The Global Economy Challenges to Recovery Prof. Jacob A. Frenkel Chairman, Merrill Lynch International Former Governor of the Bank of Israel 9 th Dubrovnik Economic Conference Dubrovnik June 26 – 28, 2003
Table of Contents n The US economy: Background and Challenges n A more sustainable growth outlook n Private sector reacts to challenges n A timely policy response n The path to economic recovery n Downside risks n Asset market vulnerability n Unwinding the current account deficit n Geo-political instability and oil shocks n Euroland economic outlook n Japan economic outlook n Emerging Asia and Latin America n Global Recessionary Deflation? June 18, 2003
US Economy Enjoys High Productivity % year-on-year 1998 -2002 average = 2. 7% Non-farm Productivity, last data point: Q 1 03 Source: Bureau of Labour Statistics June 18, 2003
Background and Challenges n Non-sustainable rapid growth in the 1990 s led to a series of real and financial imbalances n Bubbles burst in tech sectors and telecoms with fallouts in financial and real markets n Profit crunch required cost reduction n Manufacturing sector declined, employment weakened n Terrorism (9/11) damaged economic confidence n Corporate governance crisis damaged financial integrity n Confidence crisis and recession required policy response n Iraq crisis: before and after June 18, 2003
Boom, Gloom and Modest US Recovery Quarterly Real GDP (4 Quarter percentage change) Actual Numbers ML Forecast Source: Bureau of Economic Analysis, last data point: Q 1 03 Average 1996 -2000: 4. 0% Average 2001 -2002: 1. 4% Average 2003 -2004: 2. 8% June 18, 2003
A More Sustainable US Growth Outlook n A flexible, competitive and deregulated economy enables: n A smooth response by corporates and households n A timely policy response n Real GDP growth forecast: 2. 2% in 2003, 3. 4% in 2004 n Capital spending starts to recover; limited overhang n Consumer spending less buoyant but still robust n High and rising productivity yields a jobless recovery n Housing market remains a solid pillar June 18, 2003
Quick Reaction of Economic Agents and Policies n A flexible and adaptable economy, with low inflation and moderate public debt has facilitated: n An effective private sector response: n A significant reduction in labor costs n A rapid adjustment of inventories n Mitigating the profit crunch n An effective policy response: n A decisive and timely monetary policy response n A series of fiscal stimulus packages June 18, 2003
Profit Crunch Requires Adjustment % 1992 -2002 average = 10. 1% Profits as Share of Non-Financial Corporate GDP Source: Bureau of Economic Analysis, last data point: Q 1 03 US Recession June 18, 2003
Companies Lay Off Workers to Cut Costs US Job Loss Jan 01 -Dec 02 > 1. 9 m SA Unemployment Rate, as % of Total Civilian Labour Force Source: Bureau of Labour Statistics, last data point: May 03 June 18, 2003
Unit Labour Cost Pressures Have Declined % change US Recession Source: Bureau of Labour Statistics; Unit Labour Costs, Non-farm Business Sector, last data point: Q 1 03 June 18, 2003
US Inventory Reflects Flexibility % change Inventories cut by $250 bn in one year Manufacturing & Wholesale Inventories, 3 Month % Change, Annualised Source: Census Bureau, last data point: Apr 03 June 18, 2003
Decisive US Fed Rate Cuts Federal Funds Target Source: Federal Reserve Bank of New York June 18, 2003
In a Low Inflation Environment % year-on-year 10 year average = 2. 5% Source: Bureau of Labour Statistics, Merrill Lynch forecast June 18, 2003
Reinforced by Ample Fiscal Stimulus US Budget Balance as % of GDP Source: IMF World Economic Outlook, April 2003 US Gross Public Debt as % of GDP June 18, 2003
Capital Spending Leads the Recovery % change New Orders of Non-Defense Capital Goods, % change year-on-year Source: Census Bureau, last data point: Apr 03 June 18, 2003
US Tech Spending Recovers % change Real Capital Spending on Tech Equipment & Software, % change quarterly Yo. Y Source: Bureau of Economic Analysis, last data point: Q 1 03 June 18, 2003
Mortgage Refinancing Supports Consumption Mortgage Application Index for Refinancing Households “cash out” $150 -200 bn in 2002 4 Week Moving Average US Recession Source: Mortgage Bankers Association, last data point: 3 rd June 03 June 18, 2003
US Retail Sales Rebound and Stabilise % year-on-year Source: Census Bureau, Retail Sales ex-autos, last data point: May 03 June 18, 2003
Robust US Housing Starts 10 year average US Recession Source: Census Bureau; Single-Family Housing Starts, 000 s, SAAR, last data point: May 03 June 18, 2003
The Recovery Remains Jobless % Yo. Y growth Source: BEA, BLS, last data point: Employment May 03, GDP Mar 03 June 18, 2003
Global Growth Outlook Merrill Lynch Forecasts, June 2003 (*) IMF forecasts June 18, 2003
Downside Risks n Vulnerable Asset Markets Could further Affect Confidence n The investment rebound could be short-lived n Household spending could retrench n Disorderly Unwinding of US Current Account Deficit if: n Foreign investors reduce holdings of US assets n US Dollar weakens and forex markets remain volatile n US savings recover too rapidly n US investment recovers too slowly n Geo-political Instability and Oil Shocks n Global recessionary deflation? June 18, 2003
Risk Aversion in US Markets Risk Aversion Index, 30 days moving average Accounting scandals Russia/LTCM collapse September 11 Fall of Baghdad Index composed of Equity Implied Volatility, Swap Spreads & Spread Ratio between BBB & BB Corps Source: Merrill Lynch, last data point: 17 June 03 June 18, 2003
High US Corporate Debt Ratio 10 year average = 75% Long-Term Debt/Income, all Manufacturing Industries Source: Census Bureau, last data point: Q 4 02 June 18, 2003
US Corporate Debt Servicing Manageable % Current = 14. 3% 10 year average = 12. 8% Interest Expense/EBITDA Source: Bureau of Economic Analysis, last data point: Q 1 03 US Recession June 18, 2003
Corporate Bond Defaults Rise Globally US$ bn No. of issuers Amount defaulted No. of issuers Insert Footnote Text Source: Standard & Poor’s June 18, 2003
US Corporate Credit Ratings Worsen US$ bn US rating actions by value Source: Standard & Poor’s June 18, 2003
Are Residential Prices Sustainable? Residential Price Indices , 1992 =100, logarithmic scale UK USA France Japan Italy Germany Source: Bank for International Settlements June 18, 2003
A Rising Current Account Deficit Current Account balance as % of GDP Source: Bureau of Economic Analysis, Merrill Lynch June 18, 2003
Risks to External Financing of Deficits n US current account deficit projected to remain above 4% of GDP, worsening net foreign liability position n A potentially disorderly unwinding of US current account deficit is possible if: n Loss of confidence or a shift in portfolio preferences reduces foreign investors appetite for US assets n US Savings recover too quickly n US Investments recover too slowly n Possible disruption of exchange rates and interest rates June 18, 2003
Foreign Investors Withdraw from US Markets US$ bn, 12 months moving average Foreign Purchases of US Corporate Bonds Foreign Purchases of US Stocks Source: Federal Reserve, last data point: Mar 03 June 18, 2003
US Dollar Weakens US$/Euro Source: Bloomberg June 18, 2003
Oil Price (WTI) $/bbl 01/17/91 - Operation Desert Storm begins 02/28/91 - Cessation of war 08/01/90 - Iraq invades Kuwait Source: Bloomberg June 18, 2003
Fiscal Consolidation and Convergence Budget Balance as % of GDP Germany France Spain Italy Source: IMF, April 2003 June 18, 2003
Euroland Economic Outlook n Euro strength & US weakness dampen growth prospects n Unemployment is rising again n Business & consumer confidence are falling n Controversies concerning the “stability and growth” pact n The German engine is lagging n Structural measures are essential for future growth European Recovery Lags Behind US June 18, 2003
Euroland Recovery Lags Behind US % Real GDP Growth Source: Merrill Lynch forecasts June 18, 2003
Long Term Recession in Japan Real GDP %, Yo. Y OECD 10 -year Avg = 2. 4% Japan 10 -year Avg = 0. 5% Source: ESRI, Merrill Lynch forecasts June 18, 2003
Fiscal Laxity has Created Public Debt Problem Japan Budget Balance as % of GDP Source: IMF World Economic Outlook, April 2003 Japan Gross Public Debt as % of GDP June 18, 2003
Slow Progress on Japanese Bank Restructuring n A few major banks start to deal with bad loans and strengthen their capital base But… n Under-provisioning for bad loans persists n Weak capital base and low profitability of banks limit speed of bad loan disposal n Market confidence in financial sector is low June 18, 2003
Asian Economic Outlook n Growth remains strong across Asian region: n China and India insulated by strong local markets n Tech-dependent Asia pulled by policy easing n Countries with strong policy frameworks experience stronger growth n High level of foreign reserves and current account surpluses have reduced vulnerability n Incomplete corporate and bank restructuring Solid Recovery Continues In 2003 June 18, 2003
Latin America Economic Outlook n Smaller fiscal deficits and lower inflation are key n Corporate governance and political stability remain critical factors n Region dependent on capital inflows n Argentina: needs to be reborn Brazil: on the road to recovery and Chile: bright spots Venezuela, Ecuador and Peru: in trouble Mexico Outlook Reflects Domestic Policies and US Growth June 18, 2003
Global Recessionary Deflation? n US: Very unlikely n Flexible and competitive economy n High productivity growth n Decisive policy response n Euroland: Unlikely but watch for Germany n Benefits from single currency and convergence n Structural rigidities n Political and institutional challenges n Japan: In the midst of deflation n Rigid policy framework n Needs financial restructuring If US and Europe Stay the Course, Global Recessionary Deflation Will Be Avoided June 18, 2003
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