Recovery may be some time yet

Oct 7 2009 by Andrew Miller, The Journal

WE have witnessed a remarkable recovery in risky asset prices since March. Now there are growing signs that the world economy itself is on the mend. But does this mean that the outlook for the future is rosy? The answer, unfortunately, is possibly not.

There are good reasons for the optimism, which has encouraged economists and international institutions to start revising their forecasts for 2010. Many emerging markets have turned the corner, helped by early policy intervention by their governments. The “developed” economies, the worst affected by the crisis, are doing surprisingly well. The macroeconomic situation and financial markets have entered what might be termed a virtuous circle - with signs of economic recovery greeted by riskier asset classes appreciating in value, which has reinforced consumer and business confidence, setting off another positive-feedback cycle.

Looking ahead, everything looks in decent shape, with economic and market gains reinforcing each other. Moreover, the turnaround in global trade constitutes a further incentive for firms to rebuild inventories, in turn providing an extra impetus to output.

But the outlook longer term is uncertain. One of the key factors will be the ability of developed-economy consumers to spend. Any fall-off in consumption, would have serious implications - and, numerically, would overshadow the effects of the expected growth in consumption in the emerging economies.

Two factors will prove particularly important in determining future consumption trends. First, real wages in the US will be about flat at best. Unemployment will keep rising for a while yet and this will put downward pressure on wage settlements. At the same time, headline inflation is likely to start edging up, eroding away the real value of these settlements. These trends will be mirrored, to varying extents, elsewhere.

Second, there are likely to be some quite dramatic shifts in government policy in the developed economies. These will be on both the fiscal and monetary policy fronts. Having spent a lot keeping their economies afloat through the crisis, and now suffering from reduced tax revenues, governments find their finances in pretty poor shape. This will precipitate a shift from fiscal easing to fiscal tightening. Moreover, as economies recover, central banks are likely to move to tighten interest rates, although in the major countries perhaps not as quickly as financial markets expect.

All this will make things more difficult for the consumer, but one should not overdo the doom and gloom. Job opportunities will eventually start coming through again. The recent rises in the equity and credit markets will also boost individuals’ wealth, encouraging them to spend more - although the effects of this may take some time to trickle through. Moreover, we think that fears about a rapid pick-up in inflation are overdone, even if commodity prices start moving up. Nonetheless, keep an eye on consumption trends – they are likely to prove an important factor in determining the strength and longevity of the current recovery.

Andrew Miller is regional office head of Barclays Wealth in Newcastle.