Heading for a double dip?
• Growth is stepping down a gear as the boost from the inventory cycle fades creating fears that the world economy will tip into a double dip recession. Tighter fiscal policy adds to these concerns as the recovery will now be in the hands of the private sector.
• Whilst recognising that companies and households may be lacking in animal spirits at present, both ...
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sectors have made considerable progress in improving their cash flows, with savings rates rising significantly. Going forward we would expect the corporate sector to deploy its spending power and support the recovery through raising capex and recruitment. Better jobs growth should then boost household incomes and spending.
• Given the current pessimism amongst investors, such an outlook makes us optimists, yet we recognise that the risks are skewed to the downside. Of particular concern is the lack of a Plan B from central banks should growth stall. More quantitative easing is a possibility, but beyond this the options are limited to outright money printing. From this perspective, macro risks remain significant and central banks will keep policy loose for as long as possible. We are pushing out our first rate rises for the Fed and ECB to June and September 2011 respectively.
UK: Can households afford the age of austerity?
• The Chancellor’s debut Budget had to be tough if the UK was to avoid joining the Southern European debt crisis. However, with many other countries tightening fiscal policy simultaneously and the global recovery losing momentum, is the UK about to head into double-dip recession?
• We examine the UK household sector’s finances and find that UK households can afford to pay higher taxes and deleverage personal balance sheets. However, UK monetary policy must remain very accommodative if households are going to continue to increase consumption in real terms.
Global
Growth concerns to the fore as activity indicators roll over Heading for a double dip?
After little more than a year of recovery, markets have begun to fear that the world economy will go back into recession. For those who saw the recovery as little more than a policy induced boost, such concerns come as no surprise. From this perspective, fiscal policy could only provide a temporary offset to the downdraft created by de-leveraging and repair of the financial system. Now that policymakers are making plans to withdraw fiscal support, as endorsed at the recent G-20 meeting, the weakness of global demand has come back into focus.
Stepping down a gear
Recent economic data offers little comfort. The US housing market, so often an important engine of recovery, remains flat and continues to experience an L-shape profile having given back all the gains made earlier in the year when tax incentives boosted sales. Similarly, the latest US employment report showed a fall in payrolls as census hiring fell back and private sector job growth remained sluggish. Meanwhile, the crisis in the Eurozone has raised doubts about European growth as governments accelerate fiscal tightening to placate markets and ratings agencies. Even China, which had seemed immune to growth worries, is now showing signs of cooling after rapid growth over the past year.
In line with these developments, the widely followed manufacturing Purchasing Managers indices (PMI’s) have weakened and our activity indicator for the G-3 has rolled over (chart 1). On a regional basis, the slowdown has been most pronounced in Asia and the emerging economies which have led the upswing (see chart on front page)
As the boost from inventory fades, final sales will have to pickup the baton
Moving into a new phase of the recovery
Whilst recognising that the global recovery is stepping down a gear, it is useful to look at the dynamics of the upturn so far. In our view, recent developments represent an end to the first stage of the recovery where growth was driven by the inventory cycle as companies brought inventories back into line with sales, having slashed them during the recession. For example, in the year to the first quarter of 2010, inventory changes accounted for 1.4 percentage points, or half the 2.4% rise in US GDP.
Such an outcome is typical of the early stage of any recovery, but as the boost from the inventory cycle begins to fade, the challenge for the world economy is to sustain growth from other sources. Going forward, activity will have to be driven by stronger final sales which given the move toward fiscal austerity, means stronger private consumption and investment spending.
How well placed is the private sector to meet this challenge? For us the key lies with companies. In particular, we would highlight the significant improvement in the corporate sector’s finances which have swung from deficit to surplus as profits have recovered. In the US the gap between internally generated funds and investment spending is at its widest for 50 years, indicating that firms are a strong position to begin spending again (chart 2).
Employment growth to rise as productivity gains slow
One sign that this is already happening can be found in increased spending on capital equipment where orders have picked up sharply around the world (chart 3). Having cut capex to the bone, businesses in the US, Asia and Europe have started to invest in the future once more. US business investment rose at a double digit rate in the first half of this year and should match this over the next six months. 
Importantly, there are signs that companies have begun to recruit again although anaemic payroll growth means that the upturn has been termed a “jobless recovery”. Alternatively though, recent developments could also be described as a productivity miracle. “Less is more” would seem to have become the mantra as firms have raised output with fewer workers. US employment is still 2% lower than in the first quarter of last year, even though real output is more than 2% higher. Such a performance has driven the upturn in corporate profits and is likely to continue through 2010. Nonetheless, there are limits to how far companies can squeeze their workforce and we would see employment rising more closely in line with output in the second half of 2010 and into 2011. Higher employment is critical as it would boost incomes thus enabling household’s to increase their expenditure.
The strength of consumer spending will also depend on whether household’s are comfortable with their debt levels and the pace of de-leveraging. This is best gauged by the savings rate which has risen significantly in both the US and UK. Should banks decide to make access to credit even more restrictive, or were the central bank to raise interest rates it is possible that savings ratios would rise and consumer spending weaken further. However, in both economies savings rates are close to their highest levels for ten years and appear to have peaked (chart 4). Like the corporate sector, the household sector is running a surplus and this would suggest that there is scope for spending to rise at least in line with incomes, if not slightly faster in coming quarters.
Global rebalancing goes into reverse 
Private sector spending to offset fiscal headwind
In short, we believe that private spending should be sufficient to keep the global recovery on track as fiscal policy tightens in 2011 and beyond. Estimates for the drag from fiscal policy are shown in table 1, which suggest that governments will take around 1% of nominal GDP out of the OECD economies in 2011. In effect we expect private surpluses in the household and corporate sectors to decline as the government deficit narrows. Clearly, it will not be a strong recovery and growth is slowing, but we do not see this developing into another recession.
From a regional perspective, this process would be made considerably easier if the emerging world also reduced its surplus of savings over investment at the same time. Such a move would boost demand for goods in the developed economies and result in a rebalancing of the world economy.
However, although China has recently announced increased flexibility on its exchange rate and we see a long run appreciation of emerging currencies, the process of adjustment is likely to be very slow given the adherence of many Asian and emerging economies to the mercantilist model of export led growth. Indeed, the latest trade figures show the US trade deficit with China has begun to widen again – grist to the mill for those in Congress who would like to raise tariffs on Chinese imports (chart 5 on next page).
Loss of animal spirits would dent the recovery
What is plan B?
Our outlook of a reviving private sector offsetting the withdrawal of government stimulus carries considerable risks. We are relying on the corporate sector to pull us through the next phase of the recovery, yet business spending is driven by animal spirits1 and if chief executives decide they would rather wait another six months before implementing plans to increase capex or recruitment we could be in for a very difficult period. The recent and ongoing crisis in the Eurozone is an example of one factor, which would give companies pause for thought before increasing expenditure.
Alternatively companies may decide to use their surplus funds to raise dividends or engage in mergers and acquisitions (M&A). Whilst such developments would be positive for share holders in the near term, they would be at the cost of weaker growth today.
Should growth stall, unemployment will begin to rise again, government borrowing is likely to deteriorate and deflationary pressure increase. The problem then faced by the world economy is that policymakers are running low on ammunition and so cannot respond: the big cannons, monetary and fiscal policy, have been fired. From a financial market perspective, this makes the macro environment more dangerous, as if things go wrong investors can no longer rely on being rescued by the authorities. For example, the US Federal reserve may still be a friend toward equity markets, but with rates close to zero its options are limited. Although Bernanke may never have been as market friendly as his predecessor, he is unlikely to have the opportunity to create his equivalent of the Greenspan put.
Central banks are limited in their options should growth stall
The Bank of England, European Central Bank, Swiss National Bank and others are in a similar position. All would struggle to regenerate growth should we experience a renewed downturn or double dip, and all fear that they will end up like the Bank of Japan stuck in a deflationary economy with rates at zero.
It is not quite true to say that there is no plan B. There are some options. For example, the Fed and others could begin quantitative easing (QE) again – buying assets with printed money and expanding their balance sheets. This would help markets by creating liquidity and pushing up prices, but the effect would be limited if the banking sector did not increase its lending. If banks do not lend, the extra cash ends up in higher bank balances and all that would happen would be a further drop in the velocity of circulation of money without a rise in activity. All QE can do in these circumstances is rearrange the assets of the private sector and central bank, exchanging cash for bonds. The only alternative beyond this is to print money and pump it directly into the economy – a true helicopter drop. One option would be to make tax cuts to households funded by printed money. Arguably, this could also be saved, but by continuing to print money, inflation will inevitably follow. As Ben Bernanke noted before he became chairman of the Fed2 “in a paper money system, a determined government can always generate higher spending and hence positive inflation”.
Clearly, this would be a last resort and so, double dip or not, the assumption has to be that monetary policy stays as loose as possible for as long as possible as the economy negotiates the difficult period ahead. We are pushing out our first Fed funds rate rise to June next year (from March) and we also see the ECB moving three months later – in September 2011.
UK
Household sector in for bumpy ride as Chancellor sets tough deficit cutting targets
Can households afford the age of austerity?
Chancellor George Osborne’s debut budget was inevitably going to be brutal. Inheriting the worst set of public finances since the Second World War, Osborne had to send a clear signal to bond vigilantes that he is going to sort out this mess. Meanwhile, the UK economy’s sluggish recovery appears to be gathering momentum. Industrial production looks set to deliver a strong set of second quarter results, while growth in the construction sector seems to have finally returned to positive territory. Service sector growth remains lethargic having had retail sales knocked by the re-instatement of VAT at 17.5% (in January) and election uncertainty.
The concern is that the tough austerity package could hit the already fragile confidence of the household sector, causing real household consumption to fall – a crucial component of UK GDP – resulting in a double dip recession.
New government sets ambitious deficit cutting target
In June’s emergency Budget, Osborne outlined his plan to eradicate the vast majority of the UK’s structural deficit by the end of the current parliament. His target means that the government aims to cut the deficit by £177.7 billion by 2014/15, over £25bn more than his predecessor. As a percentage of GDP, this is a reduction of 9%, or 1.8% per year (see chart 6).
While we have our reservations over whether the government will be able to meet its ambitious target, the path of fiscal consolidation is tougher than we had expected. Most of the extra tightening is expected to be implemented through larger public spending cuts rather than increased taxation. Ultimately, this is going to have an impact on households that receive social benefit payments, but also public sector workers. As a result, we revised down our GDP growth forecast from 2011. For more detailed analysis on the Budget, please see “UK Emergency Budget 2010: Reality unveiled.”
HM Treasury estimates household disposable income will fall by 1.4% by 2012-13 as a result of fiscal tightening
Since the Budget, the focus of investors has shifted from the European debt crisis back to the global recovery as leading indicators around the world begin to lose momentum. This has raised questions over the sustainability of the UK recovery, but in particular, the reaction of the fragile household sector. To assess the outlook for domestic consumption, we take a closer look at household finances, and how they are likely to be affected by fiscal tightening.
Impact on household incomes
According to HM Treasury, the Budget measures are likely to reduce household disposable household income by 1.4% by 2012-13 (see chart 7). The largest negative contribution comes from the announced increase in VAT from its current rate of 17.5% to 20% in January 2011. The second largest contribution comes from the net changes to benefits, which is likely to reduce disposable income by approximately 0.5%. Finally, changes to direct taxation are expected to have a marginal negative impact. The partial increase in employees’ contribution to national insurance is likely to be offset by the increase in the personal income tax allowance.
Before we can use the above to look at the potential impact on household consumption, we must also consider the current state of the household sector’s finances, and how disposable income might develop over the coming years. Starting with nominal gross household sector income, chart 8 shows a breakdown of annual income growth by source.3 Unsurprisingly, the largest contribution comes from wages and salaries, followed by social transfers (benefit payments and tax credits).
As the recovery continues, household incomes should continue to improve…
As the economy went into recession in 2008, annual growth from all sources turned negative except for social transfers, which actually increased. This is an example of automatic stabilisers in action. Property income fell sharply as house prices and rents collapsed. However, shortly after the beginning of the recovery, annual growth in household incomes rebounded. As the above is a measure of aggregate household sector incomes, growth in wages and salaries is not just reliant on earnings growth, but also growth in employment.4 Fortunately, both of these are now recovering as illustrated by chart 9. After months of job losses, UK employment finally increased in the three months to April, albeit by a small gain of five thousand workers. The improvement should be more visible in the annual growth numbers in coming quarters.
…especially as earnings and employment growth accelerates. Households have seen interest
payments and tax bills fall through the downturn…
Looking ahead, we expect employment and earnings growth to continue to improve gradually, leading to further gains in the contribution from wages and salaries to household incomes. However, we stress that we expect a sub-trend and gradual labour market recovery. This is due to the Chancellor’s aim to reduce the deficit by having a tax raising to spending cutting ratio of 23:77. Current official estimates of public sector job losses stand at around 600,000 by 2014/15. To put this into context, that represents a 0.4 percentage point reduction in employment growth over the next five years, or almost halving employment growth from its recent average of one percent per annum.
Going back to sources of household sector income, the support from social transfers should fall as the number of people claiming unemployment related benefits falls. In addition, cuts to tax credits and limits on the growth in benefits announced in the emergency Budget will also reduce the contribution from transfers in the coming years. Overall, we expect a gradual and modest recovery in household sector income.
Impact on non-discretionary household spending
Turning to the expenditure side of household balance sheets, we start with nondiscretionary spending, or more precisely, tax expenditure and property related rent and interest payments (defined jointly as property income paid). There are a few categories of tax expenditure, but for simplicity, we are just looking at the aggregate of these categories.5 Growth in tax expenditure is dependent on a range of variables including tax rates and growth in incomes. Therefore, even if tax rates were to remain constant, as the economy continues to recover, aggregate tax expenditure rises. Chart 10 shows the breakdown of non-discretionary spending between tax and property income expenditure. In a similar pattern to income, annual growth in nondiscretionary spending collapsed heading into the recession, but in contrast to incomes, has remained negative up until now. This implies that household sector disposable income has risen in recent quarters.
Thanks to record low Bank of England policy interest rates…
…however, rates will rise eventually and tax increases announced will mean that nondiscretionary spending will rise
The biggest negative contribution to non-discretionary spending during the recession was the fall in property income paid. The vast majority of this in the UK is interest payments on mortgages, which is mostly driven by policy interest rates set by the Bank of England. Therefore, when the Bank of England cut its policy rate from a peak of 5.75% in November 2007 to just 0.5% by March 2009, this helped reduce household interest payments dramatically (see chart 11).
Looking ahead, the increase in capital gains tax and planned increase in national insurance will lead to higher tax payments in the years to come. However, people on lower incomes will see a rise in personal income tax allowances, and so the impact for the household sector as a whole will be less dramatic (as the Treasury suggests). Note that the impact of the increase in VAT is not captured in these nominal numbers as it represents a price increase. This will be taken into account at a later stage when converting nominal disposable income into real disposable income.
The contribution from property income paid is likely to rise as policy interest rates are raised from their record lows. Shortly after the tougher than expected emergency Budget, we changed our Bank of England interest rate forecast by pushing out the first rate rise to May 2011, with rates ending the year at 1.75%. We will return to the role of monetary policy in greater detail later in this piece.
The decision to save seems to be strongly linked to consumer confidence and wealth effects…
…with house prices playing a key role in making households feel more wealthy The savings ratio
Now that we have a view on household resources or income, and also have a view on non-discretionary spending, we have a view on what might happen to nominal disposable income over the coming years. Before we can estimate how this translates into real final consumption, we need to consider how much will be saved versus spent.
The UK household sector is famous for its low savings ratio, which briefly turned negative at the start of 2008. In theory, as interest rates rise and the returns on savings improve, households should be tempted to forgo current consumption for the improved interest returns. However, we have found little evidence to support this in the UK. In fact, we have found that as interest rates peaked at the end of 2007, households were forced to borrow to cover basic autonomous expenditure (hence the negative savings ratio at the start of 2008).
Putting the need to cover autonomous spending aside, we believe that consumer confidence, and the desire to hold precautionary savings tend to be important cyclical drivers of consumer behaviour. As chart 12 shows, there appears to be a robust inverse relationship between consumer confidence and the household saving ratio, particularly during cyclical upturns and downturns, where households may gain or lose confidence on the back of a stronger or weaker labour market. 
House prices are also important as residential housing is a large part of the household sector’s store of wealth. As prices rise, households feel wealthier, and therefore tend to be prepared to save less/borrow more against capital gains. Though causality between real consumption and house prices is difficult to prove, there has been a consistently strong relationship between the two (chart 13 on next page).
However, the housing market remains soft and leading indicators suggest prices may fall in the coming months
Looking ahead, chart 12 suggests that the savings ratio could fall to around 6% and fall further if confidence continues to improve, while chart 13 supports this and suggests real consumption growth should accelerate over the rest of this year. However, there is a risk that a softening housing market could present downside risks to consumption prospects. The Halifax house price survey has reported two consecutive monthly falls in prices while our favourite short-term leading indicator, the RICS sales to stock survey indicator suggests that house prices may decline further over the coming few months (chart 14).6
We forecast real disposable income growth to recover gradually and modestly as headwinds continue to persist… Consumption forecast
Taking together all of the above analysis, we have constructed a forecast for growth in real household disposable income and consumption (see table 2). Nominal household income growth is assumed to have a weak recovery by historical standards in 2010, before accelerating in 2011, but falling back in 2012 as public sector job cuts begin to accelerate. The assumed negative impact from the increases in taxation is equivalent to that estimated by HM Treasury, though most of the impact on annual tax expenditure growth will have disappeared by 2012. As for property income payments, we have adopted our interest rate forecast which is currently below consensus.7
Taking what is left, nominal household disposable income, and adjusting it for inflation, we forecast growth in real household disposable income to fall from 1.8% in 2009 to just 0.7% in 2010. This is mainly caused by a lack of repeated cuts in interest rates, and higher inflation. Disposable income is then forecast to rise by 0.9% in 2011 and 1.3% in 2012, still being held back by higher inflation and austerity measures.
For the savings ratio, we have cautiously assumed that the ratio stays at 7%, though the Office for Budgetary Responsibility (OBR) assumes the saving ratio will fall slowly to 6.4% by 2012. This represents upside risk for our consumption forecast. After adjusting disposable income for the savings ratio, we forecast real consumption expenditure growth to pick up to 0.6% this year, before rising to a robust 1.5% in 2011, before falling back slightly to 1.2% by 2012.8 This is consistent with our forecast for GDP growth, with a relatively weak household sector recovery, but a stronger corporate recovery and a strong acceleration in business investment growth.
…which will mean that BoE rates will have to remain very low for an extended period of time.
Conclusions
Though George Osborne’s debut budget was tougher than we expected, the austerity measures announced should only dampen the household sector recovery rather than derail it. We have made some conservative assumptions in our forecast and so there is plenty of upside risk to our findings. However, key to the continued household sector recovery will be the continued ultra-loose monetary policy remaining in place. If the Bank of England raises interest rates aggressively, then the risk of a double dip recession intensifies. Similarly, if there is another sharp depreciation in Sterling that causes inflation to spike up once again, then UK economy may find itself in a very stagflationary environment.
1 “Animal spirits” is the term John Maynard Keynes used in his 1936 book The General Theory of Employment, Interest and Money to describe emotion or affect, which influences human behaviour and can be measured in terms of consumer or investor confidence.
2 November 21, 2002 Deflation: Making Sure “It” Doesn’t Happen Here
3 Household sector as reported by the Office for National Statistics includes non-profit institutions serving households (NPISH), for example, charities, religious organisation, trade unions etc.
4 Total hours worked is also a factor, which has also been recovering.
5 Aggregate tax expenditure includes: Current taxes on income, wealth, etc.; social contributions; social benefits other than social transfers in kind; other current transfers.
6 Royal Institute for Chartered Surveyors
7 We expect the Bank of England to keep rates on hold until May 2010, with rates reaching 1.75% by the end of 2011. The Bloomberg consensus survey shows the consensus is for rates to rise in the first quarter of 2011, and to end 2011 at 2%.
8 Nominal disposable income is adjusted for changes in net equity of households’ in pension funds to yield total available households’ resources. Savings are then deducted from this higher amount.
Important Information:
Issued in July 2010 Schroder Investment Management Limited.
Source: ETFWorld – Schroders
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