25 May 2009
Weekly Macro Comment
Han de Jong, Chief Economist
Inflection point or turning point?
• Improvement in some key areas
• Confidence indicators continue to strengthen
• S&P puts UK’s triple-A rating on negative watch
Last week was a light one in terms of macro data, and what
was released did not show much direction either way for the
global economy. I think this is typical around inflection points or
turning points in the economy. That, I suppose, is the key
point: have we reached a turning point, or is this merely an
inflection point? The difference between the two is this. An
inflection point is when the pace of growth—or contraction as is
the case now—lessens. In mathematical terms, it is when the
second derivative of GDP changes direction, in this case: turns
positive. A turning point is when economic growth changes
direction, say from negative to positive. This would be the first
derivative.
It is safe to say that we have at least arrived at an inflection
point. I think there is a better chance than the consensus is
assuming that it will actually be the beginning of a turning
point, though it is likely to take time for the economy to turn.
What is causing this improvement in the economy? Economic
policy and the inventory cycle. While the economic downturn
has been savage, the policy response has been
unprecedented. Interest rates have been cut to the bone,
several central banks are buying a variety of securities directly
in the market (currently being labelled quantitative easing),
while budget deficits are not only allowed to go up but are
rising rapidly as a result of active policy. It would be most
surprising if all that action did not lead to an improvement in
economic conditions. The question is how much of an
improvement and how sustainable the improvement will be.
The inventory cycle is also critical. Companies have slashed
inventories in recent months. This simply cannot continue
forever. When the inventory cycle turns, demand increases
and economic activity picks up. Bear in mind that different
industries and even different companies go through different
inventory cycles.
In the past, I have identified three areas where meaningful
progress must be made before there is any hope of a
sustainable recovery. If positive developments in any of these
three are lacking, any recovery will be short lived. I will now
discuss these three areas in detail but before I do so I would
HAN DE JONG +31 (0)20 628 4201
note that some progress is being made in all three areas,
though not enough yet to claim victory. While I do not want to
downplay the problems and the risks, the consensus is too
negative in my opinion.
1. The destruction of wealth must stop
There cannot be a sustainable recovery until the destruction of
wealth stops and, ideally, reverses. Continued destruction of
wealth simply means that households and banks with
precarious balance sheets will sink deeper into trouble, which
will require more adjustment on their part (more saving, less
spending) to get back to a sustainable situation again.
US: NAHB, home-builders’ confidence
index
80
70
60
50
40
30
20
10
0
2005 2006 2007 2008 2009
Source: Bloomberg
The key asset markets are the housing market and the equity
markets. It is clear that equity markets have rallied. That is
helpful. Of course, the equity market can be volatile and the
gains can easily be lost again. But so far, so good. Cycles in
the housing market are much less volatile than in the equity
market and also tend to be significantly longer. The US
housing market started deteriorating in early 2006, with price
changes (on a year-on-year basis) falling into negative territory
in early 2007. Prices have effectively been falling for three
years. Construction activity continues to decline and is down
by 80% from its peak. But several recent indicators are
showing some improvement. The decline in house prices
seems to be moderating (second derivative only so far,
ECONOMICS DEPARTMENT
 25 May 2009

unfortunately), sentiment among builders as measured by the Fed index both rose further in May, building on the
NAHB index has improved a little, and home sales are at least improvement of recent months. In Germany, the ZEW index of
stabilising. Affordability has improved significantly and is now confidence among analysts also rose in May, by much more
better than it has been for many years. than expected. In Asia, the Bank of Japan raised its
assessment of economic prospects.
2. The credit mechanism must be fixed
An economy cannot function properly when credit arteries are Eurozone PMI composite
blocked. There are essentially three credit channels: through index
the banks, through the financial markets and between
60
companies. Following the demise of Lehman Brothers, all
credit channels were abruptly blocked. Faced with this sudden 55
lack of financing, companies were forced to be extremely
50
careful with their liquidity: they stopped ordering supplies and
started an aggressive policy of drawing down inventories. It 45
was this sudden corporate liquidity crisis that triggered the
dramatic turn in the inventory cycle. While this is rational 40
behaviour for an individual company, it leads to calamitous
35
chain effects. An unprecendented deep recession was the
2005 2006 2007 2008 2009
consequence. Companies cannot continue drawing down
inventories forever, so this downturn was always bound to Source: Bloomberg
ease somewhat. If the working of the credit channels can be
improved, a process of rebuilding some of these inventories is US: Empire State
likely, lifting economic activity at least in the short term.
index

40
The signs here are cautiously positive. Central banks have
30
taken over some credit activities by buying various types of
20
assets in the markets. And they have succeeded in restoring
10
some liquidity in various markets, for example the mortgage
0
bond market in the US and the US commercial paper market.
In addition, by injecting liquidity generously into the financial -10

system, the money markets are now in better shape. Risk -20
spreads have fallen as a result. So financing through the -30
markets has improved somewhat. Bank lending is still -40
problematic, as bank capital remains scarce and the recession 05 06 07 08 09
will mean more losses for banks and hence a further attack on Source: Bloomberg
their capital in the period ahead. Nevertheless, according to
the bank lending surveys carried out by key central banks
I believe that if there is enough of an improvement in all these
every quarter, the pace at which banks are tightening lending
three areas, a virtuous circle (or positive feedback loop if you
criteria is easing. This is true for the US as well as the
prefer) could develop and that this could be the basis for a
eurozone. That is encouraging.
more sustainable recovery. Of course, given the degree of
deleveraging that needs to take place, the recovery is unlikely
3. The recession must stop
to be particularly strong. And given the problems in the
The last area where we need to see improvement is economic
financial sector, even if there is some further improvement in
activity itself. And clearly, a range of early indicators across all
the three areas mentioned above, a relapse is always possible.
regions has improved. This is particularly true for early-cycle
On balance, cautious optimism is warranted.
sectors and economies, and for economies where government
stimulus has been the most decisive: Asia and in particular
S&P puts UK on negative watch; Bill Gross says US will
China. But business confidence indicators are improving
follow
everywhere. Last week saw the release of the preliminary
S&P has lowered its medium-term outlook on the triple-A rating
PMIs for the eurozone. The manufacturing PMI (purchasing
for UK sovereign debt from ‘stable’ to ‘negative’. This is, of
managers’ index, business confidence) rose from 36.8 in April
course, not a formal downgrade, but it is a warning. The
to 40.5 in May. The services PMI rose from 41.1 to 43.9, its
reason is that the UK’s debt-to-GDP ratio may approach 100%
third consecutive monthly rise. In the US, the Empire State
at some stage. The same happened to Japan around the turn
index of business confidence in New York State and the Philly

HAN DE JONG +31 (0)20 628 4201 ECONOMICS DEPARTMENT

 25 May 2009

of the century. Given where the debt level currently is, it all
seems somewhat premature to me. Pimco’s Bill Gross was
quick to say that the US would eventually also lose its triple-A
rating. Such a warning coming from Gross is hardly surprising.
He has argued the case for some time and has said that his
bond portfolios are overweight credits against Treasuries. So
Bill is not only providing a comment here, he is also talking his
own book.

US Treasury Secretary Timothy Geithner was quick to say that

the Obama administration is aiming to restore balance in the
public finances within a couple of years. That is all well and
good, but we must not lose sight of the overall macro picture.
The private sector needs to deleverage, which means it must
run a financial surplus. Realistically, that means that the US
government must run a deficit. When that might change
depends more on the behaviour of the private sector than the
government. The US government may be forced to run
substantial deficits for longer than Geithner is assuming.

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HAN DE JONG +31 (0)20 628 4201 ECONOMICS DEPARTMENT