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United States
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United States: confidence disappears
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US economy has one foot in recession but biggest risks lie in slow recovery.
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The word «credit» comes from the Latin «credere», meaning «to believe». Believing is similar to having confidence and confidence has been the first victim of the credit crisis brought about by subprime mortgages. In the current situation in the United States we see the coexistence of greatly depressed indicators for confidence and expectations along with indicators for economic activity which, while weak, are showing a much less extreme picture over the short term.
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The US gross domestic product (GDP) slowed in the fourth quarter of 2007 growing at 2.5% year-on-year, 0.6% annualized compared with the previous quarter. We cannot rule out that in the first quarter of 2008 we are seeing negative growth but latest economic activity indicators do not give a clear verdict in that direction. Nevertheless, the key question is not so much in the possibility of seeing negative growth in the first half of 2008 but rather in how long this period of economic weakness is going to last. In this respect, the indicators are showing a clearly downward trend that suggests that this period will not be brief. In any case, private consumption will mark out the level of economic activity and the recovery of lost confidence will be the key element for coming out of the tunnel.
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Consumer confidence at low levels but retail sales and ISM index showing gradual slowdown.
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In this respect, the consumer confidence index supplied by the Conference Board continued to drop in March going from 76.4 points to 64.5 points, the lowest level since 1993, apart from the hiatus prior to the war on Iraq. Among the components of this index, the component of the current situation, while it clearly dropped, has not gone to dramatic levels. Things change radically in the expectations component which dropped to levels not known since late 1973 when the sudden end to Richard Nixon’s presidency coincided with the start of the oil crisis at the outbreak of the Yom Kippur war. By comparison, the slowdown in retail sales in February seems moderate. These sales, excluding car sales and petrol consumption, were up 2.0% year-on-year, which, if we discount price changes, suggests a practical stagnation with a clear downward trend.
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The picture on the business side is following a very similar pattern, without sharp drops but also with a marked trend downward. The economic activity index of the Institute for Supply Management (ISM) for February was down to 48.3 points, a level below 50 indicating some predominance of pessimistic responses. In the case of the services ISM, there was a recovery to 50.8 points following the drastic drop the month before. In both cases there was notable upward pressure of the prices component.
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Labour market slowing down and wages lose purchasing power.
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Consumers have objective reasons to be pessimistic both regarding the work situation which affects their incomes and the real estate front on which a good part of their wealth depends. Some 63,000 jobs were lost in February. While the labour market is easing off relatively slowly in terms of job creation, in wage terms the process has been faster. Purchasing power of total wages ended 2006 with definite gains but in 2007 the drop was much faster than in the 1999-2002 period when the last slowdown took place. This was due to changes in kinds of jobs and the effect of energy prices. In the US case, the clearest effects of the rise in oil comes not in the pass-through to prices in other segments of the economy but in the dip in household budgets.
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Housing still not hitting bottom with real estate prices down 11%.
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On the second front, the real estate crisis, the decrease in construction spending is taking nearly one percentage point off economic growth and there are no signs that this has hit bottom. Housing starts in February were down 28.4% from the same period the year before. Pointing in the same direction, building permits, which are an indicator pointing to the level of housing starts, were down a similar 36.1%. Nevertheless, the price of real estate is a key factor in knowing how long the crisis will go on. The value of assets is at once a demonstration and a reason for confidence among consumers and investors and, in view of the Case-Shiller index for housing prices, things are still on a poor track. In January, the general index dropped by 11.4% year-on-year which comes close to a 15% loss if we add the increase in the consumer price index (CPI). Areas such as Las Vegas and Miami showed drops of close to 20%. Sales of existing houses were down 23.8% year-on-year in December while new houses, in view of the greater volatility, dropped by 29.8%.
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A wave of foreclosures is expected and, with this in mind, the Administration and the Federal Reserve are considering whether to modify loan contracts by offering a grace period to borrowers in default or to use public funds. Both solutions have serious long-term dangers but lack of action also presents major risks. In any case, the use of public funds, a course favoured by the Federal Reserve, seems less drastic that changing loan contracts.
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Inflation moderates but still above 4% despite slowdown.
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In February the CPI moderated the rise in the previous month and rose by 4.1% year-on-year. The underlying component (the general rate less food and energy) was also down slightly going from growth of 2.5% to 2.2% year-on-year, more in keeping with the expectations of the Federal Reserve which were close to 2.0%. The risk of lower growth is thus greater than the inflation risk but we should not forget that the relation growth-inflation has become less favourable than in the past so that we should not expect that this period of weakness will bring any major modification of prices.
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Trade deficit adjustment continues but dollar presents biggest risk.
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In turn, the trade balance for goods and services in January showed a deficit of 58.2 billion dollars, somewhat lower than in December. Exports continue to grow. In January they grew by 16.6% year-on-year whereas imports were up 11.9%. This improvement is important because the deficit (excluding oil products) stood 47% below the high in October 2005. Nevertheless, the correction of the deficit cannot compensate the weakness in domestic demand and the biggest risk in the foreign sector lies in one of the causes of the current improvement, the loss of value of the dollar, which again takes us to the matter of confidence, that is, confidence in assets expressed in dollars. While the value of real estate assets is in doubt, one positive element is that US government bonds continue to enjoy the favour of international investors.
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Japan
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Japan: the weakness of a long growth period
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Japan continues gradual growth but consumers form no part of it.
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The GDP of Japan’s economy grew by 1.7% year-on-year in the fourth quarter of 2007, thanks to the strength of investment in capital goods, public consumption and a rise in inventories. Excessive dependence on the foreign sector continues, along with the weakness of private consumption. This leaves the economy in a state of weakness that is worsening if we take into account that Japan does not have any shock-absorbers in monetary or fiscal policy seeing that the public debt is nearly 160% of GDP and interest rates are at a low 0.5%, which offers practically no possibilities for rate cuts.
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Dependence on foreign sector and heavy public sector debt present risks.
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Japan’s recovery has been going on for 6 years but it has two clear weaknesses. First, the level of growth has been extremely low. According to the latest revision issued by the International Monetary Fund on the weight of various countries in the whole world economy, Japan continues to lose importance. This should not be serious if we consider the enormous progress of economies like China and India. The problem comes when we compare it with other rich areas. Between 1997 and 2007 the Japanese economy went from being 46% to 41% of the total economy of the Euro Area and from 37% to 31% of the US economy. If this calculation is made in current terms, Japan’s deflation means that the decreases are even greater.
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Corporate profits concentrated in large companies.
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Secondly, the benefits of growth are not turning into wage increases in spite of the fact that the unemployment rate continues at very low levels because of dropping population. In January, the rate was 3.8% of the labour force. The reason could lie in the dual structure of Japanese companies. While the large companies did their homework in the Nineties and are now in good shape, the small and medium companies (which make up 70% of all employment) still have elements of inefficiency. As a result, with wages dropping 0.4% year-on-year in the last quarter of 2007, it is not surprising that private consumption continues weak. Consumer confidence ended the year at the 38.9 points level and, in spite of a slight rise, retail sales were up by a slim 1.3% year-on-year in January. Car sales, while far from the highs in 2005, do not fall into this grim picture but are showing something of a recovery that it is hoped will continue.
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Industrial production and retail sales maintain low profile but investment recovering.
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On the supply side, industrial production was up 2.2% year-on-year in January, down from the 4.5% in 2006 and 2.9% in 2007. That same month, machinery orders, an early indicator of investment demand, rose by 18.9% year-on-year, thanks to a sharp rise in orders by the export industry, which represents 49.7% of the total, as against 40% at the end of 2003, which again shows the dependence on foreign demand.
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Prices up due to rise in oil but deflation still continues while exports depend on Asian growth.
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In the real estate market, housing starts in January showed signs of recovery with a reduction of the drop from 19.0% to 5.7% year-on-year. However, the market is not going along and sales dropped by 44.1% in the Tokyo area in February. Prices are also easing going from an increase of 9.2% to a slight growth of 3.2%. The January CPI rose by 0.7% year-on-year and the traditionally followed index excluding fresh foods rose by 0.8%. Nevertheless, publication of the underlying index (the general index excluding energy and foods) again showed a drop of 0.1% compared with the same period the year before. As a result, all appearance of an end to the period of deflation comes from abroad as import prices continue to rise because of energy and food. The good news was again to be seen in the trade balance which maintained its surplus in January thanks to the fact that exports to Asia compensated for lower demand from the United States.
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China
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China: the search for a slight slowdown
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Chinese economy grows by strong 11.4% but showing some signs of slowing down.
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The Chinese economy grew by 11.2% year-on-year in the fourth quarter of 2007 which put the increase for the whole year at 11.4%, the highest rate since 1994. Keeping in mind the high growth rate, the trend in the second half-year marked a slight slowdown, the result of government efforts to control inflation. Economic activity indicators followed a trend similar to the national accounts. Industrial production in February was up 15.4% year-on-year, which also indicates some cooling off if we compare it with the figures of six months earlier. But private consumption continues as the part of the economy that does not grow as it should, especially in rural China. Retail sales in February, discounting price increases, slowed to an increase of 9.6% while retail sales in the rural areas (assuming a higher share of food in total consumption) could be showing negative growth rates.
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Main risk is inflation coming close to 9%, while food prices up 23%.
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The main risk for the economy now is the sharp rise in inflation. The general CPI rose by 8.7% year-on-year in February, twice the rate only eight months back. The situation is even more troubling in the food sector with prices rising 23.3% thus maintaining the trend to sharp increases. The sector represents 14.4% of total retail sales but in the rural areas, where more than 700 million people live, this percentage goes up considerably. China is an importer of food and price increases in world markets, along with changes in eating habits, mean a risk that goes beyond the purely economic sphere. The government is loath to raise interest rates in order to avoid damaging the mortgage market. The option being followed is to increase the cash ratio which, as of March (after an increase of 0.5%, the fifteenth consecutive rise since mid-2006), was set at 15.5%. With these measures, prime minister Wen Jiabao hopes to end 2008 with a CPI at 4.8%, which seems no easy task.
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Even with all its risks, China is the main engine of the world economy. On a continuation of China’s growth depend the fortunes of many economies in the Far East, both large and small, given that the Asian giant combines major trade surpluses with Europe and the United States with a sharp deficit with many countries in Asia. Government concern is focused on the loss of value of the US dollar. The appreciation of the Chinese renminbi against the greenback (when this drops) has no effect in terms of other currencies such as the euro.
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Bilateral surplus with United States stabilizes but continues to grow with Europe.
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The foreign surplus for the past 12 months ending in February eased slightly going to 250 billion dollars but, while the positive bilateral balance with the United States was stagnant at 160 billion dollars, the surplus with Europe went to 153 billion dollars, twice that in mid-2006. In contrast, the combined deficit with Taiwan, South Korea and Japan rose to 159 billion dollars.
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Mexico
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Mexico: foreign sector is Achilles heel
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Mexico grows by 3.8% with consumption and investment strong but foreign sector dropping.
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The Mexican economy held to its upward trend with growth of 3.8% year-on-year in the fourth quarter of 2007. This put the increase for the whole year at 3.3%, somewhat below the 4.8% the year before. Private consumption sharpened its rate going to 4.6%. While the figure for the third quarter was revised downward, this component is pointing upward. Private investment also gave signs of life with a rise of 8.9%. But the weaknesses in the Mexican economy continue to be in the public sector that is moving up and in a foreign sector that continues to show problems of competitiveness. The rise in exports, with an increase pf 6.4% in the fourth quarter, lost some of its strength while imports continued to rise with an increase of 10.5%.
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Among the most recent indicators of economic activity things also continue to move up. Industrial production in January rose to growth of 3.1% year-on-year although growth of 1.4% in 2007 pales when compared with the 5.0% the year before. Manufacturing was somewhat better with an increase of 3.7% in January while construction, perhaps reflecting the situation of its US neighbour, rose by a modest 0.8%.
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Industry remains slack but inflation below 4% and labour costs still moderating.
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Inflation remains stable. Prices rose by 3.7% year-on-year in February while the underlying index (the general index excluding energy and food) was up 4.0%. Thanks to increases in productivity in December, unit labour costs continued to ease following a substantial rise in May and June 2007. In turn, the official unemployment rate for February cut down the rise in the previous month putting it at a moderate 3.8% of the labour force.
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Foreign sector sharpens drop.
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The worsening of the trade balance sharpened with a cumulative trade deficit for the past 12 months ending in January rising to 11.7 billion dollars. This meant a worsening which, excluding oil exports, turns out to be more dramatic. Revealing the consequences of the weakness of the US economy, non-oil exports have dropped 10% since October while the drop in imports was not nearly as sharp. The deficit for the past 12 months up to January, excluding oil, was 56.16 billion dollars, a figure close to twice that for the not so far off year 2004.
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Raw materials
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Commodities: oil hits new highs
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Oil pierces psychological barrier of 100 dollars a barrel...
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The figures are staggering. The one-month forward price per barrel Brent was 106.54 dollars on March 14 following in the wake of the West Texas barrel which the day before reported a price of 108.96 dollars. These all-time highs, which have left the psychological barrier of 100 dollars far behind, gave way to several days with sharp swings. At the end of March prices were slightly lower than those record figures. What is happening?
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...due to growth of demand over supply in first quarter.
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There is no lack of explanations. In a recent note, the US government agency that monitors energy matters listed no less than 12 factors, from the dollar exchange rate to refinery bottlenecks as well as speculative moves in hedge funds. The evident problem is that we cannot isolate these factors and furthermore that our ability to explain them serves in some periods but not in others.
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In the first quarter, world supply was 86 million barrels a day whereas demand would have been 87 million barrels. This shows the clear trend to a reduction of inventories of oil products which has come to light in recent months. For 2008 as a whole it is expected that supply will marginally exceed demand with the former growing by 1.5% a year while the latter moving up by 3.1%.
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On top of this small margin we must add that pumping capacity is very limited and basically centred in Saudi Arabia which helps us to understand that the decision of the Organization of Petroleum Exporting Countries (OPEC) to maintain production quotas until the summer may have created notable pressures in the market.
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Commodities drop positions in March.
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In contrast with other times, other commodities have somewhat moved away from recent trends in oil. After marking up high values for various metals at the beginning of March (whether all-time highs or highs not seen for many years) these have now tended to ease. Some of the most notable monthly decreases were seen in zinc (down 15% monthly), platinum (down 5%) and aluminium (decrease of 3%). Farm commodities have followed a similar route. In this respect, we should mention corrections in soy beans (drop of 12%), coffee (down more than 16% monthly) and cocoa (decrease of 13%).
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What makes consumption move?
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Private consumption moves according to present and future household income and net worth
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Household consumption usually accounts for a large fraction of a country’s GDP. In the case of Spain, it was 57% in 2007 (see following Graph), in line with that of its neighbouring countries. In the past 10 years, its growth has been 3.9% annual, similar to average GDP growth at 3.8% (see Graph on next page). Over the long term, this similarity is not by chance. Consumption growth is determined by GDP growth which, in turn, basically depends on variables such as the increase in employment and improvements in productivity. Over the short term, however, causality also works in the opposite direction: changes in household consumption affect GDP growth. Let us show how.
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The most widely held theory in trying to explain the savings and consumption decisions of households is the Permanent Income Hypothesis developed by US economist Milton Friedman at the end of the Fifties. It argues that private consumption is determined by household wealth –in its broad sense. This concept of wealth includes all household income, both current and future income, and the total asset value net of acquired debt.
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The main source of household income is labour income. Therefore, the evolution of labour market is a crucial determinant in private consumption. In recent weeks, the figures for job creation in the United States have caught most attention from analysts of the US economic situation because they may provide clues to consumption and the likelihood the country may be in recession.
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The purchasing power of households is also determined by interest rates. In general, a decrease in real interest rates increases the borrowing capacity of households and thus their consumption. Stimulating private consumption along with investment is one of the objectives being pursued by the US Federal Reserve through its recent cuts in official interest rates.
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Finally, price fluctuations in household assets influence consumption decisions as they affect the value of their wealth. There is evidence that this «wealth effect» is relatively small in Spain’s economy, especially in the case of real estate assets. Olympia Bover, for example, has estimated that an increase of a hundred euros in a dwelling’s value would yield an increase in annual household consumption of two euros, a much more modest effect than those estimated for the US or the UK.(1)
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On the other hand, expectations on future income, and the capacity of households to «shift» part of that future income to the present, will also have an impact on present consumption. For example, in a downward stage of the economic cycle income expectations tend to drop and households consume less. The ability to use part of future income on current consumption is especially important for young people seeing that it is they who, with the purchase of durable goods, such as a car, have a greater need to spend above current income. Financial institutions, when granting a loan, play a key role in shifting this income from the future to the present. In this respect, changes in criteria for granting loans during the economic cycle have effects on household consumption.
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But not only the amount of future income is important. Also key is the uncertainty regarding that amount. In general, a higher level of uncertainty pushes up household savings in order to deal with unexpected situations such as a job loss. Some public policies, however, may reduce that uncertainty through, for example, unemployment benefits.
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Another public policy that may affect consumption and that is currently making headlines is a temporary transfer to households. This policy has recently been put into practice in the United States and its application is also being studied in Spain. If all households were behaving according to the Permanent Income Hypothesis, only a small proportion of this transfer would go into current consumption. However, not all households do behave that way.(2) Thus, if the household receiving the transfer was credit constrained, that household would be able to increase its consumption thanks to that transfer. Hence, the larger the proportion of credit-constrained households, the larger the effect of the transfer on aggregate consumption. In practice, there are also some households that consume all income whether because they like to live well or because they are barely able to cover their basic needs. For them, the transfer would mean an increase in consumption.
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On the other hand, we should also keep in mind that part of consumption is imported and the larger this proportion the less will be the effect on growth, because imports are not accounted for in the GDP as they are not produced inside the country. In an economy with full employment it is more likely that increases in consumption will translate into increased imports. Some estimates for the United States show that a transfer valued at 100 dollars increases private consumption by around 50 dollars, ten times more than the Permanent Income Hypothesis would predict.(3) For obvious reasons, this kind of result has spurred on the search for alternative consumption theories.
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In a nutshell, private consumption accounts for nearly 60% of Spain’s GDP although this does not mean that it is the reason behind long-term economic growth. Nevertheless, over the short term consumption does affect growth. For this reason, consumer confidence, the availability of credit and certain public policies come onto the radar of any economic analyst.
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