The Economy: A Scorecard for the Global Slowdown
This is the first of three parts.
One year ago, it seemed pretty clear to Standard & Poor's Ratings Services that the U.S. was in a recession. That has been confirmed by the National Bureau of Economic Research, which has said that the U.S. recession began in December 2007.
When we offered our global economic outlooks last March, we thought most economies around the world were in better shape in 2008 than they typically are to withstand a U.S. recession. But with few exceptions, the U.S. has once again shared its slump with global neighbors near and far. Although the rise of Asia and an improving picture elsewhere have reduced overall dependence on the U.S. as the leader for global growth, the U.S. is still a key part of the global economic equation. More important, the financial system problems that created the U.S. recession were far more widespread than many thought a year ago. Therefore, we believe growth in most emerging and developing economies will decelerate sharply as the developed world slides into recession.
The question for 2009 no longer concerns whether the world can escape a deep U.S. recession. What everyone wants to know now is: With so many countries sinking into recession at the same time, how severe will this global downturn become, and how long will it last?
Domestic demand and regional strength largely determine how other economies fare during a U.S. slump. In particular, many industrialized countries, which are more similar to the U.S., have not gotten a boost from government stimulus programs, at least not yet. But even countries that rely more on natural-resource exports are feeling the pinch of falling world trade and lower commodity prices. The drop in oil prices is a double-edged sword, helping consumers but hurting the OPEC and other oil-exporting countries.
The World Picture
This recession is the most synchronized in historical memory and seems likely to be the deepest downturn in the industrial countries since the Great Depression of the 1930s. It comes after an unprecedented period of world economic growth, making the contrast even more severe. We expect the recession to be long and deep. The U.S., which went into the recession slightly ahead of its peers, is also likely to emerge first, late this year. The European downturn will be similar to the U.S. recession in depth, but it is likely to take longer to run its course, in part because European economies are not fully synchronized. Japan now looks likely to have the deepest recession of the major industrial countries and could have the most difficulty in emerging because of its dependence on exports as an engine of growth.
Emerging Asia is in the best shape of the major regions. China is suffering because of the reduced demand for its goods in the industrial world, particularly in the U.S., but should be able to transfer the lead to domestic demand by spurring domestic consumption and increasing infrastructure spending. India is less export-sensitive than China but also has less room for fiscal stimulus because of the continuing budget problems it faces. Both countries are less dependent on external finance than in the past, which should keep them relatively immune from the financial problems, as long as China doesn't get too sensitive to potential investment losses.
Latin America, Africa, and the Middle East had been immune from the recession through mid-2008 because of strong commodity prices. However, the recent plunge in these prices, particularly for crude oil, is now extending the recession to these regions as well, and they might suffer the most because they have less room to substitute domestically generated growth for exports. These were the last regions to go into recession and are likely to trail on the way out as well.
Where the U.S. Appears to Be Heading
In our current view, we expect the U.S. recession will be deep and long and that it won't bottom out until the second half of 2009 as monetary and fiscal stimulus kicks in. Standard & Poor's expects that GDP will fall for four consecutive quarters, starting with the third quarter of 2008 through the second quarter of 2009. We now expect a peak-to-trough drop in real GDP of about 3.8%, but more will be in 2009 and less in 2008. Signs of recovery would likely show up in late 2009.
We expect GDP to fall 2.5% this year, much worse than the meager 1.1% increase in 2008. Growth will likely improve modestly in 2010, increasing just 2.0%. Housing will likely keep depressing the expansion through early 2010. Housing starts and sales are expected to hit bottom this spring—but with little improvement through 2009. Home prices aren't likely to hit their trough until early 2010.
Business conditions could continue to erode and bring about a much harder landing, with a worse contraction than the negative 2.5% GDP drop that we currently expect for 2009, which would likely increase weakness abroad. However, our longer-term outlook remains upbeat, with growth possibly returning to more than 3% by 2011.
We think that credit markets must thaw for the U.S. economy to recover. Unfortunately, they remain locked up. There have been some encouraging signs, with the Treasury-to-Eurodollar (TED) spread, a measure of banks' willingness to lend, at 98 basis points (bps) and well below the 214-basis-point spread seen three months ago. However, quality spreads remain wide, with lending tight. To get the market and the economy back in action, the Federal Reserve slashed rates to the lowest they can go and has intervened in other markets. The Fed has begun dealing in Agency securities and has announced its intent to continue that practice. It has also been buying commercial paper. The early results have been good; mortgage rates have dropped to their lowest level of the year.
The Fed made clear that it would employ the Fed's balance sheet aggressively to try to free up credit markets and that "all available tools would be employed to promote the resumption of sustainable economic growth and to preserve price stability." It will continue to use policies aimed at pushing credit into individual lending markets. We expect to see more Fed purchases of non-Treasury securities, including but not limited to mortgage-backed securities and commercial paper. The programs do seem to be working. Mortgage rates have dropped to a record low of 5.1% (30-year conventional), and commercial paper markets have opened up. The London Interbank Offering Rate has fallen back to 1.4% (three-month), still very high relative to the federal funds rate but far below the 6% it hit three months ago.
Risk of a Japan-Like Scenario
The real worry is that the U.S. economy could do even worse. The parallels between the U.S. today and Japan at the beginning of the 1990s are too clear for comfort. In both cases, heavy capital losses resulting from property loans constrained the banking system. In Japan, that led to a decade of stagnation, with growth averaging 0.8% from 1992 through 2002. Home prices remain 25% below their peak, and the Nikkei stock index is still trading at one-third its level of 20 years ago. Although there are differences, the risk of the U.S. falling into a Japan-like scenario is frighteningly real.
The U.S. reliance on foreign capital adds more risk. America's current account deficit reached a record of 6.4% of GDP in third-quarter 2006, but it was a still-high 4.7% in 2008. Private money was almost entirely financing it—at very low interest rates.
Now, foreign investors have lost confidence in most U.S. securities, and money is not so easy to come by. With markets likely to remain tight, we expect the current account deficit to narrow to 2.1% of GDP in 2009. However, for now at least, increased risks abroad have investors sending money into the U.S. and into the safe haven of Treasuries, strengthening the U.S. dollar and bringing 10-year Treasury yields down to 2.83% on Mar. 5, up from the 54-year low of 2.08% on Dec. 18. A rising dollar cuts into U.S. exports and supports the trade surpluses of other U.S. trading partners. But shrinking trade flows also add the risk of protectionist action, which would hurt global growth.
We expect investor fears outside the U.S. about the risk of a dollar decline and credit risk to increase, so the result could be both a sharp drop in the dollar and a sharp rise in U.S. interest rates, extending the recession. For the moment, however, the other developed economies are in as much trouble as the U.S., and because exchange rates are relative, there is likely to be little change in the bilateral rates.
Next: A look at economies in Europe, Asia, and other regions.