, reversing its recovery trend. While the ISM services index encouragingly indicated the first services-sector growth since September last year, the details suggest that only five out of 18 industries actually grew, leading the ISM analysts themselves to conclude that their members’ views on the economy remained mixed;
- Businesses remain hesitant about hiring or investing. Orders for core capital goods weakened, suggesting that the business sector lacks the confidence to expand capacity. Surveys show that businesses were not keen to raise inventories even if demand continued to recover at the current pace;
- Employment conditions point to weak consumption. The labour market is turning out to be much weaker than necessary for a sustained recovery. Not only were the job losses in September much bigger than expected at 263,000, but the government agency responsible for the data also announced that it would be revising up the estimate of total job losses in the economy in November by a truly horrible figure of 824,000. Cashstrapped state and local governments are retrenching workers on a massive scale, offsetting the expansionary efforts of the federal government; and
- Consumers are wary. The Con ference Board consumer confidence in dex reversed its recovery last month. Retail sales fell as soon as the “cash for clunkers” programme was ended. With the workweek declining again (implying no sign of businesses even starting to consider expanding work opportunities) and earnings weak, there are few underpinnings to demand.
As the subsidy for first-time home buyers expires in November, demand will come under further pressure.
Key adjustments are not happening convincingly
Taking the data as a whole, the recovery looks rather fragile, depending substantially on government programmes to boost demand, some of which are about to expire. If demand is to sustain recovery as these government programmes end, the economy has to complete a good part of the adjustments needed to restore the major economies, especially that of the US, to health. Progress has been made but, overall, these adjustment processes have not gone far enough to allow a sustained recovery.
- US households need to save much more. The latest consumer income and spending data shows a fall in the household savings rate to 3%, from a peak of 5.9% in May. US households will need to claw back spending for a while more to rebuild their balance sheets and return their savings rate to between 8% and 10%, which economists believe is an equilibrium;
- Consumer deleveraging is slow. Consumer-credit balances resumed their sharp fall in July, showing that this process of deleveraging has a long way more to go. Bank loans are still falling;
- US external imbalances have to decline fundamentally. Instead, the trade deficit rose again in July. Even the non-oil trade deficit has surged again, so one cannot argue that the rise was due to commodity price increases. The US imbalance in its external accounts, identified as a contributing factor to the financial crisis, is not being rectified in a hurry;
- The shakeout in the banking sector has barely begun. So far, at least 95 banks have failed in the US. Bank analysts such as IRA estimate that more than 1,000 will fail in this crisis: We have 900 more to go! The process of cleansing the financial sector has a long way to go; and
- The housing sector is stabilising but remains fragile. Housing data shows encouraging signs of bottoming out — sales data and prices are ticking up month-on-month. With the labour market worse than expected and GDP recovery uncertain, however, the stirrings of housing recovery are at risk.
Implications for Asia
Of course, the data in Asia continues to show a recovery. China’s trade, production and monetary data continues to highlight the country’s strong recovery. Singapore’s economy is clearly on a recovery track too. Elsewhere in Asia, the South Korean economy is beginning to hum again, leading its central bank to start signalling a possible rate rise. In Australia, the economy is already so strong that its central bank has actually started raising rates. The analysis above suggests, however, that Asian economies that depend on external demand, especially from the US, should be wary. The economic news flow may not continue to surprise on the upside as we move towards year-end and enter the new year.
Leaving aside the day-to-day economic data, the balance seems to be shifting to less pleasant news for markets:
- At the global level, currencies are likely to generate more uncertainty. Confidence in the US dollar appears to be under pressure, as financial markets worry about the sustainability of current policies. The US economy was showing signs of bottoming and probably rose in 3Q2009 after the longest period of decline in post-war history. But, we would not be surprised if this rebound loses momentum as early as 4Q2009, given some of the weaknesses highlighted above; and
- More weaknesses in US public sector capacity to support growth could be shown up as the economic headwinds strengthen again. The federal government needs to do more to shore up state and local governments, which would mean spending even more and raising the deficit overhang. Federal agencies need to do more to clean up the mess, but many are in bad shape, with the recent concerns over the Federal Deposit Insurance Corp being just one example.
In short, financial markets are running more on a massive wave of liquidity than on fundamentals. Just as a wise man does not stand in front of an oncoming train, the wise economist has to be careful not to be too bearish when liquidity is cheap and plentiful. This liquidity-driven equity market may well go on surging for a while yet — but history shows that liquidity can carry markets for only so long.