No stabilisation of the cycle before the second half of 2009

We repeatedly underlined our scepticism regarding both the decoupling story and the idea that the financial crisis would come rapidly to an end. Decoupling was hard to imagine. When the economic indicators of the OECD countries were pointing to a very strong moderation in activity, the rest of the globe could hardly be unaffected as its potential for exports was shrinking. The end of the financial crisis was equally difficult to imagine as long as the inventories kept exerting a downward pressure on house prices in the US and consequently kept inflating defaults.

Following the Lehman debacle mid September and the worsening in the financial crisis that followed we had to revise down our forecasts. The outlook already negative deteriorated even further over the last two months. The recession that the US, the eurozone and the UK are now experiencing is likely to be as deep as the early 1980’s recession, rather than the comparatively mild recessions in the early 1990’s and 2001.

In the US, GDP decreased by 0.3% (seasonally adjusted annual rate) in Q3. The contractions could reach, or even surpass, 3% in the coming quarters as suggested by the ISM, a reliable indicator of the GDP developments. The GDP is expected to contract by close to 1.5% next year. The stabilisation of the cycle would only take place in the second half of 2009. Household consumption is not any more supported by wealth effects nor by higher reliance on debt. It will be dampened by the conjunction of an increase in the savings rate, the decrease in employment and the impact of rising unemployment on wage settlements. Despite the moderation in inflation, consumption is expected to contract by 1% in 2009. If the decrease in residential investment is expected to moderate following two years of impressive contractions, corporate investment is to experience a two digit decrease as a result of tougher financing conditions, retrenchment in profits and above all a widening output gap. Exports are losing momentum as a result of the global deterioration in economic conditions. Besides, the regained strength of the dollar will not to help.

The large fall in oil prices together with a widening negative output gap will result in a strong decrease in inflation, which could get well below 1% next year and even disappear temporarily in Q3 due to base effects. Against that backdrop, we expect the Fed to cut the Fed Funds target rate by 50 bp down to 0.5% as it seems important to keep real rates in accommodative territory in a context of deleveraging and to anchor inflation expectations in positive territory in order to avoid the risk of deflation. It is likely that the Fed will not stop there. The Humphrey Hawkins testimony next February could well be the occasion to announce quantitative measures (the purchase of longer term Treasuries), in fact the monetisation of public debt. Besides, a fiscal package (tax cuts, infrastructure spending…) is to be adopted by the coming new administration.

In the eurozone, GDP has dropped by 0.2% q/q both in Q2 and Q3. The slowdown is sharp as shown by the annual growth down from 1.4% in Q2 to 0.7% in Q3. Economic indicators (PMIs, EC monthly surveys) point to further contractions, eurozone GDP could decrease by 1% next year. Stabilisation in activity can be expected at year end, followed by a mild recovery in 2010. In the UK, GDP has dropped by 0.5% q/q in Q3, and more significant contractions are expected, resulting in a drop of GDP by about 2% next year.

The rate of inflation in the eurozone is to contract and get below 1% in Q3 2009. Without any inflation concern and economic activity much weaker than in 2002, ECB is likely to bring its refi rate below 1.5% before mid 2009. The BoE cut its base rate very aggressively in November by 150bp. The base rate is expected to be set below 2% very soon.

The recession in the OECD countries is not without repercussions for the emerging countries, considering the consequences for its export markets, but also as a result of the financial crisis. Besides the unwinding of the carry trade positions, the repatriation of capital aimed at covering losses resulted in falling assets prices and financing difficulties in countries that are indebted in foreign currencies, especially those with current account deficits. The IMF has revised down its forecast for EMK growth to 5.1% from 6.1% in October 2009. Global growth is seen at just 2.3% against 3% in last month. Despite this revision this outlook can be seen as too optimistic as it comes with a decrease in GDP of just 0.3% for the advanced economies.

After three cuts in interest rates, China has just announced the implementation of a fiscal package aimed at supporting economic activity in 2009 and 2010 (worth at least 3% of GDP for both years), that just testifies that the Chinese economy is experiencing a considerable slowdown, the target is to keep growth in the province of 8% (12.5% in 2007), a level that is seen necessary to absorb the increase in the urban labour force.