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THE GLOBAL ECONOMY: TERROR ON TOP OF RECESSION Klas Eklund, SEB SNS, October 23, THE GLOBAL ECONOMY: TERROR ON TOP OF RECESSION Klas Eklund, SEB SNS, October 23, 2001 1

STARTING POINT: OECD INDUSTRY IN RECESSION 2 STARTING POINT: OECD INDUSTRY IN RECESSION 2

US PRE-TERROR: BOTTOMING OUT? 3 US PRE-TERROR: BOTTOMING OUT? 3

THE KEY: CONSUMER CONFIDENCE 4 THE KEY: CONSUMER CONFIDENCE 4

RISING UNEMPLOYMENT 5 RISING UNEMPLOYMENT 5

US CYCLE, PRE-TERROR Y-o-y percentage change 6 6 5 5 4 Forecast SEB 4 US CYCLE, PRE-TERROR Y-o-y percentage change 6 6 5 5 4 Forecast SEB 4 3 3 2 2 1 1 0 6 00 01 Sources: Eco. Win, SEB 02 03 0

THE ATTACKS: IMMEDIATE EFFECTS • In a macro perspective, small material damage: 0. 1 THE ATTACKS: IMMEDIATE EFFECTS • In a macro perspective, small material damage: 0. 1 -0. 2% of GDP • But nonetheless recession in Q 3 -Q 4 – Losses in communications sectors, finance, tourism, retail, etc – Supply chain broken • Financial markets: Flight to safety • Central banks in successful concerted action to guarantee liquidity • Steeper yield curves: Short rates fall, while bonds are affected by opposite forces 7

STOCK MARKET: DOWN AND UP 8 STOCK MARKET: DOWN AND UP 8

YIELD CURVE: STEEPER 9 YIELD CURVE: STEEPER 9

NOW: AN INTERIM STAGE • Consumer confidence and retail sales down • Important industries NOW: AN INTERIM STAGE • Consumer confidence and retail sales down • Important industries severely hit • Monetary and fiscal stimulus in the US • Building broad political coalition, ground troops on their way • The future will be decided by military/ political developments and effects on consumer confidence - and how this affects the fragile recovery 10

THREE SCENARIOS • Quick solution – Earthquake scenario • Drawn out conflict – Gulf THREE SCENARIOS • Quick solution – Earthquake scenario • Drawn out conflict – Gulf War scenario • The ugly case – Dramatic escalation of conflict Remember: Our starting point was below consensus 11

SCENARIOS Y-o-y percentage change 6 6 5 5 4 Forecast SEB 4 3 3 SCENARIOS Y-o-y percentage change 6 6 5 5 4 Forecast SEB 4 3 3 2 2 1 1 0 12 00 01 Sources: Eco. Win, SEB 02 03 0

1. THE QUICK SOLUTION • Successful retaliation • No further terror attacks; the Anthrax 1. THE QUICK SOLUTION • Successful retaliation • No further terror attacks; the Anthrax scare fades away • Low oil price • Confidence restored after some months • Fiscal stimulus works well • Stock markets rebound • Very short recession: Economic recovery in 2 -3 quarters 13

US FISCAL INITIATIVES When? Before Sep 11 Immediately after Now discussed Sum new initiatives US FISCAL INITIATIVES When? Before Sep 11 Immediately after Now discussed Sum new initiatives Total stimulus 14 What? How much? Tax cuts 40 Emergency relief 40 Guarantees 15 Military spending 35 Special stimulus 60 -75 150 -175 Around 200

IMPACT OF SHOCKS 2002 GDP impact NEGATIVE SHOCKS POSITIVE SHOCKS 0. 5% higher unemployment: IMPACT OF SHOCKS 2002 GDP impact NEGATIVE SHOCKS POSITIVE SHOCKS 0. 5% higher unemployment: 1. 0% 20% decline in stock market: 0. 7% Global repercussions: 0. 5% Fiscal easing: 1. 5% Monetary easing: 1. 0% Total negative impact: 2. 0 -2. 5% Total positive impact: 2. 5% 15

US GDP IN “EARTHQUAKE” SCENARIO Per cent 6 Y-o-y percent change Per cent 6 US GDP IN “EARTHQUAKE” SCENARIO Per cent 6 Y-o-y percent change Per cent 6 5 5 4 4 Forecast SEB 3 3 2 2 1 1 0 0 -1 16 00 Sources: Eco. Win, SEB 01 02 03 -1

2. A DRAWN-OUT CRISIS • • Limited success in retaliation The broad coalition breaks 2. A DRAWN-OUT CRISIS • • Limited success in retaliation The broad coalition breaks down Risks of more terror attacks Stability in the Middle East is threatened. Oil prices move up Equity prices decline further Consumer confidence takes a hit Over-capacity remains a great problem; continued cuts of personnel and capex Economic recovery is delayed until 2003 17

CONSUMER CONFIDENCE: PREVIOUS EXPERIENCES EVENT 1973 1980 1987 1990 1998 18 Oil shock Credit CONSUMER CONFIDENCE: PREVIOUS EXPERIENCES EVENT 1973 1980 1987 1990 1998 18 Oil shock Credit squeeze Market crash Gulf war LTCM collapse CONFIDENCE - 53 36 15 47 19

CONFIDENCE NOW. . . 19 CONFIDENCE NOW. . . 19

…AND TOMORROW? 20 …AND TOMORROW? 20

SAVINGS RATE MOVES UP • According to IMF (2001), US personal savings have been SAVINGS RATE MOVES UP • According to IMF (2001), US personal savings have been lowered by: – – – Higher equity wealth Higher public saving Higher per capita Medicare transfers Improved household access to credit Lower inflationary expectations • Major influences now point to increasing savings • 1% change of savings ratio means 0. 7% change of GDP 21

SAVINGS RATE AND STOCK MARKETS 22 SAVINGS RATE AND STOCK MARKETS 22

RICARDIAN EQUIVALENCE 23 RICARDIAN EQUIVALENCE 23

US INDUSTRIAL PRODUCTION 24 US INDUSTRIAL PRODUCTION 24

CAPACITY UTILISATION 25 CAPACITY UTILISATION 25

NEW ORDERS 26 NEW ORDERS 26

INVESTMENTS 27 INVESTMENTS 27

DEFAULT RATE (High yield, Emerging markets, Convertibles) 28 DEFAULT RATE (High yield, Emerging markets, Convertibles) 28

STOCK MARKETS • Many claim the Fed model showed “fair value” before Sep 11 STOCK MARKETS • Many claim the Fed model showed “fair value” before Sep 11 • That claim was based on optimistic earnings estimates for 2002 • The 64, 000 dollar question: What is priced in? • If earnings estimates are overly optimistic - then the recent market rebound is a false start 29

EARNINGS ESTIMATES 30 EARNINGS ESTIMATES 30

US GDP IN “GULF WAR” SCENARIO Per cent 6 Y-o-y per cent change Per US GDP IN “GULF WAR” SCENARIO Per cent 6 Y-o-y per cent change Per cent 6 4 4 Forecast SEB 2 2 0 0 -2 00 Sources: Eco. Win, SEB 31 01 02 03 -2

3. THE UGLY CASE • Escalation of terrorist attacks and retaliation. Attacks spread to 3. THE UGLY CASE • Escalation of terrorist attacks and retaliation. Attacks spread to Europe. • Many Muslim countries hostile to the US and its allies. The Saudi House is toppled and Pakistan (nuclear state) turns militant Muslim supporting the Talibans • Oil supplies in disorder and prices soar • More fiscal and monetary stimulus, but inflation fears push up bond rates and savings ratio rises 32

EFFECTS ON EUROPE • Europe is not insulated • Several economic transmission mechanisms – EFFECTS ON EUROPE • Europe is not insulated • Several economic transmission mechanisms – Direct trade links – Stock market links – Consumer confidence • ECB will cut further • Some fiscal stimulus - but careful • Conclusion: Euro zone will follow the US, but the amplitude will be smaller 33

JAPANESE TRIPLE DIP • Deflation, banking sector crises, debt explosion • Structural reforms, NPL JAPANESE TRIPLE DIP • Deflation, banking sector crises, debt explosion • Structural reforms, NPL solution and monetary policy must be co-ordinated • Reforms in the pipeline - but only slowly • Bo. J prints money • Deep recession 2001 -02, slow recovery earliest by 2003 • Is Koizumi Thatcher or Gorbachev? 34

EMERGING MARKETS • • • Increased risks; premium high Tourism severely affected China strong: EMERGING MARKETS • • • Increased risks; premium high Tourism severely affected China strong: WTO and reforms Rest of Asia: Mixed picture Eastern Europe relatively stable, but Poland in crisis • Turkey: A drawn-out crisis • Argentina: Large or small default? Devaluation or dollarisation? – Contagion effects? 35

GROWTH IN DIFFERENT SCENARIOS 2001 2002 2003 US “Earthquake” “Gulf” Euro zone “Earthquake” “Gulf” GROWTH IN DIFFERENT SCENARIOS 2001 2002 2003 US “Earthquake” “Gulf” Euro zone “Earthquake” “Gulf” 36 1. 0 0. 8 1. 5 -0. 3 3. 5 2. 9 1. 5 1. 4 1. 7 0. 7 2. 6

CONSENSUS FORECASTS GDP forecasts for 2002 37 CONSENSUS FORECASTS GDP forecasts for 2002 37

HUGE UNCERTAINTY • New prel. OECD forecast 2001 -2002: – – US 1. 1% HUGE UNCERTAINTY • New prel. OECD forecast 2001 -2002: – – US 1. 1% and 1. 3% Japan -0. 7% and -0, 8% Germany 0. 7% and 1. 0% OECD 1. 0% and 1. 2% i. e close to SEB’s “earthquake” scenario • Analysts’ forecasts wildly scattered – standard deviation doubled – On the V side: Goldman, Deutsche – On the recession side: CSFB, MSDW 38

V SCENARIO PROBLEMS • Even if the effects of terror attacks per se look V SCENARIO PROBLEMS • Even if the effects of terror attacks per se look like a V, they come on top of a weak US economy • Fed cuts are counteracted by lower credit quality and falling investments. . . …and tax cuts by higher savings • Profit margins are low • Even if the US effects were to be mild, the risks of a global recession increase – Japan is on the brink – Emerging markets slide 39

WISHFUL THINKING? “It is surely wishful thinking to hope that the bursting of one WISHFUL THINKING? “It is surely wishful thinking to hope that the bursting of one of the biggest financial bubbles in history, combined with the aftershocks from the most serious attack ever on America’s soil, will be followed by the mildest recession in history” The Economist, Oct 20 40

MULTIPLE EQUILIBRIA? • Best case scenario still pretty good • But worse case significantly MULTIPLE EQUILIBRIA? • Best case scenario still pretty good • But worse case significantly worse • Risk-weighted outcome may not follow normal distribution • Several likely outcomes, depending on small shifts • Will make market adjustment jittery 41

SUMMARY • US and Japan are moving into recession, Europe more resistant • The SUMMARY • US and Japan are moving into recession, Europe more resistant • The consensus view is a rebound early next year. But do not preclude a drawnout recession! • The problem is the combination of – hangover from a burst bubble – psychological effects of terror – global interaction • Volatile stock markets, risk of a false start. Steep yield curves 42