Recession still potentially ugly

The 2009 "recovery" was based on low or zero interest-rate policies of major central banks. Massive government intervention also helped arrest the rate of decline. Without government support, it is probable that most economies would have been in serious recession. Just as China practised capitalism with Chinese characteristics, developed economies discovered socialism with western characteristics.

Fragile

Capital injections, central bank purchases of "toxic" assets and explicit government support for deposits and debt issues helped stabilize the financial system. Changes in accounting rules deferred writedowns of potentially bad assets. Despite these actions, the global financial system remains fragile.

Further losses are likely from consumer loans, including mortgages. In the U.S. mortgage market, one in 10 householders is at least one payment behind (quarter 3, 2009), up from one in 14 (Q3, 2008). If foreclosures (now at 4.47 per cent, up from 2.97 per cent one year ago) are included, then one in seven mortgagors are in some form of housing distress.

Recent stability in U.S. house prices may be misleading, reflecting the effect of government incentives (the $8,000 first-time homebuyer tax credit) and low mortgage rates driven, in part, by the Fed's MBS (mortgage-backed securities) purchases. The value of 20 to 30 per cent of properties is less than the loan outstanding. Home sales remain modest, with around 25 to 30 per cent of sales of existing homes being foreclosures.

Housing inventories also remain high in historic terms. With more adjustable-rate mortgages resetting in 2010 and 2011, the risk of further losses on mortgages cannot be discounted, unless economic conditions improve.

Rising vacancy rates, falling rentals and declining values of commercial real estate, primarily office and retail properties, are apparent global. In London, Japanese investment bank Nomura secured a 20-year lease of a new office development on the Thames -- the 12-storey Watermark Place -- for 40 pounds per square foot. This was more than 40 per cent lower than the rents of nearly 70 pounds per square foot demanded prior to the global financial crisis. Nomura will also not pay any rent until 2015. Mark Lethbridge, partner at Drivers Jonas who advised Nomura, told the Financial Times: "... I'm unlikely to see (these terms) again in my career."

Banks are likely to remain capital-constrained in the near future, reducing availability of credit. Commercial and consumer loan volumes have declined, reflecting a lack of supply, but also a lack of demand as companies and individuals reduce leverage.

Incentives

The real economy remains fragile. Government actions such as fiscal stimulus and special industry support schemes (Cash for Clunkers, investment incentives, trade credit subsidies) have boosted demand and industrial activity in the short term. The problem remains that government incentives encourage current consumption and investment, but ultimately steal from future demand.

Employment, a key indicator, given the importance of consumption in developed economies, continues to decline, albeit at a slower pace. In the United States, unemployment reached 10 per cent.

In many countries, enforced reduction in working hours and taking paid or unpaid leave reduced the rise in unemployment levels significantly. Working hours and personal income have fallen.

Changes in the structure of the labour force also distort the real picture. If workers working part-time involuntarily and looking for full-time employment are included, the U.S. underemployment figure is in the 16 to 18 per cent range. Long-term and youth unemployment also remain high.

European economies, especially countries such as Spain, are also experiencing significant unemployment. In some economies, unemployment is a new "export" as guest workers are shipped back to their country of origin or remittances home fall sharply.

In developed countries, where an increasing part of the population is nearing retirement age, wealth effects affect consumption behaviours. Low interest rates and reduced dividend levels limit income and expenditure.

In 2009, global trade stabilized after precipitous falls. According to the CPB Netherlands Bureau for Economic Policy Analysis, as of September 2009, world trade was eight per cent above the low of May 2009, but 14 per cent below its peak of April 2008. Trade protectionism threatens recovery in global trade.

Major risks in the financial and real economy remain and may disrupt the hoped-for resumption of business as usual.

Monday: Botox Economics - Part 2

Satyajit Das is author of the soon-to-be-released Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives - Revised Edition (2010, FT-Prentice Hall), and a consultant to Jory Capital.

Republished from the Winnipeg Free Press print edition March 13, 2010 B9