The world has registered the most serious economic and financial crisis in 70 years with devastating consequences sparing few asset classes. At the end of last winter I called a bottom to the rout and predicted a recovery in the markets that would be commensurate to the scale of the disaster (see previous papers).

After a roaring rise that took equity prices more than 50% above the early March lows and doubled oil prices to 70 $ per barrel, the debate among investors and market professionals shows a deep rift in perceptions and to this day, the bear case continues to be espoused by some distinguished signatures.

Taking the risk of simplification for the sake of an integrated global view we can say that the Bears essentially argue that once the impact of stimulative countercyclical measures wanes, demand will again slump, as consumers are weakened by considerably higher unemployment, a negative wealth effect from deflated asset prices, continued deleveraging and last but not least the pitfalls that will arise from the inevitable withdrawal of reflationary measures that have devastated public finances throughout the world.

My view of the situation leaves little of this standing.

We have indisputably gone through wrenching wealth destruction from the summer of 2007 to the first quarter of 2009. The US Treasury’s dramatic oversight when letting Lehman fail led to disastrous consequences that eventually induced a collapse of the financial system.

A containable crisis originating in the risky subprime mortgage market has been allowed by the most ill advised decision in modern policy history to destroy confidence, the very essence of economic and financial systems, and thereby opening the floodgates to the first synchronous global crisis in post war history.
If confidence is the necessary critical ingredient of any market economy, it’s shattering has even more dramatic consequences in highly leveraged modern economic and financial systems that have created an era of unprecedented global economic growth and prosperity over the last generation.

Faced with the implosion of financial markets and the ensuing economic plunge, the Government of the United States, soon followed by Europe, Japan and China have collectively pledged the extraordinary sum of 12 trillion dollars (equivalent to the total Gross Domestic Product of the United States, or some 12% of the world’s GDP) to guarantee counterparty financial risk, shore up ‘too big to fail’ balance sheets and reflate demand.

It worked.

Prohibitive panic spreads melted, allowing the money circuits to be restored in less then 6 months, markets rallied powerfully and the undeniable signs of economic recovery now hit our screens every week.

The global economy has been saved. Or has it?

Many still believe that when the impact of these massive reflationary measures wanes we will be confronted by a relapse.

The critical argument of the bears rests with the misleading assumption that the rise in unemployment will sap consumer spending power and leave the economy prey to a double dip.

But Bears fail to consider some critical points which we will now examine briefly.
Unemployment is always a laggard and never a leader in the economic cycle. Inventories are the leader and from the depleted levels reached in the second quarter of 2009 they will propel a dramatic surge in output in the second half of 2009 as the fall in demand stabilized.

The impact of replenishing inventories on output and payrolls means that unemployment is already peaking and an imminent positive turn in employment will boost confidence and incomes, providing a sustainable character to the recovery in consumer demand.

Business spending will emerge as another substantial supporting factor in the mechanics of the incipient recovery. Figures have shown that corporations have been agile and ruthlessly efficient in fighting the collapse in demand in 2008 and have remarkably contained the damage on cash flows. Corporate results show that the implacable cuts in costs, payrolls and investment over the last 8 quarters have left most industrial and service businesses in general in a remarkably healthy underlying condition. With the exception of some spectacular showcases like GM and Chrysler the corporate sector passed the crisis without structural damage. Business spending and investment will concur and amplify the recovery in consumer spending.

International trade is already recovering and the OECD has recently revised its forecasts anticipating a renewed expansion in world trade that will ensure that a synchronized world recovery is in the making.

A notable modification from the growth model that prevailed before the crisis is emerging in China and will set the country as the major engine of global growth in the years ahead. China’s economy has become too big to rely on continued predatory onslaughts on export markets as the key driver of economic growth. Even as it becomes the world’s leading export nation the focus of economic growth will shift to continued infrastructure spending (energy, transportation and communications, health services and education) and domestic consumption. This shift will open and develop its markets for imports and will support the prosperity of world trade with substantial impact for the rest of the world.

The central issue of consumer income and demand deserves some further comment.
The temporary collapse in spending has been rooted in negative sentiment, rising unemployment, the substantial negative wealth effect from the fall in equity and property values and the attending need to restore personal balance sheets to the deflated levels of assets and income.

At this point in time savings ratios have registered a substantial increase over the last two years. Equity wealth has recouped part of its earlier losses and property prices are stabilizing, heralding a recovery.

The crisis has boosted unemployment drastically from around 5.0% to 9.5% but what most people fail to appreciate is that for more then 90% of the working force –the people that have jobs- the bandwagon of disinflation has substantially boosted purchasing power.

Consider these simple but central figures: Hourly earnings (as of the last release) are up by 2.5% year-on-year while core inflation is up only 1.5% and more importantly the all encompassing Consumer Price Index is down by 2.0% compared to year ago levels. The hidden elementary but crucial outcome is that the real (deflated) income of wage earners in the United States is up by a substantial 4.5%. In Europe and other important economies throughout the world a similar picture is emerging.

Such a considerable rise in purchasing power, combined with the substantial rise in the savings ratio from roughly zero to over 5.0% leaves over 90% of the population well placed to resume a consistent pattern of spending. The spending propensity of consumers will benefit from the recovery in sentiment and the spending ability from the imminent improvement in the employment market.
The elements and developments outlined above are not coherently articulated by the pundits, governments or the disoriented IMF. Their impact will be all the more considerable because unforeseen.

We are looking into the coming unfolding of the first synchronous upturn for the world economy spanning the United States, China, Europe, the major emerging economies and to some extent at least Japan under the new leadership.
While such a synchronic economic revival can raise fears of upcoming inflation, the risks can be appropriately contained in time.

As the gradual upturn in consumer and business spending will be seen, the very large reserves of unused productive capacity both for capital and labor will for at least 3 years be entirely sufficient to ensure that output can meet the recovery in demand without a generalized pressure on prices.
This provides an ample time window for the gradual withdrawal of stimulus measures.
Monetary policy, which has flooded the market with quantitative easing of liquidity and near zero interest rates will move towards a gradual withdrawal of liquidity as the money and credit multipliers are restored. A removal of temporary liquidity facilities synchronized with the restoration of the money and credit multipliers will ensure appropriate balance and avoid unwanted squeezes as much as negligent effects.

In a second stage starting in the spring of 2010, as disinflation wanes, interest rates will need to be raised gradually but timely towards levels of around 4.0% that will be consistent with underlying inflation rates moving back and stabilizing around 2.0% in 2011-2012.

Fiscal policy will be confronted with the task of reining in massive deficits but the endeavor should prove less daunting then feared. Automatic stabilizers will boost tax revenues and reduce claims for unemployment compensation as the recovery sets in. Public loans and guarantees will be a source of interest income for the State and equity stakes in troubled private sector entities are expected indeed to yield a profit as these entities recover.

Major fiscal issues like pensions and health care costs will remain but these are structural elements which are not linked to the crisis. The cyclical part of the deficits is liable to be gradually resolved with a combination of cost containment and the beneficial interplay of automatic stabilizers at a time of economic recovery.

To this manageable outlook we need to explicitly add an important caveat: limited output elasticity in oil (because of cartelization and relatively limited spare capacity) can and may indeed translate into a new sustained rise in energy prices as the world economy recovers. Indeed we see the distinct probability of oil at 90 dollars a barrel in the medium term and moving to 120 towards 2011-2012.
Similar rises will be seen for a number of industrial metals but outside the area of energy and raw materials the vast unused productive capacity of capital and labor will combine to limit underlying inflationary pressures for 2010 and 2011 at least.

Over the longer term, structural overcapacity in industry worldwide will continue to moderate inflationary pressures that will only gradually affect services when high levels of employment will be reached.
The gradual withdrawal of fiscal and monetary stimulation will provide ample margin for policy to constrain the revival of inflation over the medium to long term.

As the consumer prepares to rally business spending will recover sharply from the depths reached in early 2009. Industrial production, now down 13% year-on-year in the United States, will rapidly swing into positive territory as the end of the inventory drawdown of the last year will struggle to meet recovering demand.
Consumer and business sentiment indicators have already all turned up over the last few months heralding a solid signal that a considerable and sustainable rebound in demand in already under way.

Markets have saluted this with the strongest up move in decades and indeed while a correction would normally follow - to offer time for the economy to prove its mettle - such a correction may not materialize in any drastic fashion in the absence of any unforeseen major events such as those that afflicted the autumn of 2007 and 2008.

It is never possible to depart from the core uncertainty that lies at the heart of market mechanisms and psychology but a correction, when it occurs, could well remain relatively shallow and in any case temporary.

Anecdotal evidence of cash levels of institutional investors and conversations with decision makers strongly suggest that most missed the sizzling up move since March and may, as a result dampen the risk of a significant correction by taking advantage of dips and lulls in the bull market to enter the cyclical bandwagon.
Equity prices have recovered from distressed levels but the solid position of the private sector has not been structurally damaged and further gains in equity prices will move in tandem with improving earnings prospects.

The onset of any correction in markets will be generally taken as a tactical opportunity to enter or reinforce investors’ participation in what should prove a sustainable, if irregular, up move whose potential can deliver one of the most remarkable rides in post war history.

Antonio Ferreira
September 1st, 2009