Tuesday, June 23, 2009

And now a W-shaped recovery?

In the last three months, green shoots have been sprouting across the global economic landscape - equity markets are looking up and volatility is down; commodity prices are rising; corporate credit spreads (the difference between the yield of corporate and government bonds) have narrowed dramatically, as government-bond yields have increased sharply; and the dollar has weakened as demand for safe dollar assets has abated.

Nouriel Roubini, whose forecasts are a bell-wether for the world economy, feels that this upturn is driven by excessively optimistic expectations of a rapid recovery of growth toward its potential level and by a liquidity bubble that is raising oil prices and equities too fast too soon. He feels that "extremely loose monetary policies (zero interest rates, quantitative easing, new credit facilities, emissions of government bonds and purchases of illiquid and risky private assets), together with the huge sums spent to stabilize the financial system, may be causing a new liquidity-driven asset bubble in financial and commodity markets", as in the case of Chinese state-owned enterprises which have been buying equities and stockpiling commodities well beyond their productive needs using the huge amounts of easy money and credit they gained access to. He writes,

"Recent data from the US and other advanced economies suggest that the recession may last through the end of the year. Worse, the recovery is likely to be anemic and sub-par — well below potential for a couple of years, if not longer — as the burden of debts and leverage of the private sector combine with rising public sector debts to limit the ability of households, financial firms and corporations to lend, borrow, spend, consume and invest.

This more challenging scenario of anemic recovery undermines hopes for a V-shaped recovery, as low growth and deflationary pressures constrain earnings and profit margins and as unemployment rates above 10% in most advanced economies cause financial shocks to re-emerge, owing to mounting losses for banks’ and financial institutions’ portfolios of loans and toxic assets. At the same time, financial crises in a number of emerging markets could prove contagious, placing additional stress on global financial markets.

The increase in some asset prices may, moreover, lead to a W-shaped, double-dip recession. In particular, thanks to massive liquidity, energy prices are now rising too high too soon. The role that high oil prices played last summer in tipping the global economy into recession should not be underestimated. Oil above US$140 a barrel was the last straw — coming on top of the housing busts and financial shocks — for the global economy, as it represented a massive supply shock for the US, Europe, Japan, China and other net importers of oil.

Meanwhile, rising fiscal deficits in most economies are now pushing up the yields of long-term government bonds. Some of the rise in long rates is a necessary correction, as investors are now pricing a global recovery. But some of this increase is driven by more worrisome factors: the effects of large budget deficits and debt on sovereign risk, and thus on real interest rates; and concerns that the incentive to monetize these large deficits will lead to high inflation after the global economy recovers from next year to 2011 and deflationary forces abate. The crowding out of private demand, owing to higher government-bond yields — and the ensuing increase in mortgage rates and other private yields — could in turn endanger the recovery.

As a result, one cannot rule out that by late next year or 2011, a perfect storm of oil above US$100 a barrel, rising government-bond yields and tax increases (as governments seek to avoid debt-refinancing risks) may lead to a renewed growth slowdown, if not an outright double-dip recession."


Update 1
A primer on V-, L-, W-, and U-shaped recessions.

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