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The international investment outlook for 2009
By Keith Collister
Jamaica Observer Sunday, January 18, 2009
For most investors 2008 was a horrible year. Most of the damage could have been avoided, however, if only investors had understood the extreme severity of the financial crisis, and that the US had fallen into recession at the beginning of 2008, as outlined in a number of my Observer columns last year. At the beginning of 2009, a similar focus on the US economy and financial crisis is still necessary to avoid further severe damage to investor portfolios, both in Jamaica and the US
The current consensus forecast for the US economy (amongst Wall Street economists and strategists at least) is for a recovery in the second half of 2009. This would be a sharp turnaround from what is likely to be an awful fourth quarter 2008, with GDP growth expected to contract by up to six per cent in the wake of a sharp fall in personal consumption and private domestic investment.
It is, however, much more likely that the US economy is less than halfway through the recession that started in December 2007, and that the US recession will be the longest and most severe in the post-war period, almost a modern day depression.
Some would view this as an overly negative outlook, noting that asset bubbles like the US housing bubble that helped fuel the current financial market crisis are not new.
However, the current financial crisis is far more than the consequences of the bursting of a housing bubble, and never was merely a sub prime mortgage problem, but represented the much bigger collapse of a "sub-prime financial system". The balance sheets of all the major financial institutions, including the large international banks, were damaged to the point that interbank lending dried up, channels for underwriting commercial paper and short municipal paper vanished, and even the international payments system needed to be rescued by unprecedented Central Bank intervention.
The collapse of Lehman Brothers on September 15th represented the financial "heart attack" that finished off an already very weak US economy, and was followed by an acceleration of already negative unemployment and consumer and business confidence trends.
Just how much damage a severe financial crisis can do to asset values and the economy is outlined in a recent research paper by prominent economist Kenneth Rogoff of Harvard University and Carmen Reinhart of the University of Maryland. Their paper "The Aftermath of Financial Crises," was the keynote presentation at the American Economic Association conference (a conference of the world's best economists) in early 2009, and was a sequel to their work presented at the 2008 conference. The paper outlined the very real differences between normal business-cycle recessions and a recession brought on by a financial crisis, the latter being much more severe. The paper looks at the aftermath of 14 "severe" financial crises, including historical crises (the US Great Depression in 1929 and Norway in 1899) as well as the more recent "big-five" crises in the rich world-Spain in the late 1970s, Norway in 1987, and Finland, Japan and Sweden in the early 1990s, to try to gauge how bad America's recession might be.
Of particular interest to emerging market countries such as Jamaica is that the sample also now includes seven emerging market crises that were left out of the earlier analysis in 2008.
Rogoff notes "In our earlier analysis, we deliberately excluded emerging market countries from the comparison set, in order not to appear to engage in hyperbole. After all, the United States is a highly sophisticated global financial centre. What can advanced economies possibly have in common with emerging markets when it comes to banking crises?"
One year on, the emerging market countries are now included. Mr Rogoff advises that this is because the hubristic belief in America that "we don't have financial crises" is now obviously false, with the authors finding that banking crises have been almost as common in rich economies as developing ones.
Their conclusions are sobering.
"... Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of severe financial crises share three characteristics. First, asset market collapses are deep and prolonged. Real housing price declines average 35 per cent stretched out over six years, while equity price collapses average 55 per cent over a downturn of about three and a half years. Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of seven percentage points over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over nine per cent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment. Third, the real value of government debt tends to explode, rising an average of 86 per cent in the major post-World War II episodes.
Whilst these numbers are not ideal guides to the future, they are still likely to be a much better guide to the severity of the downturn than the numbers from Wall Street economists standard forecasting models.
In the case of the US, even if one assumes that GDP falls from its peak by only half (five per cent) of the nine per cent average fall in the paper, this implies a further fall of three to four per cent of US GDP meaning that there will be no recovery in 2009. The forecast for US growth in 2009 of Professor Nouriel Roubini, now known as "Dr Doom" on Wall Street as one of those who successfully predicted the financial crisis, is in line with this projection. Roubini projects first quarter 2009 at negative five per cent, second quarter 2009 at negative four per cent, third quarter 2009 at negative 2.5 per cent, fourth quarter 2009 at negative one per cent, all adding up to a yearly real GDP growth of negative 3.4 per cent for the US in 2009.
Current consensus projections in the US are that unemployment peaks at nine per cent (currently 7.2 per cent) without the Obama
Stimulus package. Leaving aside the real impact of the proposed US stimulus package for another day, using the seven per cent average rise of unemployment in Rogoff's paper suggests unemployment peaks at a much higher 11-12 per cent. Obama himself predicts double digit unemployment without a stimulus package. In my view, double digit unemployment is a near certainty even with a stimulus package, as the US is forced to correct for several decades of excess.
Most importantly in terms of the current crisis, house prices take an average of five years to reach bottom nadir and fall by 36 per cent in real terms. The housing downturn began in 2006, and is therefore unlikely to end in 2009. US house prices are likely to fall at least another 10 -15 per cent in the course of the year, partly due to rising unemployment.
The financial excesses created by a prolonged bull market lead suggest that US equities will lose significantly more than half of their value by the time they reach bottom. A further fall of up one third from current levels, to around Dow 5000, is entirely possible, even likely.
Finally, the US will almost definitely exceed the average rise in real government debt of 86 per cent in study. The US fiscal deficit for 2009 could reach US$2 trillion, including the Obama stimulus plan, the likely expansion of unemployment insurance, and underperforming tax revenues. Interestingly, the study suggests that the huge rise in debt is not so much due to the fiscal damage of bailing out the banks, but rather a result of the collapse in tax receipts as a consequence of recession and, in most countries, a big increase in public spending to shore up the economy.
The punch line is that such huge deteriorations in public finances are, however, still not enough to prevent deep and prolonged downturns. We will explore what all this means for the Jamaican economy in a future article.
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By Keith Collister
Jamaica Observer Sunday, January 18, 2009
For most investors 2008 was a horrible year. Most of the damage could have been avoided, however, if only investors had understood the extreme severity of the financial crisis, and that the US had fallen into recession at the beginning of 2008, as outlined in a number of my Observer columns last year. At the beginning of 2009, a similar focus on the US economy and financial crisis is still necessary to avoid further severe damage to investor portfolios, both in Jamaica and the US
The current consensus forecast for the US economy (amongst Wall Street economists and strategists at least) is for a recovery in the second half of 2009. This would be a sharp turnaround from what is likely to be an awful fourth quarter 2008, with GDP growth expected to contract by up to six per cent in the wake of a sharp fall in personal consumption and private domestic investment.
It is, however, much more likely that the US economy is less than halfway through the recession that started in December 2007, and that the US recession will be the longest and most severe in the post-war period, almost a modern day depression.
Some would view this as an overly negative outlook, noting that asset bubbles like the US housing bubble that helped fuel the current financial market crisis are not new.
However, the current financial crisis is far more than the consequences of the bursting of a housing bubble, and never was merely a sub prime mortgage problem, but represented the much bigger collapse of a "sub-prime financial system". The balance sheets of all the major financial institutions, including the large international banks, were damaged to the point that interbank lending dried up, channels for underwriting commercial paper and short municipal paper vanished, and even the international payments system needed to be rescued by unprecedented Central Bank intervention.
The collapse of Lehman Brothers on September 15th represented the financial "heart attack" that finished off an already very weak US economy, and was followed by an acceleration of already negative unemployment and consumer and business confidence trends.
Just how much damage a severe financial crisis can do to asset values and the economy is outlined in a recent research paper by prominent economist Kenneth Rogoff of Harvard University and Carmen Reinhart of the University of Maryland. Their paper "The Aftermath of Financial Crises," was the keynote presentation at the American Economic Association conference (a conference of the world's best economists) in early 2009, and was a sequel to their work presented at the 2008 conference. The paper outlined the very real differences between normal business-cycle recessions and a recession brought on by a financial crisis, the latter being much more severe. The paper looks at the aftermath of 14 "severe" financial crises, including historical crises (the US Great Depression in 1929 and Norway in 1899) as well as the more recent "big-five" crises in the rich world-Spain in the late 1970s, Norway in 1987, and Finland, Japan and Sweden in the early 1990s, to try to gauge how bad America's recession might be.
Of particular interest to emerging market countries such as Jamaica is that the sample also now includes seven emerging market crises that were left out of the earlier analysis in 2008.
Rogoff notes "In our earlier analysis, we deliberately excluded emerging market countries from the comparison set, in order not to appear to engage in hyperbole. After all, the United States is a highly sophisticated global financial centre. What can advanced economies possibly have in common with emerging markets when it comes to banking crises?"
One year on, the emerging market countries are now included. Mr Rogoff advises that this is because the hubristic belief in America that "we don't have financial crises" is now obviously false, with the authors finding that banking crises have been almost as common in rich economies as developing ones.
Their conclusions are sobering.
"... Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of severe financial crises share three characteristics. First, asset market collapses are deep and prolonged. Real housing price declines average 35 per cent stretched out over six years, while equity price collapses average 55 per cent over a downturn of about three and a half years. Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of seven percentage points over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over nine per cent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment. Third, the real value of government debt tends to explode, rising an average of 86 per cent in the major post-World War II episodes.
Whilst these numbers are not ideal guides to the future, they are still likely to be a much better guide to the severity of the downturn than the numbers from Wall Street economists standard forecasting models.
In the case of the US, even if one assumes that GDP falls from its peak by only half (five per cent) of the nine per cent average fall in the paper, this implies a further fall of three to four per cent of US GDP meaning that there will be no recovery in 2009. The forecast for US growth in 2009 of Professor Nouriel Roubini, now known as "Dr Doom" on Wall Street as one of those who successfully predicted the financial crisis, is in line with this projection. Roubini projects first quarter 2009 at negative five per cent, second quarter 2009 at negative four per cent, third quarter 2009 at negative 2.5 per cent, fourth quarter 2009 at negative one per cent, all adding up to a yearly real GDP growth of negative 3.4 per cent for the US in 2009.
Current consensus projections in the US are that unemployment peaks at nine per cent (currently 7.2 per cent) without the Obama
Stimulus package. Leaving aside the real impact of the proposed US stimulus package for another day, using the seven per cent average rise of unemployment in Rogoff's paper suggests unemployment peaks at a much higher 11-12 per cent. Obama himself predicts double digit unemployment without a stimulus package. In my view, double digit unemployment is a near certainty even with a stimulus package, as the US is forced to correct for several decades of excess.
Most importantly in terms of the current crisis, house prices take an average of five years to reach bottom nadir and fall by 36 per cent in real terms. The housing downturn began in 2006, and is therefore unlikely to end in 2009. US house prices are likely to fall at least another 10 -15 per cent in the course of the year, partly due to rising unemployment.
The financial excesses created by a prolonged bull market lead suggest that US equities will lose significantly more than half of their value by the time they reach bottom. A further fall of up one third from current levels, to around Dow 5000, is entirely possible, even likely.
Finally, the US will almost definitely exceed the average rise in real government debt of 86 per cent in study. The US fiscal deficit for 2009 could reach US$2 trillion, including the Obama stimulus plan, the likely expansion of unemployment insurance, and underperforming tax revenues. Interestingly, the study suggests that the huge rise in debt is not so much due to the fiscal damage of bailing out the banks, but rather a result of the collapse in tax receipts as a consequence of recession and, in most countries, a big increase in public spending to shore up the economy.
The punch line is that such huge deteriorations in public finances are, however, still not enough to prevent deep and prolonged downturns. We will explore what all this means for the Jamaican economy in a future article.
Talk Back
No comments have been posted
Post your comments