Jed Brewer Quarterly Economic Forecast

October 1, 2009

Jed Brewer, economist and senior vice president of Finance & Resource Management Consultants, sounds a note of caution on early signs of recovery in the global economy.

Jed Brewer: expectations are tempered

France, Germany, and Japan experienced growth in their economies in the second quarter of 2009, a welcome change from the steep contractions in previous quarters. Many global major stock market indices are up year-to-date 10% or more and are well above their lows. The US will likely see mild economic growth in the third quarter of 2009. Furthermore, government fiscal interventions are beginning to show effects. Media reports tend to be more positive and consumer confidence is rising.

Indeed, the October 2009 Global Financial Stability Report released by the International Monetary Fund (IMF) begins its 238-page report with these words, “Systemic risks have been substantially reduced following unprecedented policy actions and nascent signs of improvement in the real economy. There is growing confidence that the global economy has turned the corner…”

On one hand, I am encouraged by the adjustments we are seeing in the global economy (those listed above and others). On the other hand, though, I am worried we may be too optimistic in the direction we believe we are headed now that we have “turned the corner.” We need to keep in mind that the global economy has just experienced the steepest contraction in the history of fairly reliable record keeping. While it is positive that we seem to be finding a bottom, the bottom we are finding is still pretty deep. It will take a year to two at minimum for the global economy to begin producing the same level of output it was producing before the global financial crisis began – ie just to get back to where we were.

In a couple of days the IMF will be releasing its estimate for global economic growth in 2010 (for all of next year). It will likely be somewhere around the 3% range. We need to be mindful that, while 3% growth is certainly better than a 2 or 3% contraction, it is still right on the threshold of being considered a global recession. Yes, things are looking better, but not that much better.

And this is assuming a still deteriorating private-sector in many parts of the world (eg Japan, UK, US) does not create further problems for global financial institutions. The IMF report appropriately states… “the risk of reintensification of the adverse feedback loop between the real and financial sectors remains significant as long as banks remain under strain and households and financial institutions need to reduce leverage.” With unemployment at extreme levels households will continue to reduce leverage and with further writedowns to come banks will too.

Global bank writedowns stemming from the crisis have amounted to $1.3 trillion through June 2009. It is estimated that an additional $1.5 trillion of assets will need to be written down by the end of 2010. US banks have recognised about 60% of their estimated writedowns. Euro Area and UK banks have only recognised about 40% of theirs. Banks will need to raise additional capital to offset these impending losses. US banks need to raise as much as $150 billion, UK banks $125 billion, and Euro Area banks $325 billion to maintain 4 % tangible common equity to total asset threshold ratios. In all three regions the amount of new capital needed amounts to between 1 and 1.5% of banks’ consolidated total assets. Can this capital infusion come from anywhere other than governments? Monetary authorities worldwide are asking themselves this same question and hoping an answer will present itself? I am skeptical.

With banks far from being out of trouble, it is no wonder why many of you may be finding credit difficult to come by even as credit tightening has moderated. And, for those that are able to easily get it, it may not be as cheap as you would expect. The chart below is an index of major economy real interest rates taken from the IMF report. While real short-term rates have moved down markedly since the end of 2007, due to global monetary easing, private borrowing rates remain high. The spread or gap between the two rates is at its highest since the financial crisis began. Higher spreads, while good for bank profits, hurt your and other businesses, weigh down economic activity, and limit growth in the near term.

So while in perspective I am encouraged that we may have “turned the corner,” my expectations for the next year remained tempered. Downside risks certainly outweigh upside ones and we cannot rule out the possibility of further economic contraction, especially as the financial sector confronts reality.

To date, global monetary authorities have responded truly quite admirably making difficult decisions amidst great uncertainty with little time to ponder all the implications. In the next couple of years we will discover the implications of those decisions and learn how to deal with them.

Dr. Jedidiah Brewer is vice president of FRMC, Inc.